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Learning Objectives financial enterprises manufacture products (e.g., cars, steel,
After reading this lesson, you will understand computers) and/or provide non-financial services (e.g.,
transportation, utilities, computer programming). Financial
• Significance and definition of financial system
enterprises, more popularly referred to as financial
• Importance Of Financial Institutions institutions, provide services related to one or more of the
• Role Of Financial Intermediaries following: let us see what are those.

• Financial System – Various Types Of Classification • Transforming financial assets acquired through the market
• Functions Of Financial Institution and constitution them into a different, and more widely

preferable, type of asset-which becomes their liability. This is
Dear students, today is our first lecture on Management of

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the function performed by financial intermediaries, the
Financial Institution. Before we get deep into the subject, the
most important type of financial institution.
primary basic thing for us to understand is the significance, role,
importance and function of financial institution. • Exchanging of financial assets on behalf of customers.
• Exchanging of financial assets for their own accounts.
What is the Significance and Definition of Financial

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• Assisting in the creation of financial assets for their
System? customers, and then selling those financial assets to other
We all know that the growth of output in any economy market participants.

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depends on the increase in the proportion of savings/
investment to a nation’s output of goods and services. So the
financial system and financial institutions help in the diversion
• Providing investment advice to other market participants.
• Managing the portfolios of other market participants.
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of rising current income into savings/investments. So now you are aware that financial intermediaries include
We can define financial system as a set of institutions, depository institutions (commercial banks, savings and loan
instruments and markets, which foster savings and channels associates, savings banks, and credit unions), which acquire the
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them to their most efficient use. The system consists of bulk of their funds by offering their liabilities to the public
individuals (savers), intermediaries, markets and users of mostly in the form of deposits: insurance companies (life and
savings. Economic activity and growth are greatly facilitated by property and casualty companies); pension funds; and finance
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the existence of a financial system developed in terms of the companies.

efficiency of the market in mobilising savings and allocating What are the Role of Financial Intermediaries?
them among competing users. Financial intermediaries obtain funds by issuing financial claims
Well-developed financial markets are required for creating a against themselves to market participants, and then investing
balanced financial system in which both financial markets and those funds; the investments made by financial intermediaries-

financial institutions play important roles. Deep and liquid their assets- can be in loans and/or securities. These
markets provide liquidity to meet any surge in demand for investments are referred to as direct investments. Market
liquidity in times of financial crisis. Such markets are also participants who hold the financial claims issued by financial
necessary to derive appropriate reference rates for pricing intermediaries are said to have made indirect investments.

financial assets. We can elaborate this further by understanding that financial

This lesson introduces the financial intermediary. Intermediaries institutions are business organisations that act as mobilisers
include commercial banks, savings and loan associations, and depositories of savings, and as purveyors of credit or
investment companies, insurance companies, and pension finance. They also provide various financial services to the
funds. The most important contribution of intermediaries is a community. They differ from non-financial (industrial and
steady and relatively inexpensive flow of funds from savers to commercial) business organisations in respect of their dealings,
final users or investors. Every modern economy has i.e., while the former deal in financial assets such as deposits,
intermediaries, which perform key financial functions for loans, securities, and so on, the latter deal in real assets such as
individuals, households, corporations, small and new machinery, equipment, stocks of goods, real estate, and so on.
businesses, and governments. You should not think that the distinction between the financial
What is the Importance of Financial Institutions? sector and the “real sector” is something ephemeral or
Now coming to the importance of Financial Institution that i.e. unproductive about finance. At the same time, it means that the
why is financial intermediaries so important in any country or role of financial sector should not be overemphasised. The
for that matter in any economy. The answer is simple. Business activities of different financial institutions may be either
entities include non-financial and financial enterprises. Non- specialised or they may overlap; quite often they overlap. Yet you

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11.621.6 1
need to classify financial institutions and this is done on the interlinked by the laws, contracts, covenants and

basis of their primary activity or the degree of their communication networks.

specialisation with relation to savers or borrowers with whom Financial markets are sometimes classified as primary (direct)
they customarily deal or the manner of their creation. In other and secondary (indirect) markets. You all must be well aware
words, the functional, geographic, sectoral scope of activity or that primary markets deal in the new financial claims or new
the types of ownership are some of the criteria, which are often securities and, therefore, they are also known as new issue
used to classify a large markets. On the other hand, secondary markets deal in securities
Financial System – Various Types of Classification already issued or existing or outstanding. The primary markets
We can classify financial institutions into banking and non- mobilise savings and supply fresh or additional capital to
banking institutions. You know that the banking institutions business units. Although secondary markets do not contribute
have quite a few things in common with the non-banking ones, directly to the supply of additional capital, they do so indirectly
but their distinguishing character lies in the fact that, unlike by rendering securities issued on the primary markets liquid.
other institutions, they participate in the economy’s payments Stock markets have both primary and secondary market

mechanism, i.e., they provide transactions services, their deposit segments.
liabilities constitute a major part of the national money supply, Very often financial markets are classified as money markets
and they can, as a whole, create deposits or credit, which is and capital markets, although there is no essential difference

money. Banks, subject to legal reserve requirements, can advance between the two as both perform the same function of

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credit by creating claims against themselves, while other transferring resources to the producers. This conventional
institutions can lend only out of resources put at their disposal distinction is based on the differences in the period of maturity
by the savers, and the latter as mere “purveyors” of credit. of financial assets issued in these markets. While money
While the banking system in India comprises the commercial markets deal in the short-term claims (with a period of maturity

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banks and co-operative banks, the examples of non-banking of one year or less), capital markets do so in the long-term
financial institutions are Life Insurance Corporation (LIC), Unit (maturity period above one year) claims. Contrary to popular
Trust of India (UTI), and Industrial Development Bank of usage, the capital market is not only co-extensive with the stock

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India (IDBI). We shall discuss this in detail later.
There are also few other ways to classify financial institution.
market; but it is also much wider than the stock market.
Similarly, it is not always possible to include a given participant
in either of the two (money and capital) markets alone.
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Like they can be classified as intermediaries and non-
Commercial banks, for example, belong to both. While treasury
intermediaries. As we have seen earlier, intermediaries
bills market, call money market, and commercial bills market are
intermediate between savers and investors; they lend money as
examples of money market; stock market and government
well as mobilise savings; their liabilities are towards the ultimate
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bonds market are examples of capital market.

savers, while their assets are from the investors or borrowers.
Non--intermediary institutions do the loan business but their The above classification can be tabulated in the table format as
resources are not directly obtained from the savers. All banking given below:
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institutions are intermediaries. Many non-banking institutions Table 1

also act as intermediaries and when they do so they are known
as Non-Banking Financial Intermediaries (NBFI). UTI, Classification by nature of claim:
Debt Market
LIC, General Insurance Corporation (GIC) is some of the Equity Market
NBFIs in India. Non-intermediary institutions like IDBI,

Classification by maturity of claim:

Industrial Finance Corporation (IFC), and National Bank for Money Market
Capital Market
Agriculture and Rural Development (NABARD) have come Classification by seasoning of claim :
into existence because of governmental efforts to provide Primary Market
Secondary Market
assistance for specific purposes, sectors, and regions. Their

Classification by immediate delivery or future delivery:

creation as a matter of policy has been motivated by the Cash or spot Market
Derivative Market
philosophy that the credit needs of certain borrowers might not Classification by organizational structure:
be otherwise adequately met by the usual private institutions. Auction Market
Over -the-counter Market
Since they have been set up by the government, we can call them Intermediated Market

Non-Banking Statutory Financial Organisations (NBSFO).

Let us now shift our focus to financial markets. Financial
markets are the centers or arrangements that provide facilities What are the points of difference related to financial
for buying and selling of financial claims and services. The instruments? These instruments differ from each other in
corporations, financial institutions, individuals and respect of their investment characteristics, which of course, are
governments trade in financial products in these markets either interdependent and interrelated. Among the investment
directly or through brokers and dealers on organised exchanges characteristics of financial assets or financial products, the
or off--exchanges. The participants on the demand and supply following are important: (i) liquidity, (ii) marketability, (iii)
sides of these markets are financial institutions, agents, brokers, reversibility, (iv) transferability, (v) transactions costs, (vi) risk of
dealers, borrowers, lenders, savers, and others who are default or the degree of capital and income uncertainty, and a
wide array of other risks, (vii) maturity period, (viii) tax status,

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2 11.621.6
(ix) options such as call-back or buy-back option, (x) volatility


of prices, and (xi) the rate of return-nominal, effective, and real.
What are the Functions of Financial Institution?
After a detailed discussion on financial institution it becomes
easy for us to determine the functions of financial institution.
Financial institutions or intermediaries offer various types of
transformation services. They issue claims to their customers
that have characteristics different from those of their own
assets. For example, banks accept deposits as liability and
convert them into assets such as loans. This is known as
“liability-asset transformation” function. Similarly they
choose and manage portfolios whose risk and return they alter
by applying resources to acquire better information and to

reduce or overcome transaction costs. They are able to do so
through economies of scale in lending and borrowing. They
provide large volumes of finance on the basis of small deposits

or unit capital. This is called “size-transformation” function.

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Further, they distribute risk through diversification and thereby
reduce it for savers as in the case of mutual funds. This is called
“risk-transformation” function. Finally they offer savers
alternate forms of deposits according to their liquidity
preferences, and provide borrowers with loans of requisite

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maturities. This is known as “maturity-transformation”

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A financial system also ensures that transactions are effected
safely and swiftly on an on-going basis. It is important that
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both buyers and sellers of goods and services should have the
confidence that instruments used to make payments will be
accepted and honoured by all parties. The financial system
ensures the efficient functioning of the payment mechanism.
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In a nutshell, financial markets can be said to perform

proximate functions such as
1. Enabling economic units to exercise their time preference,
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2. Separation, distribution, diversification, and reduction of

3. Efficient operation of the payment mechanism,
4. Transmutation or transformation of financial claims so as to

suit the preferences of both savers and borrowers,

5. Enhancing liquidity of financial claims through securities
trading, and

6. Portfolio management.
Questions to Discuss
1. What is the Significance And Definition of Financial System?
2. What is the Importance Of Financial Institutions?
3. What is the Role Of Financial Intermediaries?
4. What are the various classifications of Financial Institutions?
5. What are the functions of Financial Institutions?

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11.621.6 3


Learning Objectives This economic function of financial intermediaries-

After reading this lesson, you will understand transforming more risky assets into less risky ones- is called
diversification. Although individual investors can do it on their
• Maturity Intermediation
own, they may not be able to do it as cost-effectively as a
• Reducing Risk Via Diversification financial intermediary, depending on the amount of funds they
• Reducing The Costs Of Contracting And Information have to invest. Attaining cost-effective diversification in order to
Processing deduce risk by purchasing the financial assets of a financial

• Providing A Payments Mechanism intermediary is an important economic benefit for financial
• Asset/ Liability Management Of The Financial Institutions
Reducing the Costs of Contracting and Information

• Nature Of Liabilities

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• Liquidity Concerns Processing
• Brokerage and asset transformation
You can also reduce the cost of contracting and information
processing. Suppose you are an investor purchasing financial
• Advantages of financial institutions
assets. You should take the time to develop skills necessary to
• Criteria To Evaluate Financial Institutions understand how to evaluate an investment. Once these skills are

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After getting aware of the characteristics of financial institution, developed you should apply them to the analysis of specific
let us understand some other related concepts. financial assets that are candidates for purchase (or subsequent

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What do you Mean by Maturity Intermediation?
The commercial bank by issuing its own financial claims in
sale). If you as an investor wants to make a loan to a consumer
or business you will need to write the loan contract.
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essence transforms a longer-term asset into a shorter-term one Although there are some people who enjoy devoting leisure
by giving the borrower a loan for the length of time sought and time to their task, most prefer to use that time for just that-
the investor/depositor a financial asset for the desired leisure. Most of us find that leisure time is in short supply, so
investment horizon. This function of a financial intermediary is to sacrifice it, we have to be compensated; the form of
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called maturity intermediation. compensation could be a higher return that we obtain from an
You should understand that maturity intermediation has two
implications for financial markets. First, it provides investors In addition to the opportunity cost of the time to process the
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with more choices concerning maturity for their investments; information about the financial asset and its issuer, there is the
borrowers have more choices for the length of their debt cost of acquiring that information. All these costs are called
obligations. Second, because investors are naturally reluctant to information processing costs. The costs of writing loan
commit funds for a long period of time, they will require that contracts are referred to as contracts are referred to as contracting
long-term borrowers pay a higher interest rate than on short- costs. There is also another dimension to contracting costs, the

term borrowing. A financial intermediary is willing to make cost of enforcing the terms of the loan agreement.
longer-term loans, and at a lower cost to the borrower than an With this in mind, consider the two examples of financial
individual investor would, by counting on successive deposits intermediaries- the commercial bank and the investment
providing the funds until maturity. Thus, the second company. People who work for these intermediaries include

implication is that the cost of longer-term borrowing is likely to investment professionals who are trained to analyse financial
be reduced. assets and manage them. In the case of loan agreements, either
standardised contracts can be prepared, or legal counsel can be
What is Reducing Risk Via Diversification?
part of the professional staff that writes contracts involving
Next shall discuss the way to reduce the risk through
more complex transactions. The investment professional can
diversification. Consider the example of the investor who places
monitor compliance with the terms of the loan agreement and
funds in an investment company. Suppose that the investment
take any necessary action to protect the interests of the financial
company invests the funds received in the stock of a large
intermediary. The employment of such professionals is cost-
number of companies. By doing so, the investment company
effective for financial intermediaries because investing funds is
has diversified and reduced its risk. Investors who have a small
their normal business.
sum to invest would find it difficult to achieve the same degree
of diversification because they do not have sufficient funds to In other words, there are economies of scale in contracting and
buy shares of a large number of companies. Yet by investing in processing information about financial assets because of the
the investment company for the same sum of money, investors amount of funds managed by financial intermediaries. The
can accomplish this diversification, thereby reducing risk. lower costs accrue to the benefit of the investor who purchases

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4 11.621.6
a financial claim of the financial intermediary and to the issuers investment company that agrees to repurchase shares at any


of financial assets, who benefit from a lower borrowing cost. time.
Providing a Payments Mechanism Nature of Liabilities
You have seen that most transactions made today are not done By the liabilities of the financial institution we mean the
with cash. Instead, payments are made using cheques, credit amount and timing of the cash outlays that must be made to
cards, and electronic transfers of funds. These methods for satisfy the contractual terms of the obligations issued. The
making payments are provided by certain financial liabilities of any financial institution can be categorized
intermediaries. according to four typed as shown in the below table. The
At one time, non-cash payments were restricted to cheques categorisation in the table assumes that the entity that must be
written against non-interest-bearing accounts at commercial paid the obligation will not cancel the financial institution’s
banks. Similar check writing privileges were provided later by obligation prior to any actual or projected payout date.
savings and loan associations and saving banks, and by certain The descriptions of cash outlays as either known or uncertain
types of investment companies. Payment by credit card was also are undoubtedly broad. When you refer to a cash outlay as

one time the exclusive domain of commercial banks, but now being uncertain, you do not mean that it cannot be predicted.
other depository institutions offer this service. Debit cards are There are some liabilities where the “law of large numbers”
offered by various financial intermediaries. I am sure all of us makes it easier to predict the timing and/or amount of cash

present over here must be having at least one debit card apart outlays. This is the work typically done by actuaries, but of

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from credit cards. And you all must also be aware that a debit course even actuaries cannot predict natural catastrophes such as
card differs from a credit card in that, in the latter case, a bill is floods and earthquakes.
sent to the credit card holder periodically (usually once a month) Table 2
requesting payment for transactions made in the past. In the

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case of a debit card, funds are immediately withdrawn (that is, Nature of Liabilities of Financial Institutions

debited) from the purchaser’s account at the time the transaction Liability type Amount of Cash Outlay Timing of Cash Outlay

takes place

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The ability to make payments without the use of cash is critical
for the functioning of a financial market. In short, depository
Type I
Type II
Type III
Type IV
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institutions transform assets that cannot be used to make
payments into other assets that offer that property.
Let us illustrate each one of them
Asset/ Liability Management of the Financial
Type I Liabilities
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Institutions Both the amount and the timing of the liabilities are known
To understand the reasons mangers of financial institutions with certainty. A liability requiring a financial institution to pay
invest in particular types of financial assets and the types of Rs.50, 000 six months from now would be an example. For
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investment strategies they employ, it is necessary that you have a example, depository institutions know the amount that they are
general understanding of the asset/ liability problem faced. committed to pay (principal plus interest) on the maturity date
The nature of the liabilities dictates the investment strategy a of a fixed-rate deposit, assuming that the depositor does not
financial institution will pursue. For example, depository withdraw funds prior to the maturity date.
institutions seek to generate income by the spread between the

Type I Liabilities
return that they earn on assets and the cost of their funds. That
however, are not limited to depository institutions. A major
is, they buy money and sell money. They buy money by
product sold by life insurance companies is a guaranteed
borrowing from depositors or other sources of funds. They sell
investment contract, popularly referred to as a GIC. The
money when they lend it to businesses or individuals. In

obligation of the life insurance company under this contract is

essence, they are spread businesses. Their objective is to sell
that, for a sum of money (called a premium), it will guarantee
money for more than it costs to buy money. The cost of the
an interest rate up to some specifies maturity date. For example,
funds and the return on the funds sold is expressed in terms of
suppose a life insurance company for a premium of Rs.10
an interest rate per unit of time. Consequently, the objective of
million issues a five-year GIC agreement to pay 10%
a depository institution is to earn a positive spread between the
compounded annually. The life insurance company knows that
assets it invests in (what it has sold the money for) and the
it must pay Rs16.11 million to the GIC policyholder in five
costs of its funds (what it has purchased the money for).
Life insurance companies- and, to a certain extent, property and
casualty insurance companies- are in a spread business. Pension Type II Liabilities
funds are not in the spread business in that they do not raise The amount of cash outlay is known, but the timing of the
funds themselves in the market. They seek to cover the cost of cash outlay is uncertain. The most obvious example of a Type
pension obligations at a minimum cost that is borne by the II liability is a life insurance policy. There are many types of life
sponsor of the pension plan. Investment companies face no insurance policies but the most basic type is that, for an annual
explicit costs for the funds they acquire and must satisfy no premium, a life insurance company agrees to make a specified
specific liability obligations; one exception is a particular type of

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11.621.6 5
dollar payment to policy beneficiaries upon the death of the certain types of investment companies, it means not being able

insured. to find new buyers for shares.

Type III Liabilities Brokerage and Asset Transformation
With this type of liability, the timing of the cash outlay is Now let us move ahead to discuss the services. Intermediary
known, but the amount is uncertain. An example is where a services are of two kinds, brokerage function and asset
financial institution has issued an obligation in which the transformation activity. Brokerage function as represented by
interest rate adjusts periodically according to some interest rate the activities of brokers and market operators, processing and
benchmark. Depository institutions, for example, issue supplying information is a part and parcel of all intermediation
accounts called certificates of deposit, which have a stated by all institutions. Brokerage function brings together lenders
maturity, the interest rate paid need not be fixed over the life of and borrowers and reduces market imperfections such as search,
he deposit but may fluctuate. If a depository institution issues information and transaction costs. The asset transformation
a three-year floating-rate certificate of deposit that adjusts every activity is provided by institutions issuing claims against
three months and the interest rate paid is the three-month themselves, which differ, from the assets they acquire. Mutual

Treasury bill rate plus one percentage point, the depository funds, insurance companies, banks and depositors with a share
institution knows it has a liability that must be paid off in three of a large asset or issuing debt type liabilities against equity type
years, but the dollar amount of the liability is not known. It assets. While providing asset transformation, financial firms

will depend on three-month Treasury bill rates over the three differ in the nature of transformation undertaken and in the

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years. nature of protection or guarantees, which are offered. Banks
Type IV Liabilities and depository institutions offer liquidity, insurance against
There are numerous insurance products and pension contingent losses to assets and mutual funds against loss in
obligations that present uncertainty as to both the amount and value of assets.

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the timing of the cash outlay. Probably the most obvious Through their intermediary activities banks provide a package of
examples are automobile and home insurance policies issued by information and risk sharing services to their customers. While
doing so they take on part of heir risk. Banks have to manage

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property and casualty insurance companies. When, and if, a
payment will have to be made to the policyholder is uncertain.
Whenever damage is done to an insured asset, the amount of
the risks through appropriate structuring of their activities and
hedge risks through derivative contracts to maximize their
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the payment that must be made is uncertain. profitability.
What are the Liquidity Concerns? Financial institutions provide three transformation services.
By liquidity concerns what do you understand? Because of the Firstly, liability, asset and size transformation consisting of
mobilization of funds and their allocation (provision of large
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uncertainty about the timing and/ or the amount of the cash

outlays, a financial institution must be prepared to have loans on the basis of numerous small deposits). Secondly,
sufficient cash to satisfy its obligations. Here it has been maturity transformation by offering the savers the relatively
assumed that the entity that holds the obligation against the short- term claim or liquid deposit they prefer and providing
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financial institution may have the right to change the nature of borrowers long-term loans which are better matched to the cash
the obligation, perhaps incurring some penalty. For example, in flows generated by their investment. Finally, risk transformation
the case of a certificate of deposit, you as a depositor may by transforming and reducing the risk involved in direct lending
request the withdrawal of funds prior to the maturity date; by acquiring more diversified portfolios than individual savers
can. The expansion of the financial network or an increase in

typically, the deposit-accepting institution will grant this request

but assess an early withdrawal penalty. In the case of certain financial intermediation as denoted by the ration of financial
types of investment companies, shareholders have the right to assets of all kinds of gross national product accompanies
redeem their shares at any time. growth. To a certain extent, growth of savings is facilitated by
the increase in the range of financial instruments and expansion

Some life insurance products have a cash-surrender value. This

of markets.
means that, at specified dated, the policyholder can exchange the
policy for a lump-sum payment. Typically, the lump-sum Finally What are the Advantages of Financial
payment will penalize the policyholder for turning in the policy. Institutions?
There are some life insurance products that have a loan value, After discussing the financial institution now tell me students
which means that the policyholder has the right to borrow that is there any advantage of financial institution at all. I am
against the cash value of the policy. sure you all will have the same answer YES. Benefits provided
In addition to uncertainty about the timing and amount of the by financial intermediaries consist of reduction of information
cash outlays, and the potential for the depositor of policyholder and transaction costs, grant long-term loans, and provide liquid
to withdraw cash early or borrow against a policy, a financial claims and pool risks. Financial intermediaries economise costs
institution has to be concerned with possible reduction in cash of borrowers and lenders. Banks are set up to mobilize savings
inflows. In the case of a depository institution, this means the of many small depositors, which are insured. While lending,
inability to obtain deposits. For insurance companies, it means the bank makes a single expert investigation of the credit
reduced premiums because of the cancellation of policies. For standing of the borrower saving on several investigations of

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6 11.621.6
Financial intermediaries make it possible for borrowers to • Financial reforms are not merely a question of “credit


obtain long-term loans even though the ultimate lenders are limits”; they encompass issues involved in “limits of credit”.
making only short-term loans. Borrowers who wish to acquire • State intervention is not the best way to achieve a fair
fixed assets do not want to finance them with short-term loans. distribution of credit.
Although the bank has used depositors funds to make long-
• Financial institutions must evolve from below rather than be
term loans it still promises its depositors that they can
imposed from above. Financial development ought to take
withdraw their deposits at any time on the assumption that the
place at a slow and steady pace rather than in spurts and in a
law of large numbers will hold. Bank deposits are highly liquid
programmed or (time) encapsulated manner.
and one can withdraw the deposit any time, though on some
kinds of deposits the interest previously earned on it has to be • There should be a replacement of large-scale by small-scale,
foregone. Finally, banks by pooling the funds of depositors wholesale by retail, and class by mass banking.
reduce the riskness of lending. Indirect finance in some reduces • The sufficing principle rather than the maximising one
the information and transaction costs of lenders and should power the financial system. The functioning of
different financial institutions must be on the basis of a

borrowers, renders deposits liquid and reduces the risk of
lending. communitarian spirit, not competition and profit motive.
The ability of the financial intermediaries to ensure the most • The financing of investment which results in the

efficient transformation of mobilized funds into real capital has displacement or retrenchment of labour should be

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not, however, received the attention it deserves. Institutional discouraged.
mechanisms to ensure end use of funds have not been efficient • The scope for financing various sectors is ultimately
in their functioning, leaving the investor unprotected. Efficient constrained by domestic saving. The substantial increase in
financial intermediation involves reduction of the transaction the total saving in India is unlikely to take place now.
cost of transferring funds from original sabers to financial

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• The working of the Indian financial system should not be
investors. The total coat of intermediation is influenced by
financial layering, which makes the individual institution’s costs

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additive in the total cost of intermediating between savers and
ultimate borrowers. The aggregate cost of financial
intermediation from the original saver to ultimate investor is
• There are limits to the overall and industrial growth, and,
therefore, a “ceiling” on the targeted rate of growth has to be
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much higher in developing countries than in developed • The only legitimate role of the financial markets is
countries. infrastructural, hence they should not exist to provide
opportunities to make quick, disproportionate pecuniary
Criteria to Evaluate Financial Institutions
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Given the controversy regarding the contribution of financial
sector, it is necessary to have a framework to evaluate the • It is the primary markets activity of supporting new,
performance of the country’s financial sector. Let us first look at economically and socially productive real investment, trade,
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the criteria formulated, in the form of questions, by Richard D. and flows of goods and services, which is of foremost
Erb, the former Deputy Managing Director of the International importance. The enthusiasm, hyperactivity, and
Monetary Fund: (i) Do institutions find the most productive preoccupation with the secondary markets ought to be
investments? (ii) Do institutions revalue their assets and avoided.
liabilities in response to changed circumstances? (iii) Do Summary

investors and financial institutions expect to be bailed out of Financial institutions provide various types of financial services.
mistakes and at what price? (iv) Do institutions facilitate the Financial intermediaries are a special group of financial
management of risk by making available the means to insure, institutions that obtain funds by issuing claims to market
hedge, and diversify risks? (v) Do institutions effectively participants and use these funds to purchase financial assets.

monitor the performance of their users, and discipline those Intermediaries transform funds they acquire into assets that are
not making proper and effective use of their resources? (vi) more attractive to the public. By doing so, financial
How effective is the legal, regulatory, supervisory, and judicial intermediaries do one or more of the following: (1) provide
structure? (vii) Do financial institutions publish consistent and maturity intermediation; (2) provide risk reduction via
transparent information? diversification at lower cost; (3) reduce the cost of contracting
These criteria, useful as they are, do not encompass social and and information processing; or (4) provide a payments
ethical aspects of finance which ought to be regarded as mechanism.
important as economic aspects. Therefore, the relevant The nature of their liabilities determines the investment strategy
normative criteria, organising principles, and value premises pursued by all financial institutions. The liabilities of all
which should guide the functioning of the financial system are: financial institution will generally fall into one of the four types
• Finance is not the most critical factor in development. shown in Table 2.
• The use of finance must be imbued with the virtues of
austerity, self--limit, and minimisation.

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11.621.6 7
We shall discuss the classifications, roles, functions and

advantages of the financial institutions in detail in our later

Questions to Discuss:
1. What do you mean by Maturity Intermediation?
2. What is Reducing Risk Via Diversification?
3. What is the nature Of Liabilities?
4. What are the Liquidity Concerns?
5. What are the Advantages of financial institutions?
6. What are the criteria To Evaluate Financial Institutions?

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8 11.621.6

Learning objectives human and physical capital are its important sources and any
After reading this lesson, you will understand increase in them requires higher saving and investment, which
the financial system helps to achieve. Second, the financial
• Effects of financial system on saving and investment
system contributes to growth not only via technical progress
• Relationship between financial system and economic but also in its own right. Economic development greatly
development depends on the rate of capital formation. The relationship
• A cautionary approach- between capital and output is strong, direct, and monotonic

• The process of financial development (the position which is sometimes referred to as “capital
fundamentalism”). Now, the capital formation depends on
• Criteria to evaluate financial sector
whether finance is made available in time, in adequate quantity,

Students, today in the class let us discuss the correlation of and on favourable terms-all of which a good financial system

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financial system and the economic development. The role of achieves. Third, it also enlarges markets over space and time; it
financial system in economic development has been a much- enhances the efficiency of the function of medium of exchange
discussed topic among economists. Is it possible to influence and thereby helps in economic development.
the level of national income, employment, standard of living,
We can conclude from the above that in order to understand the
and social welfare through variations in the supply of finance?

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importance of the financial system in economic development,
In what way financial development is affected by economic
we need to know its impact on the saving and investment
processes. The following theories have analyzed this impact: (a)

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There is no unanimity of views on such questions. A recent
literature survey concluded that the existing theory on this
subject has not given any generally accepted model to describe
The Classical Prior Saving Theory, (b) Credit Creation or Forced
Saving or Inflationary Financing Theory, (c) Financial Repression
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Theory, (d) Financial Liberalisation Theory.
the relationship between finance and economic development.
The Prior Saving Theory regards saving as a prerequisite of
The importance of finance in development depends upon the
investment, and stresses the need for policies to mobilise saving
desired nature of development. In the environment-friendly,
voluntarily for investment and growth. The financial system has
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appropriate-technology-based, decentralised Alternative

both the scale and structure effect on saving and investment. It
Development Model, finance is not a factor of crucial
increases the rate of growth (volume) of saving and
importance. But even in a conventional model of modem
investment, and makes their composition, allocation, and
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industrialism, the perceptions in this regard vary a great deal.

utilisation more optimal and efficient. It activises saving or
One view holds that finance is not important at all. The
reduces idle saving; it also reduces unfructified investment and
opposite view regards it to be very important. The third school
the cost of transferring saving to investment.
takes a cautionary view. It may be pointed out that there is a
considerable weight of thinking and evidence in favour of the How is this achieved? In any economy, in a given period of

third view also. Let us briefly explain these viewpoints one by time, there are some people whose current expenditures is less
one. than their current incomes, while there are others whose current
expenditures exceed their current incomes. In well-known
In his model of economic growth, Solow has argued that
terminology, the former are called the ultimate savers or
growth results predominantly from technical progress, which is
surplus--spending-units, and the latter are called the ultimate

exogenous, and not from the increase in labour and capital.

investors or the deficit-spending-units.
Therefore, money and finance and the policies about them
cannot contribute to the growth process. Modern economies are characterized (a) by the ever-expanding
nature of business organisations such as joint-stock companies
You All Tell Me What are your Opinions Regarding or corporations, (b) by the ever-increasing scale of production,
this? (c) by the separation of savers and investors, and (d) by the
differences in the attitudes of savers (cautious, conservative, and
Effects of Financial System on Saving and Investment
usually averse to taking risks) and investors (dynamic and risk-
It has been argued that men, materials, and money are crucial
takers). In these conditions, which Samuelson calls the
inputs in production activities. The human capital and physical
dichotomy of saving and investment, it is necessary to connect
capital can be bought and developed with money. In a sense,
the savers with the investors. Otherwise, savings would be
therefore, money, credit, and finance are the lifeblood of the
wasted or hoarded for want of investment opportunities, and
economic system. Given the real resources and suitable
investment plans will have to be abandoned for want of
attitudes, a well--developed financial system can contribute
savings. The function of a financial system is to establish a
significantly to the acceleration of economic development
bridge between the savers and investors and thereby help the
through three routes. First, technical progress is endogenous;
mobilisation of savings to enable the fructification of

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11.621.6 9
investment ideas into realities. Figure below reflects this role of providing insurance services and hedging opportunities, and by

the financial system in economic development. making financial services such as remittance, discounting,
acceptance and guarantees available. Finally, it not only
Relationship Between Financial System and
encourages greater investment but also raises the level of
Economic Development resource allocational efficiency among different investment
channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business
units or borrowers through more systematic and expert project
appraisal, feasibility studies, monitoring, and by generally
Economic Development
keeping a watch over the execution and management of
The contribution of a financial system to growth goes beyond
increasing prior-saving-based investment. There are two strands

of thought in this regard. According to the first one, as
Savings & Investment or
Capital Formation emphasized by Kalecki and Schumpeter, financial system plays a
positive and catalytic role by creating and providing finance or

credit in anticipation of savings. This, to a certain extent,

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ensures the independence of investment from saving in a given
Surplus Spending Deficit Spending period of time. The investment financed through created credit
Economic Units Economic Units generates the appropriate level of income. This in turn leads to
an amount of savings, which is equal to the investment already
undertaken. The First Five Year Plan in India echoed this view

rd. F
Income Minus Income Minus when it stated that judicious credit creation in production and
(Consumption + (Consumption + availability of genuine savings has also a part to play in the
Own investment)

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process of economic development. It is assumed here that the
investment out of created credit results in prompt income
generation. Otherwise, there will be sustained inflation rather
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Surplus or Saving Deficit or Negative
Saving than sustained growth.
The second strand of thought propounded by Keynes and
Tobin argues that investment, and not saving, is the constraint
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Financial System on growth, and that investment determines saving and not the
other way round. The monetary expansion and the repressive
policies result in a number of saving and growth promoting
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forces: (a) if resources are unemployed, they increase aggregate

demand, output, and saving; (b) if resources are fully
employed, they generate inflation which lowers the real rate of
A financial system helps to increase output by moving the
return on financial investments. This in turn, induces portfolio
economic system towards the existing production frontier. This
shifts in such a manner that wealth holders now invest more in
is done by transforming a given total amount of wealth into

real, physical capital, thereby increasing output and saving; (c)

more productive forms. It induces people to hold less savings
inflation changes income distribution in favour of profit
in the form of precious metals, real estate land, consumer
earners (who have a high propensity to save) rather than wage
durables, and currency, and to replace these assets by bonds,
earners (who have a low propensity to save), and thereby
shares, units, etc. It also directly helps to increase the volume

increases saving; and (d) inflation imposes tax on real money

and rate of saving by supplying diversified portfolio of such
balances and thereby transfers resources to the government for
financial instruments, and by offering an array of inducements
financing investment.
and choices to woo the prospective saver. The growth of
“banking habit” helps to activise saving and undertake fresh The extent of contribution of the financial sector to saving,
saving. The saving is said to be “institution-elastic” i.e., easy investment, and growth is said to depend upon its being free or
access, nearness, better return, and other favourable features repressed (regulated). One school of thought argues that
offered by a well-developed financial system lead to increased financial repression and the low/ negative real interest rates
saving. which go along with it encourage people (i) to hold their saving
in unproductive real assets, (ii) to be rent -seekers because of
A financial system helps to increase the volume of investment
non-market allocation of investible funds, (iii) to be indulgent
also. It becomes possible for the deficit spending units to
which lowers the rate of saving, (iv) to misallocate resources and
undertake more investment because it would enable them to
attain inefficient investment profile, and (v) to promote capital-
command more capital. As Schumpeter has said, without the
intensive industrial structure inconsistent with the
transfer of purchasing power to an entrepreneur, he cannot
factor-endowment of developing countries. Financial
become the entrepreneur. Further, it encourages investment
liberalisation or deregulation corrects these ill effects and leads to
activity by reducing the cost of finance and risk. This is done by

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10 11.621.6
financial as well as economic development. However, as Second, it has been pointed out that the roles of capital


indicated earlier, some economists believe that financial formation and finance in development have been unduly or
repression is beneficial. The most recent thinking on this subject disproportionately stressed; that capital shortage is not the
says that the empirical foundations of financial liberalisation are single most important barrier to development. Empirically, it
not robust enough, and that mild, moderate, small repression has been very often found that the rate of capital formation
is more growth promoting than either large-scale repression or increased without raising the growth rate; and the relation
complete laissez-faire. between capital and growth has been one of correlation rather
than causation. It is estimated that in industrialized countries,
capital accumulation could account for at most one--fourth of
the rate of economic growth in the 19th and 20th centuries.
Increase in capital without suitable social, economic, political
conditions cannot cause growth; and, on the other hand,
favourable developments in the conditions just mentioned can

achieve much growth with minimum of capital. The
conventional thinking has always stressed the need for
substitution of capital for other factors but the scope and

possibilities for this kind of substitution, particularly in the

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light of factor endowments, have never been really explored.
For growth, much additional capital, and, therefore, much
finance, is not always required; through depreciation allowances,
better composition of capital, appropriate technology, and
higher productivity, a lot of growth can be achieved. The

rd. F
methodology used for estimating the financial resource
requirements (incremental capital-output ratio) is also riddled

iza D with many valuations, measurement, and other problems.

The thrust and message of the above analysis are clearly
expressed in the following statements:
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• Real growth cannot be bought with money alone (Chandler).
• By and large, it seems to be the case that where enterprise
leads, finance follows (Joan Robinson). Societies in which
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Financial Sector and Economic Development: a other conditions of growth were favourable were usually
capable of devising adequate financial institutions
Cautionary Approach
Many economists have taken a cautionary view of the role of
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financial markets in development. The capital market • The role of finance in development is a subsidiary one
enthusiasm and optimism implicit in certain theories of (Newlyn).
finance, viz., Capital Asset Pricing Model and Efficient Market The Process of Financial Development
Hypothesis with their multiple unrealistic, restrictive How does financial development occur? Is it influenced by

assumptions, have been questioned in different ways. economic development? Does the former always precede the
First, it has been argued that the financial sector can perform the latter? The literature talks about “supply leading” and “demand
developmental role if it functions efficiently, but in practice, it is following” financial development. Under the former, financial
not efficient. Tobin’s analysis in this respect is highly instructive. development occurs first and stimulates economic growth.

With logic and examples, he has explained how the prices in Under the latter, as trade, commerce and industry expand, the
financial markets rarely reflect intrinsic values; how very little of financial institutions, instruments, and services needed by them
the work done by the securities industry has to do with also expand as a matter of response. The financial development
financing real investment; how the allocation of funds by is said to be “active” in the first case, and “passive” in the
financial markets is hardly optimal; and that the services of second one.
financial system do not come cheap. According to him, financial Such a characterisation of the process of financial development
system serves us all right. But its functioning does not merit is not very apt. It is difficult to establish precisely the sequence
complacency. Financial activities generate high private reward of real and financial sector developments; the cause and effect
disproportionate to their social productivity. The ‘casino effect’ relationship between them is difficult to disentangle. It will be
of financial markets cannot be forgotten. The speculation in more correct to say that their growths are intertwined,
financial markets is a negative-sum game for the general public. symbiotic, and mutually reinforcing. While financial markets
More recently, through the application of chaos and fractal accelerate development, they, in turn, grow with economic
analyses to financial markets, it has been shown that they are development. In the words of Schumpeter, “the money market
characterized by asymmetry, turbulence, discontinuity, is always the headquarters of the capitalist system, from which
stampedes, non-periodicity, and inefficiency. orders go out to its individual divisions, and that which is

© Copy Right: Rai University

11.621.6 11
debated and decided there is always in essence the settlement of corporate-sector-centric. (k) There are limits to the overall and

plans for further development. All kinds of credit requirements industrial growth, and, therefore, a “ceiling” on the targeted rate
come to this market; all kinds of economic project are first of growth has to be imposed. (l) The only legitimate role of
brought into relation with each other and contend for their the financial markets is infrastructural, hence they should not
realization in it; all kinds of purchasing power flows to it to be exist to provide opportunities to make quick, disproportionate
sold. This gives rise to a number of arbitrage operations and pecuniary gains. (m) It is the primary markets activity of
intermediate manoeuvres, which may easily veil the supporting new, economically and socially productive real
fundamental thing. Thus, the main function of the money or investment, trade, and flows of goods and services, which is of
capital market is trading in credit for the purpose of financial foremost importance. The enthusiasm, hyperactivity, and
development. Development creates and nourishes this market. preoccupation with the secondary markets ought to be avoided.
In the course of development, it becomes the market for
Questions to Discuss:
sources of income themselves.”
1. What are the effects of Financial System on saving and
Criteria To Evaluate Financial Sector Investment?

At the end of the discussion let us evaluate financial sector
2. Discuss the relationship Between Financial System and
critically. Given the controversy regarding the contribution of
Economic Development?
financial sector, it is necessary to have a framework to evaluate

the performance of the country’s financial sector. Let us first 3. Discuss a cautionary approach on Financial Sector and

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look at the criteria formulated, in the form of questions, by Economic Development?
Richard D. Erb, the former Deputy Managing Director of the 4. What are the criteria To Evaluate Financial Sector?
International Monetary Fund: (i) Do institutions find the most Notes:
productive investments? (ii) Do institutions revalue their assets
and liabilities in response to changed circumstances? (iii) Do

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investors and financial institutions expect to be bailed out of
mistakes and at what price? (iv) Do institutions facilitate the

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management of risk by making available the means to insure,
hedge, and diversify risks? (v) Do institutions effectively
monitor the performance of their users, and discipline those
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not making proper and effective use of their resources? (vi)
How effective is the legal, regulatory, supervisory, and judicial
structure? (vii) Do financial institutions publish consistent and
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transparent information?
These criteria, useful as they are, do not encompass social and
ethical aspects of finance, which ought to be regarded as
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important as economic aspects. Therefore, the relevant

normative criteria, organizing principles, and value premises
which should guide the functioning of the financial system are:
(a) Finance is not the most critical factor in development. (b)
The use of finance must be imbued with the virtues of

austerity, self--limit, and minimization. (c) Financial reforms are

not merely a question of “credit limits”; they encompass issues
involved in “limits of credit”. (d) State intervention is not the
best way to achieve a fair distribution of credit. (e) Financial

institutions must evolve from below rather than be imposed

from above. Financial development ought to take place at a
slow and steady pace rather than in spurts and in a programmed
or (time) encapsulated manner. (f) There should be a
replacement of large-scale by small-scale, wholesale by retail, and
class by mass banking. (g) The sufficing principle rather than the
maximising one should power the financial system. The
functioning of different financial institutions must be on the
basis of a communitarian spirit, not competition and profit
motive. (h) The financing of investment, which results in the
displacement or retrenchment of labour, should be
discouraged. (i) The scope for financing various sectors is
ultimately constrained by domestic saving. The substantial
increase in the total saving in India is unlikely to take place now.
(j) The working of the Indian financial system should not be

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12 11.621.6

Learning objectives Allocational Efficiency

After reading this lesson, you will understand When financial markets channelise resources into those
investment projects and other uses where marginal efficiency of
• Financial development: some concepts
capital adjusted for risk differences is the highest, they are said to
• Reforms model for economic growth have achieved allocational efficiency.
Today we shall discuss some important concepts most
frequently used in financial world..
Financial innovation can be variously defined as the

Financial Development: Some Concepts introduction of a new financial instrument or service or practice,
In this section we discuss a few concepts, which describe the or introducing new uses for funds, or finding out new sources
phenomenon of change and development in a financial system.

of funds, or introducing new processes or techniques to handle

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All these concepts are closely inter-related, and at present they are day-to-day operations, or establishing a new organisation-all
widely referred to in the discussions on financial markets. these changes being on the part of existing financial
Efficiency institutions. In addition, the emergence and spectacular growth
What do you mean by efficiency? The ultimate focus of the of new financial institutions and markets is also a part of
efficiency in financial markets is on the nonwastefulness of financial innovation. The word “new” here means not only the

rd. F
factor use and the allocation of factors to the socially most coming into being of what did not exist till then but also the
productive purposes. The following five concepts are useful in new way of using existing instruments, practices, technology,

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judging the efficiency of a financial system.
Information Arbitrage Efficiency
and so on. Similarly, the use or adoption of an already existing
financial instrument, by financial institution(s), which
previously did not do, so is also regarded as an innovation. The
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This is the degree of gain possible by the use of commonly marked transformation in the roles of financial institutions and
available information. If one can make large gains by using the departure from the conventional notions regarding their
commonly available information, financial markets are said to functions also constitute financial innovation. As per one
be inefficient. Thus, the efficiency is inversely related to this type definition, financial innovations are “unforecastable
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of gain. Under conditions of perfect market, the possibilities of improvements” in the array of available financial products and
such a gain are nil because the prices in such a market already processes.
reflect fully and immediately all relevant and ascertainable
Financial innovations bring about wide ranging changes as well
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available information, and no one would know anything that is

as effects in the financial system. They lead to the broadening,
not already known and therefore not reflected in market prices.
deepening, diversification, structural transformation,
Fundamental Valuation Efficiency internationalization and sophistication of the financial system.
When the market price of a security is equal to its intrinsic value They result in the financialisation of the economy whereby
or investment value, the market is said to be efficient. The financial assets to total assets ratio tends to increase. This

intrinsic value of an asset is the present value of the future financialisation may occur with the growth of
stream of cash flows associated with the investment in that institutionalisation or intermediation and securitisation
asset, when the cash flows are discounted at an appropriate rate simultaneously, or it may occur with the growth of one at the
of discount. This again would happen when markets are cost of other.

perfectly competitive. The process of financial innovation has been characterised

Full Insurance Efficiency differently by different authors. These innovations are regarded
This indicates the extent of hedging against possible future as responses to regulatory and tax regimes, financial constraints,
contingencies. The greater the possibilities of hedging and and so on. The literature on the subject suggests the following
reducing risk, the higher the market efficiency. groups of factors as being responsible for financial innovations:
(i) tax asymmetries that can be exploited to produce tax savings;
Functional or Operational Efficiency
(ii) transaction costs; (iii) agency costs; (iv) opportunities to
The market which minimizes administrative and transaction
reduce or reallocate risk; (v) opportunities to increase asset-
costs, and which provides maximum convenience (or minimum
liquidity; (vi) regulatory or legislative change; (vii) level and
inconvenience) to borrowers and lenders while performing the
volatility of interest rates and prices; and (viii) technological
function of transmission of resources, and yet provides a fair
return to financial intermediaries for their services, is said to be
operationally or functionally efficient.

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11.621.6 13
Financial Engineering intermediaries may occur when they are subject to interest rate

This is perhaps the latest terminological addition to the world ceilings while the open market rates of return are rising.
of finance, which, incidentally, is a new example of the invasion The terms securitisation and disintermediation are often used
of social thinking by technology. After innovations, industrial interchangeably. Although these terms are very closely related,
engineering and social engineering, we now have financial one should be careful in using them interchangeably. A decline
engineering. It basically means financial innovations; the two in the share of only a particular type of financial intermediary,
terms have often been used interchangeably. The dictionary say commercial banks, does not necessarily mean
meanings of innovation and engineering perhaps give a clue to disintermediation. Similarly, securitisation in the second sense
the possible difference between financial innovations and does not involve disintermediation.
financial engineering. To innovate means to introduce new
methods, new ideas, and make changes. To engineer means to Broad, Wide, Deep and Shallow Markets
arrange, contrive, to bring about artfully or skilfully. All these are closely related terms. The broad and wide financial
market attracts funds in greater volume and from all types of
Financial engineering thus connotes development of new
national and international investors. In such a market, financial

financial technology to cope with financial changes. It involves
institutions offer, even globally, 24-hour sales and trading
construction, designing, deconstruction, and implementation
capability in debt and equity instruments. The deep market is
of innovative financial institutions, processes, and instruments.
one where there are always sufficient orders for buying and

It means the formulation of creative solutions to problems in
selling at fine quotations both below and above the market

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finance. The development and use of skills, means, techniques,
price, and where there are good opportunities for swap deals. A
tools for changing and managing cash flows and investment
swap deal is a medium-term or long-term arrangement between
features of financial instruments form a part of financial
two parties in which each party commits to service the debt of
engineering. In today’s highly volatile markets, it seeks to limit
the other. In other words, a swap is the exchange of future
financial risk by creating financial instruments for hedging,

rd. F
streams of payment between two or more parties. The shallow
speculation, arbitraging, and by fine-tuning portfolio
market, on the other hand, means an underdeveloped market,
adjustments. It also seeks to maximise profits quickly. The
its underdevelopment being the result of financial repression

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creation of financial derivatives and securitisation are its two
examples. Computer power and human insight are combined
to spot arbitrage opportunities, measure risk, and to react to
or administered finance.
Financial Repression
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news very fast in financial engineering. It represents economic conditions in which the government’s
regulatory and discretionary policies distort financial prices or
Financial Revolution interest rates (i.e., the real interest rates are kept low or negative),
Some people believe that a veritable financial revolution has discourage saving, reduce investment, and misallocate financial
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taken place in the world of finance in the recent past. The resources. The government-directed credit program, and direct
concept of financial revolution is an extension of the concepts rather than indirect credit controls predominate in a repressed
of financial innovations and engineering. It is meant to convey system. As indicated above, it is also known as the system of
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that, of late, the magnitude, speed, and spread of changes in administered interest rates and finance.
the financial sector the world over has been simply tremendous,
prodigious, phenomenal; that it has undergone a “future Financial Reforms, Financial Liberalisation, and
shock”. It indicates that life in the world of finance is no longer Deregulation
easy and that financial markets now work 24 hours a day. The Financial reforms involve instituting policies, which will increase

innovations in computers and satellite communications, and the allocative efficiency of available saving, promote the growth
the linking up of the two have completely changed the of real sector, and enhance the health, stability, profitability, and
production, marketing, and delivery of financial products. And viability of the financial institutions. In theory, they need not
as with every revolution, not all changes have been for the best, necessarily increase the market -orientation of the system, but in

and there have been unexpected consequences. practice at present, they have come to mean greater market
Diversification orientation. Therefore, liberalisation, deregulation, and reforms
In one sense, diversification means the existence or the mean the same thing currently. They refer to the policy of
development of a very wide variety of financial institutions, reducing or removing completely the legal restrictions, physical
markets, instruments, services, and practices in the financial or administrative or direct controls, ceilings on interest rates,
system. In another but related sense, it refers to the presence of restrictions on the flow of funds, official directives regarding
opportunities for investors to purchase a large mix or portfolio sectoral and other allocations of funds, restrictions on the scope
of varieties of financial instruments. With the diversified of activities of banks and other financial institutions, and so
portfolio, investors can minimise the risk for a given rate of on, which exist under the administered finance. It is obvious
return, or they can maximise the return for a given risk. that liberalisation is the process in which the intervention or
interference of the government in financial markets is reduced
and the markets are allowed, as far as possible, to function on
It refers to the phenomenon of decline in the share of financial
the basis of free market or competitive principles.
intermediaries in the aggregate financial assets in an economy
because people “switch out of’ their liabilities into direct
securities in the open market. Such a flow of funds out of these

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14 11.621.6
Privatisation Securitisation


It is regarded as a necessary part of financial reforms. It means The term “securitisation” is used in financial literature in two
increasing the ownership, management, and control of the senses. First, it means the faster growth of direct (primary)
financial sector by individuals and private incorporated and financial markets and financial instruments than that of
unincorporated bodies. This may be achieved partly by financial intermediaries. In other words, it refers to the growing
denationalisation, disinvestments by the state, allowing private ability and practice of firms to tap the bond, commercial paper,
sector entry, and abstaining from new ownership by the state. and share markets as alternatives to institutional financing.
Second, it refers to the process by which the existing assets of
Prudential Regulation
the lending financial institutions are “sold” or “removed” from
This is another major element of financial sector reforms. It
their balance sheets through their funding by other investors. In
means regulation without suppression, and supervision and
this process, investors are sold securities, which evidence their
control without constriction. It implies that the authorities have
interest in the underlying assets without recourse to the original
not abdicated the role of and responsibility for evolving a
lender. The redemption of these securities does not become the
healthy, strong, sound, safe, stable, and viable financial system.

obligation of the original lender. The payments to the investors
It aims to impart greater transparency and accountability in
are made to the extent of cash flows realised from the
operation, and to restore credibility and confidence in the
underlying assets. What happens is that a number of assets of
financial system. It relates to income recognition, assets

a given lender having similar characteristics are pooled together,
classification, provisioning for bad and doubtful debts, and

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and undivided interests in this pool are sold in the form of
capital adequacy. The prudential regulation is the policy of the
what are called Pass Through Certificates (PTC). The tenor
State with regard to macro and micro prudential concerns.
(maturity) of the PTC generally matches the average maturity of
1ntegration the pooled assets. The cash flows from the underlying assets are
It refers to the establishment of close connections or effective passed through, after retaining management fees, to the holders

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linkages between different constituents or parts, and between of PTC in the form of periodic (monthly) payments of interest
different sub-parts of the financial system. As a result, there are and principal. The redemption of securities is made only to the

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substantial flows of funds between them, and there is a greater
correspondence between interest rates in different parts of the
financial system. Financial integration is the opposite of the
extend of the cash flows realised from the underlying assets.
The securitisation essentially involves the “collateralised
financing” rather than the “sale of assets”. The ever-increasing
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maturitywise, geographical, institutional, seasonal, instrumental, resource requirements and the desire to maintain high levels of
segmentation or partitioning or compartmentalisation of the disbursements while keeping the overall size of assets within
financial markets. certain limits have led financial institutions to innovate in the
form of securitisation. The deal between ICICI and Citibank to
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Internationalisation and Globalisation

These terms indicate the extension of activities of a financial securitise ICICI’s Sellers Line of Credit Bills of Exchange, had
system beyond the national boundaries. The extension may marked the first securitisation deal in India.
take place in the form of borrowing as well as lending, and it
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Indian Financial Markets and Banking System-

may take place through official or private or commercial channel.
Reforms Model for Economic Growth
In the process of internationalisation, the domestic financial
Cross-country evidence suggests that economic growth is
institutions participate in foreign financial markets, and the
positively related to financial development. Recent economic
foreign institutions participate in domestic markets to a
research studies by leading global investment bankers indicate

significant extent. In other words, the domestic and foreign

that, over the next few decades, the growth generated by the
financial markets get integrated and interlinked, and the supply
large developing countries, particularly the BRICs (Brazil,
and demand curves of funds assume a different character.
Russia, India and China) could become a much larger force in
When globalisation occurs, financial instruments may be
the world economy than it is now. For India, the multi-
denominated in several currencies, and there would be a

dimensional reforms model adopted for our financial sector a

convergence of interest rates in different national markets,
decade ago is now bringing in a robust picture of the financial
because interest rate changes originating in one financial centre
system and our economy.
would be quickly transmitted to other centres.
The pre-reforms phase of pre-emption of resources and micro-
Sometimes, a distinction is made between internationalisation
management by Government, interest rate regulation, “a licence
and globalisation. While the former term is used to indicate the
Raj” and a closed economy gave way to a unique reforms model
absence of regulation or control of any national authority on
with multiple dimensions for all-round development of the
financial markets, the latter is said to refer to the establishment
financial sector. The financial sector reforms followed the
of interlinkages among national markets as a result of the
traditional “pancha sutra” approach of cautious and proper
progressive liberalisation and the removal of exchange controls.
sequencing; mutually reinforcing measures; complementarity
This distinction is not really convincing; it is based on the
between reforms in the banking sector and changes in fiscal,
ideology-induced narrowing down of the meaning of the term
external and monetary policies; developing financial
infrastructure; and developing financial markets.
The reforms have covered key segments of the Indian financial
markets: capital markets, the money and Government securities

© Copy Right: Rai University

11.621.6 15
markets and the forex markets. With prudential strengthening developing unique credit risk models for risk-rating and pricing

of the banking system coupled with real sector reforms, there and real-time credit monitoring. The risk management
has been a gradual transformation of the Indian economy. framework for market risk using internal models is being
The capital markets have demonstrated improved market developed by Indian banks. Use of derivatives for market risk
efficiency and transparency. The institutionalisation of SEBI, management is on the increase. Banks are now moving towards
the incorporation of NSE, the enactment of Depositories Act, the Basel II framework for capital allocation and risk
screen-based trading, entry of FIIs and mutual funds, access to management. Banks are actively considering measures to contain
international capital markets through ADRs, GDRs, FCCBs etc. impact of operational risks to manageable limits.
have all contributed to this transformation. Inspite of the The challenges for the banks in the times to come would be to
Monday mayhem on our bourses following the election results, counter increased competition, meeting the demanding
the following week’s figures indicated that there were net standards of customers, stepping up of income and to move
inflows through the FII route. Our systems for managing towards becoming “one-stop financial hyper-markets”. The key
market volatility in the Stock Exchanges also clicked into place as for this would be in technological advances, going in for risk-

was evident with the “circuit breakers” for sudden market bundling and rebundling through new financial products,
swings getting into operation. sound risk management architecture and enhancing share-
The money markets have now gradually become a conduit for holder value.

providing an equilibrating mechanism for evening out short- Our reforms model would dynamically incorporate measures

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term surpluses and deficits in the financial system. Measures are for risk management, adequate capital allocation, sound
being taken to have a pure inter- bank call/ notice money regulatory and supervisory practices. These would provide
market. Collateralised borrowing and lending obligation necessary conditions for a long-term growth path towards our
(CBLO) has been operationalised as a money market country becoming one of the largest economies.

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instrument through the Clearing Corporation of India Ltd.
The ultimate goal of the financial system is to accelerate the rate
The G-sec market has seen significant liquidity and depth post-

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1990. The initial reforms of moving to an auction based system
for issuing Government debt, terminating the system of
of economic development. While financial markets may
accelerate development, they themselves, in turn, develop with
economic development. The relationship between economic
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automatic monetisation of fiscal deficit were complementary to development and financial development is thus symbiotic.
interest rate deregulation in the banking sector. Primary Dealers Efficient financial markets are characterised by the absence of
were institutionalized. FIIs were allowed to invest in G- information-based gain, by correct evaluation of assets, by
securities and T-bills in primary and secondary markets subject maximisation of convenience and minimisation of transactions
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to certain ceilings. Other measures included issuance of uniform costs, and by maximisation of marginal efficiency of capital. In
accounting norms for repo and reverse repo transactions, facility reality, the contribution of the financial system to growth is
for anonymous screen-based order-driven trading system for G- highly constrained because it does not work efficiently and
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secs on stock exchanges, introduction of exchange-traded capital is not the most important barrier to growth. The role of
interest rate derivatives on the National Stock Exchange (NSE), finance in development is believed to be secondary by many
relaxation in regulation relating to sale of securities by experts. A framework to evaluate the working of any financial
permitting sale against an existing purchase contract, facilitating sector must include economic, commercial as well as social and
the roll over of repos and switch over to the DVP III mode of ethical criteria. Financial innovations refer to wide-ranging

settlement. Market Stabilisation Scheme (MSS) has been changes in the financial system. The introduction of new
introduced to differentiate the liquidity absorption of a more financial institutions, markets, instruments, services,
enduring nature by way of sterilisation from the day-to-day technology, organisation, and so on are parts of financial
normal liquidity management operations. innovations. Financial engineering connotes skilful

Our Forex policies are in line with global best practices. Forex development and use of new financial technology, creative
reserves of over $118 billion are now a buffer for crisis solutions, and tools to cope with financial changes. It involves
prevention, providing confidence to the markets and protection construction, designing, deconstruction of innovative financial
against exchange rate volatility. Substantial delegation of powers instruments, institutions and processes to reduce risk and to
to the banking system in the area of international trade, maximise profits quickly. Financial revolution means that the
remittances, borrowings and investments has helped bring magnitude, speed, and spread of changes in the financial sector
about greater openness and reassured the global market players are simply phenomenal. The markets, which attract funds in
of our inherent strengths. large volume and from all types of investors, are known as
The impact of reforms on the banking industry has been broad financial markets. The markets, which provide
substantial. There has been an increase in operational efficiency opportunities for sufficient orders at fine rates below and above
and profitability. NPA levels are coming down. There is greater the market price, are called deep financial markets. Markets that
use of technology for transaction processing and information are underdeveloped due to governmental regulations and
management using computer and communication devices. Our controls are termed as shallow financial markets. Financial
banks have now a greater awareness of credit risk management. repression exists when the regulatory policies of the
Further progress on this front would have to be taken up by government distort interest rates, discourage saving, reduce

© Copy Right: Rai University

16 11.621.6
investment, and misallocate resources. Financial reforms or


liberalisation aim at creating a market-oriented, competitive
financial system by removing physical, administrative, and direct
controls. Financial integration refers to the establishment of
close and effective interlinkages between various parts and sub-
parts of the financial system so that interest rates differentials in
the system are minimised. Securitisation refers to a fast growth
of direct (primary) financial instruments, and to a collateralized
financing through the “sale” of existing assets of financial
institutions. Disintermediation refers to the “switch out of’ the
liabilities of financial intermediaries by the investors.
Internationalisation or globalisation of financial markets occurs
when national and foreign markets become integrated.

Questions to Discuss:
1. What do you mean by efficiency? Discuss five concepts are
useful in judging the efficiency of a financial system.

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2. What do you understand by innovations, privatization and
3. Discuss the Indian Financial Markets & Banking System-
Reforms Model for Economic Growth.

rd. F

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w.p m
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11.621.6 17


Learning Objective government, collected revenue on behalf of the government,

After reading this lesson, you will understand managed the transfer of funds from one centre to another, and
some of them had the monopoly as mint-masters and money
• Evaluation of various constituents of Indian Financial
changers. In later years, their direct contacts with the
system prior to 1950.
government as financiers declined. They continue to perform
• Evaluation of currency and money supply other functions, albeit in a declining proportion. The financial
The Indian financial system has covered a long journey. It has instrument they have popularised is hundi. A notable feature

and always will hold an important position in our economy. Let of this institution is that it functions with a personal touch that
us understand how? is often lacking in a modern banking system.
Currency and Money Supply Structure and Growth of Modern Banks

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Currency and exchange form an essential part of any financial You know that the growth of the modern banking business in
system. Prior to Independence, the Indian currency had not India was negligible till the beginning of the present century.
been standardised. For about 60 years till 1893, it had remained During the second half of the 18th century, agency houses used
on the silver standard and subsequently on the gold exchange to perform banking business as an adjunct to their main
standard. During this period (with the exception of the war business. The foundation of modern banking was laid during

rd. F
years), even though gold could be procured through import the early part of the nineteenth century with the establishment
without any restrictions, the system did not fulfill the other of three Presidency Banks, namely the Bank of Bengal (1806),

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essential requirements of the gold standard. First, gold coins
were not very much in circulation. Second, the currency authority
did not accept the responsibility of selling gold without limit. It
Bank of Bombay (1840), and the Bank of Madras (1846).
During the second half of the 19th century, some exchange
banks and Indian joint stock banks also were set up. In 1900,
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had acquired legally the option of offering gold or sterling there were nine Indian joint-stock banks, eight exchange banks,
against rupees. As sterling was on the gold standard, the rupee and three Presidency Banks. In the total private deposits of Rs
can be said to have been on the gold exchange standard. With 3146 lakh in 1900, the shares of each of these types of banks
the abandonment of the gold standard by England in were respectively 25.68 per cent, 33.38 per cent and 40.94 per
w.p m

September 1931, the sterling exchange standard came to be cent. The slow rate of growth of the banking business till the
established in India. beginning of the present century was due to (a) a high rate of
Paper currency has been used in India since the beginning of the failure of banks, because most of them had been created in a
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19th century. Currency notes were issued by the commercial speculative rush; (b) stagnant economic conditions during this
banks and their use was extremely limited. In 1861, the period; (c) a decline in prices; and (d) the passing of the
government acquired the monopoly of issuing notes. An idea Currency Act, 1861 which took away the power of banks to
of the progress of monetisation can be obtained from the issue notes.
volume of notes issued and their circulation. While the volume During the first half of the present century, the banking system

increased from Rs 11 crore in 1874 to Rs 1199 crore in 1948, the progressed rapidly. The deposits in banks increased from Rs 82
circulation increased from Rs 10 crore to Rs 1188 crore during crore in 1910 to Rs 957 crore in 1948. Except during the
the same period. If we take the total money supply (currency depression of the 1930s, the rate of economic progress was
and demand deposits), it increased from Rs 285 crore in 1935 quite high in this period. The World Wars contributed to raising

and to Rs 384 crore in 1939, and to Rs 2052 crore in 1945. the level of economic activity and the monetary resources in the
Thereafter, it declined to Rs 1970 crore in 1948, and to Rs 1833 economy. In 1921, the three Presidency Banks were
crore in 1950.3 Thus the major increase in the volume of amalgamated to form the Imperial Bank of India (IBI).
money in India occurred during the Second World War. Although the IBI functioned as a quasi-central bank, the money
Currency constituted a major portion of the money supply. The market was without a proper central bank until 1935 when the
percentage of currency to total money supply increased from Reserve Bank of India (RBI) was established. After the
57.22 per cent in 1935 to 65.61 per cent in 1950 and 66.68 per establishment of the RBI, the IBI used to act as the agent of
cent in 1952. the RBI in places where the RBI did not have any offices of its
Banking Sector own. Similarly, even after 1935, the IBI continued to act as a
The two most important constituents of the money market in banker for other banks (to a very limited extent). It used to
India are the modern banks and the indigenous bankers. discount hundis and grant demand loans against government
Modern banking became an effective force only after 1910. securities. All these functions are now performed by the State
Before that the indigenous bankers dominated the scene. Until Bank of India (SBI), and the special position of SBI in the
1860, they financed trade, acted as bankers to the company banking system today stems from these historical antecedents.

© Copy Right: Rai University

18 11.621.6
Around 1950, the banking system in India comprised the RBI, Banking Portfolios


IBI, cooperative banks, exchange banks, and Indian joint-stock Comparable data on the liabilities and assets of various groups
banks. Indian joint-stock banks were divided into four classes, of banks over a sufficiently long period of time is not available
according to the amount of paid-up capital and reserves held by to evaluate in precise terms the trends in portfolio management.
them. Class A had Rs 5 lakh and over; Class B (Rs 1 lakh and The preferences of different categories of banks in respect of
over but less than Rs 5 lakh); Class C (Rs 50,000 and over but various items in the portfolio were not similar. For example,
less than 1 lakh); and Class D (less than Rs 50,000). After the class Al banks used to invest less in government securities than
creation of the RBI, banks were divided into scheduled and did the IBI. Consequently, the credit/deposit ratio of the
non-scheduled banks. Class A banks, which became scheduled former used to be usually higher than that of the latter. Subject
banks were known as Class A1 banks; while others came to be to these limitations, certain broad features of portfolio
known as Class A2 banks. The relative importance of different behaviour in the banking system are discussed below. The
types of banks in 1950 is indicated in Table1. analysis is based mainly on certain important banking ratios of
the IBI.

Table 1 Structure of Commercial Banking in 1950
Category of Banks No. of Banks Deposits
Deposits are the mainstay of any bank. The proportion of
1 All banks 1205
(Rs lakh)
fixed deposits with the banks appears to have declined
(8) (1251) significantly over the period 1921-1950. Before the First World

2 Commercial banks 605 100217
(8) (1249) War, fixed deposits of the five big banks were as high as 70 per

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3 Indian joint-stock banks 584 82770
(5) (1197) cent or more, of the total deposits. Later there was a decline in
4. Imperial Bank 1
this ratio. It was around 60 to 65 per cent till 1925, 45 percent in
5. (a) Class A 1 banks
(b) Class A2 banks
1935, and 32 per cent in 1950. The most common maturity
(c) Class B banks
(d) Class C banks
period of fixed deposits then was one year. The major factors
(e) Class D banks 124 131 behind this marked decline in fixed deposits were: (a) inflation

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6. Exchange banks 15 17039
(3) (52) during the war years; (b) competition from post office savings
accounts and life insurance companies; (c) growing opportunity

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Note: Figures in brackets relate to the year 1870.
Source: RBI, Banking and Monetary Statistics in India, Bombay,
and increasing preference for investment in industrial securities;
and (d) decline in interest rates on fixed deposits.
Table 2 presents some important banking ratios over the period
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1954. 1921-1950. It will be observed that generally the credit/deposit
Although the number of commercial banks in 1950 was small, ratio was pretty low. The most popular form of bank credit was
they accounted for 77 per cent of deposits of the entire banking cash credit/ overdraft, followed by loans. The practice of bill
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system. The share of Indian joint-stock banks, and the Imperial financing declined sharply over this period. Except at the end of
Bank in total deposits was 63.46 per cent and 13.06 per cent the Second World War, the call money market was not active.
respectively. During 1910-50, Indian joint stock banks expanded Inactivity of bill and call markets meant that various
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rapidly at the expense of both the IBI and the exchange banks. constituents of the organised money market were very loosely
Within the joint-stock banking sector, scheduled banks linked and virtually functioned in isolation. As a result, the
accounted for 63 per cent of deposits in that sector. Within the money market was characterised by sharp imbalances between
class Al banks, the top 5 to 7 banks’ accounted for the major the supply and demand for funds, both regionally and
portion of deposits. On the basis of the available evidence, the seasonally. The spread of interest rates between regions and

following conclusions emerge with respect to the banking seasons, therefore, varied sharply. As expected, unless compelled
system in India. (a) There was a high degree of concentration by circumstances, banks did not invest heavily in government
in-the banking business. The top seven6 joint-stock banks and securities. In 1935 and 1945, the ratios of investment in
the ill I accounted for most of the banking business. (b) The government securities were high for different reasons. In 1935,

degree of concentration increased till 1935 and declined the lack of alternative investment opportunities due to a slack in
thereafter. (c) The smaller banks were responsible for providing business must have led banks to utilise funds for holding
banking facilities in about two-thirds of the places on the government securities. In 1945, the compulsions of war finance
banking map of India. It was these banks that mobilised. must have forced them to invest in government securities. As
savings from sources which the big banks would not tap, and it soon as the war was over, the ratio declined significantly.
was they that catered to the financial needs of such borrowers From the other available information, it would appear that
who would have been shunned by the big banks. Thus, there was a tendency to invest more in short--term government
qualitatively, the services of smaller banks were of much securities (less than five years maturity) than in long-term
importance. (Bank of India, Central Bank of India, Allahabad securities. While the share of the former increased from 21 per
Bank, Punjab National Bank, Bank of Baroda, Bank of Mysore, cent in 1945 to 29 per cent in 1950, that of the latter declined
and Indian Bank of Madras) from 31 per cent to 17 per cent during the same years. The
banks did not invest in industrial securities to any significant
extent. The ratio of their investment in industrial securities to
total investments was around 4 per cent in 1949 and 1950.

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11.621.6 19
A study of the sectoral distribution of advances shows that the

shares in 1948 of commerce, industry, and agriculture were

about 46 per cent, 31 per cent, and 2 per cent respectively. The
major part of advances to the commercial sector was given to
wholesale trade (46 per cent). About 86 per cent of bank
advances were on a secured basis.

Table 2 Some Banking Ratios of the Imperial Bank of India (1921 to 1950) (Percentage)
Ratio 1921 1935 1939 1945 1950
1. Credit/Deposit 60.65 33.67 42.58 26.40 43.09
(50.95)* (55.93) (40.82) (51.22)
2. Loans/total advances 36.22 23.99 25.05 28.50 93.79
3. Cash credits overdrafts/ Total advances 43.70 66.31 63.77 64.42 -
4. Bills discounted and purchased/total
20.07 9.70 11.18 7.00 6.21
5. Total advances/tota1 assets 53.98 21.16 37.25 25.00 39.97
(43.48) (46.28) (34.14) (39.77)

6. Government Securities/ Total assets 13.05 47.18 44.72 56.02 38.80
(34.33)* (32.19) (43.0) (31.0)
7. Money at call/tota1 advances 0.63 0.56 0.52 8.58 2.98
Notes: (i) Figures in brackets are for Class A1 banks.

(ii)* Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India, Bombay, 1954.

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(i) Figures in brackets are for Class A1 banks.

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(ii) Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India,
Bombay, 1954.
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An important aspect of the growth of commercial banking,
which serves as an indicator of the progress of the banking
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habit, volume of transactions, and the velocity of deposits i.e.,
the number of times each deposit is used to settle transactions
in a given period of time is the volume of cheque clearances. By
1947, there were 29 clearing houses in the country of which
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those at Bombay, Calcutta, Delhi, Kanpur, Madras were the

major ones. The volume of cheques (in terms of amount)
cleared at the clearing houses increased from Rs 212 crore in
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1900 to Rs 2185 crore in 1939, and to Rs 6461 crore in 1947. The

number of cheques cleared increased from 153 lakh in 1939 to
246 lakh in 1947.
Questions to Discuss:

What do you understand by money supply?

Discuss the structure and growth of modern banks.

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20 11.621.6

Learning Objective
After reading this lesson, you will understand Table Growth of Cooperative Banking (1916 to 1950) (Amount in Rs Lakh)

• Evaluation of banking system Land

State Cooperative Central Cooperative Primary Agricultural
Item Mortgage
• Evaluation of insurance Funds Banks Banks Societies

• Evaluation of stock funds 1916 1935 1950 1916 1935 1950 1916 1935 1950 1938 1950
1. Number 6 11 14 239 615 498 14509 76045 116534 202 288
• Evaluation of Government securities

2. Total Working 77 1163 3045 323 2940 4987 375 2492 3522 411 1273
Let us evaluate some of the securities in today’s lecture. We shall 3.
Loans and
56 573 1625 220 1713 2397 40 185 393 375 1159
discuss them in brief here and later on have a detailed held from

discussion on each of the banks. 4. Loans due '58 498 1412 288 2040 2892 402 2342 2496 370 1046

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Commercial Banks
Commercial banks provided mainly short-term credit to the
industrial sector. Further, they provided credits mainly to the
large-scale units. Thus, before 1950 there were two important 1. Data on primary agricultural credit societies separately was
gaps in the field of industrial finance-the lack of supply of not available for the years 1935, but was available for the year

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long-term funds to all industrial units, and the lack of supply 1950. Assuming the ratio in 1950 to be applicable for other
of any form of capital to small-scale industrial units. Attempts years, the figures have been calculated for those years.

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were made to bridge these gaps by setting up certain industrial
banks in the private sector. In 1923, there were about eight
industrial banks, of which four were liquidated by 1935. In the
2. Loans and deposits in case of primary agricultural credit
societies are from both members and non members.
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3. Data on land mortgage banks is for both primary and central
intervening period, other banks came up with the result that land mortgage banks.
there were about seven such banks working in 1936-37. These
Source: RBI, Banking and Monetary Statistics of India,
banks used to accept some deposits from the public. The
Bombay, 1954.
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volume of their operations was quite limited. The lack of

institutional arrangements to supply adequate long-term Small Savings
industrial finance remained, till the beginning of the planning Small savings have been one of the oldest media for
community savings. In India, with its huge population and
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period, a persistent and important gap in the financial structure

in India. varying low income levels of different groups of people, the
importance of this method was recognised by the company
Co-operative Banks government. It encouraged wage earners, small and medium
Apart from the inadequate supply of long-term finance to farmers, and the middle class to save through government-run
industry, another serious gap in the financial system in India savings banks. These banks were attached either to the

that persisted till the end of the period under discussion was Presidency Banks or district treasuries, or post offices. The Post
the inadequate supply of short--term as well as long-term Office Savings Banks (POSB) took over the savings bank
funds to the agricultural sector. In order to supplant money business of district treasuries in 1886, and that of Presidency
lenders and indigenous bankers, efforts were being made since Banks in 1896. Thus by 1896, the POSBs had monopolised the

the second decade of the present century to organise co- small savings business.
operative credit institutions. In the forty years since their
inception, cooperative banks made very little progress in Apart from the POSB deposits, the Postal Department did not
absolute terms; their progress was particularly negligible in offer any other financial asset to the, investors till 1915.
relation to the demand for funds in the agricultural sector. The Subsequently, it offered various certificates of different
setting up of the RBI in 1935 and its efforts to channelise more maturities at different periods of time. The Government also
funds to this sector did help the cooperative movement, but introduced, between April 1941 and April 1947, the Post Office
not to the desired extent. The total working capital, deposits Defence Saving Deposits. Among these assets, deposits
from individuals, and loans due to state, central, and primary remained, during the entire period under discussion, the major
cooperative banks were, in 1950, only Rs 115 crore, Rs 44 crore financial asset issued by small savings organisations. In
and Rs 68 crore, respectively. In the same year Land Mortgage comparison with the period after 1950, the diversity in schemes
Banks (LMBs) had working capital, deposits, and loans of Rs offered was very limited.
13 crore, Rs 12 crore, and Rs 10 crore, respectively. The POSB deposit receipts increased from Rs 366 lakh in 1896
to Rs 9875 lakh in 1950. The outstanding deposits in these two
years were Rs 904 lakh, and Rs 16,866 lakh. The amount of

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11.621.6 21
outstanding certificates increased from Rs 57 lakh in 1939 to Rs sanctioned, but not for the actual capital issues. The per year

2,8211akh in 1950. Thus, the total volume of small savings was average amount of capital issues applied for and sanctioned
Rs 17,687 1akh in 1950. The number of small savings banks during 1945 to 1952, was Rs 193 crore and Rs 141 crore
had increased from 6,343 to 9,256 between 1896 and 1950. respectively. Understandably, there were marked ups and downs
in the new issue activity. The three years following each of. the
Insurance Funds
two World Wars were characterised by an unusually high
The life insurance business in India began on sound lines with
amount of capital issues. The annual average amount of capital
the enactment of the Indian Life Insurance Companies Act,
issues was Rs 183 crore during 1918 to 1920; while during 1945-
1912. It was carried on by Indian and foreign life insurance
47 this figure was Rs 255 crore. In both cases, the boom was
companies, provident societies, and the Post and Telegraph
followed by a steep fall in capital issues in the subsequent 4-5
department. In addition, certain provinces transacted insurance
years. As expected, during the depression years, there was a
business for their own employees. Indian and foreign
marked slack in the new issue activity.
companies conducted general insurance business also for
emergencies such as fire, marine and miscellaneous. A major proportion of capital was raised by the issuance of

ordinary shares. In contrast with the period after 1960,
Over time, the volume of general insurance business declined
debentures were not very popular in India during the period
relatively to that of life insurance. As far as the business of life
before 1950. It has been pointed out by Muranjan that the
insurance is concerned, the foreign companies’ share in it

unpopularity of debentures was due to the following reasons-
declined significantly, and Indian companies’ share increased. Of

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unfamiliarity of the general public with this form of
the total premium of all life insurance companies, the latter’s
investment, the preference of rich classes for speculative scrips,
share was 50 per cent in 1928 and 83 per cent in 1950. The
heavy stamp duties on purchases and transfers of debentures,
volume of business of provident societies, and of the Post and
and the avoidance of debentures by insurance and other
Telegraph department has always been negligible.
financial institutions with large investible resources.

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The size and growth of the insurance business in India is
The security prices also reflect the tenor of the working of stock
shown in Table below.
markets. The available data on index numbers of security prices

1. Life insurance business in force
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Table Insurance Funds in India in 1928, 1948 and 1950 (Rs lakh)
1928 1948 1950
for the period 1927 to 1949 help us to draw some important
conclusions. First, unlike the later period, prices of government
securities and fixed-yield industrial securities showed marked
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(a) Number of companies 70 275 244
(b) Sum insured 13502 73505 82545
(c) Premium Income 670 3607 4150 fluctuations. The index number of government security prices
2. Non-Life Insurance
(a) Number of companies 128 157 174 varied in the range of 82 to123. It should, however, be noted
(b) Premium income 354 1507 1663
that these fluctuations occurred before the establishment of the
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RBI. After 1935, the prices of government securities remained

Source: RBI, Banking and Monetary Statistics of India, quite stable. There is no doubt that this must have been due to
Bombay, 1954. the RBI’s policy because in the post-1935 period the prices of
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other securities increased phenomenally. Debenture prices

Stock Market
fluctuated in the range of 95 to 196; the level of these prices was
The private sector as well as the government raises large
higher than the level of prices of ordinary shares during 1927 to
amounts of funds on the stock market. The first Stock
1942. It was only after 1942 that the latter exceeded the former.
Exchange in India was established at Bombay in 1887. The
Third, there was an economic depression between 1927 and
volume of funds raised on the stock market by the private

1933. There was a boom between 1934 and 1946 (except 1938
sector industrial units and the government increased
and 1939); prices again declined substantially during 1947-49.
significantly during the first half of the 20th century. The
The ordinary share prices reached their nadir in 1932 (index was
increased pace of industrialisation during this period which was
64.4), and their zenith in 1946 (index was 264.9).
caused by the two World Wars, protection to domestic

industries, and other fiscal measures adopted by the Public Deposits

government, led to the growth of active new issue markets and It is appropriate here to draw attention to the then prevalent
stock exchanges. The expansion of government activity for practice which later assumed such significant dimensions as to
developmental purposes and the demands made by the two cause serious concern to the monetary authorities, namely, the
wars also meant an increase in the amount of government financing of fixed assets by companies with deposits from the
securities issued. public. These deposits were for a fixed period of one to seven
The growth of the private sector is reflected in the increased years. Unlike in the later period, these deposits were then much
number and paid-up capital of joint-stock companies. The more local; they used to be offered on the basis of the
paid-up capital increased from a mere Rs 24 crore in 1890 to Rs reputation for business integrity, or social and caste affiliations
570 crore in 1948. We do not have very reliable figures on the of the concerned management. Around 1930, these deposits
actual capital issues by the corporate sector for this period. It accounted for about 11 per cent and 39 per cent of the total
can, however, be stated that on an average, the capital issues of finance of the Bombay and Ahmedabad mills respectively. It is
joint-stock companies amounted to Rs 70 crore per year during interesting to note that in some cases, the interest rates on these
the period 1918 to 1939. For the years 1945 to 1952, we have deposits were equal to or lower than the average lending rates
figures for the amount of capital issues applied for and of commercial banks of the time.

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22 11.621.6
Government Securities and Treasury Bills A rough consolidated picture about the relative sizes and


The markets of government securities and treasury bills also growth or different financial resources is presented in Table
expanded phenomenally during this period. The amount of below:
gross issues of central and provincial government securities
increased from a meagre Rs 2 crore in 1890 to Rs 382 crore in Table Financial Structure in India, 1890 -1948 (Rs Crore)

1947. By the 1940s, the gilt-edged market had become fairly Year Private Small saving Total capital of Paid-up. Premium. Gross issues State
deposits of deposits and all co-op capital of income of of Provident
wide and active. Banks, life insurance companies, princes and all banks certificates
societies. joint-stock Insurance Government Fund
cos cos securities
princely state governments, and private trusts, took an interest
in this market. Securities of different maturities were being 1890 25 6 -- 24 0.11 2.0 0.49
1900 31 10 -- 36 0.52 - 1.37
issued, and innovative steps like giving attractive names to these 1910 82 16 3 63 2.0 2.50 3.59
1920 220 27 36 164 8.0 21.35 19.71
issues were undertaken to make them popular. During the 1930 221 75 91 282 25.0 37.25 58.24
1939 261 135 109 290 - 28.42 72.46
Second World War, to ensure their sale, many issues were made 1941 364 95 112 302 59.0 147.36 75.03
1943 719 118 132 339 - 146.53 83.96
on a tap basis rather than by prescribing a specific subscription 1945 109 221 146 389 - 221.79 93.02

period. The foundation of the policy of maintaining stability in 1947
the gilt-edged market was laid down during the Second World
War when a large amount of funds was needed by the

government. In subsequent years, although the reasons for a Note: If there is any discrepancy in figures in this Table and

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large amount of funds changed, the policy of maintaining figures quoted earlier on any item, it is not an error, it may be
stability continued. The setting up of the RBI in 1935 facilitated due to differences in sources, definition of item and coverage,
the pursuit of such a policy. Earlier the IBI used to buy and sell etc. Figures for 1947 and later are for the Indian Union. Source:
securities depending on the position of its own resources. It Muranjan, S.K., op. cit., p. 32; and RBI, Banking and Monetary
rarely operated in the market out of consideration for market Statistics of India, Bombay, 1954.

rd. F
Interest Rates
Treasury bills (TBs) were first issued in India in October 1917. A detailed study or the level and structure or interest rates

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Originally, these bills were of different maturities-of three, six,
nine, and twelve months. On a few occasions, bills of maturity
of four and eight months were also issued. On several
before 1950 is too big a topic to be attempted here. We would
like to point out here only three important features or the
interest rates during this period.
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occasions, joint issues of more than one maturity were also
First, the interest rates on the same type or deposits and
made. Since 1933-34, only bills of three months’ duration have
advances differed for different banks. While the IBI did not pay
been in vogue. Treasury bills used to be sold by tender and on
any interest on current deposits, exchange banks and Indian
w.p m

tap; the latter method was adopted generally for the purpose of
joint-stock banks offered interest on them. The average rate of
provincial governments, semi--government institutions, and
interest on current deposits by one or the leading commercial
some foreign holders. During the pre-war years, these bills were
banks in India was 2.56 per cent in 1921, 1.29 per cent in 1935
often issued to induce an inflow of foreign funds. During the
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and 0.26 per cent in 1943. Similarly, the interest rates on fixed
war years, the consideration changed to one of providing liquid
and savings deposits varied from one type of bank to another.
assets to the banks. Although the RBI offered the facility of
On advances also, these rates varied a great deal. In short, from
discounting TBs to banks, they did not have a wide appeal
the point or view or interest rates, the banking system was not
among banks and other institutions. The IBI was the main
homogeneous. This aspect of interest rates has certainly

supporter of this market. Provincial governments also used to

undergone a definite change in the planning era during which it
issue TBs, but they were not preferred by any institution
has become much less heterogeneous.
including the RBI. This was reflected in the fact that the
discount rate on provincial TBs was higher than that on TBs of Second, there was much variation in interest rates in different
the central government. The practice of issuing ad hoc TBs had regions. They were the highest in Chennai and South India; and

started during this period. The amount of TBs sold by tender also quite high in the Indus and Gangetic plains. In Mumbai,
was Rs 87 crore in 1919 and Rs 85 crore in 1948. There was a Ahmedabad, and Kolkata, which were the areas or
substantial decline in this amount in the intervening years (Rs manufacturing, finance, and business, the rates were relatively
51 crore in 1947, for instance). low. Such geographical differentials in the interest rates were
dependent on such factors as: (a) the degree or closeness or links
between the Central Bank and the concerned locality; (b) the size
of capital supply in general, and deposits in particular, in the
locality; (c) whether funds can be attracted and transferred to
different places; (d) whether the major activity in the area is
agriculture, manufacturing or commerce. With the progress
towards integration in the banking system, growth of branch
banking, increase in the spread of offices of the RBI,
improvement in remittance facilities, growth in transport and
communication and the resultant facilities for the quick transfer
of funds, geographical differentials in the interest rates have

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11.621.6 23
greatly diminished since 1950, although they have not

completely disappeared.
Third, the level of interest rates even in the organised sector
during the major part of this period was quite high. This needs
to be emphasised because during the planning period, a case has
been made in certain circles for a cheap money policy on the plea
that, historically, borrowers and lenders in India have been used
to a low cost of finance. A plea such as this is based on the
experience of a very brief period in the economic history of
India. The yield of 3.5 per cent government securities ruled
between 4 to 7 per cent during 1870--1949 except for the
periods, 1891-1915, and 1936-1949 when it varied between 3 to
4 per cent. The average interest rate charged by banks for lending

was 6 to 7 per cent during this period except for 1932-1949. The
rate of interest of the Bank of Bombay varied between 6.2 to
9.8 per cent during 1890 to 1899. Further, in the first decade of

the 19th century, agency houses charged 10 to 12 per cent on

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their loans. Around the same time, investments in
governments fetched the high yield of 8 to 9 per cent, and
commercial bills were discounted at a rate between 6 and 12 per
cent. Similarly, even in the slack season, commercial banks
charged 10 to 11 per cent against wheat pits in the 1920s. On

rd. F
current deposits, the Central Bank of India paid an interest rate
between 2 and 2.5 per cent till 1931. It is only after 1933 that

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interest rates declined steeply; they have been maintained at a
low level since the beginning of the planning period.
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On the whole, the Indian Financial system was fairly developed
even on the eve of planning. Though banking business was
concentrated in the hands of few large banks, yet the services of
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smaller banks were of great importance. At that time banks did

not invest much in government securities, hence the major
beneficiaries of bank credit were commerce followed by
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Questions to Discuss:
1. Evaluate the banking system.
2. Evaluate the insurance Funds.

3. Evaluate the stock funds.

4. Evaluate the Government securities.

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24 11.621.6


i al
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rd. F
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w.p m
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11.621.6 25

Learning Objective these, the RBI and SEBI have special role and responsibility. We
After reading this lesson, you will understand shall first discuss the functioning of the RBI followed by the
• Organisation and management of RBI
• Function and Roles of RBI What is the Organisation and Management of RBI
The Reserve Bank of India was established on April 1,1935,
• Treasury Bills

under the Reserve Bank of India Act, 1934. The main functions
Today we shall discuss one of the most important aspects of of the Bank are to act as the note-issuing authority. Banker’s
Financial Institution in India. Bank, Banker to the government and to promote the growth

Introduction of the economy within the framework of the general economic

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A study of financial institutions in India can appropriately policy of the government, consistent with the need to maintain
begin with a brief discussion of the regulatory framework of price stability. The Bank also performs a wide range of
the country. Since the financial markets are characterised by promotional functions to support the pace of economic
various degrees of imperfections, the need for regulation- development. The Reserve Bank is the controller of foreign
prudential or otherwise-even in a liberalised framework cannot exchange. It is the watchdog of the entire financial system. The

rd. F
be denied. The financial system deals in other people’s money Bank is the sponsor bank of a wide variety of top-ranking
and, therefore, their confidence, trust and faith in it is crucially banks and institutions such as SBI, IDBI, NABARD and NHB.

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important for its smooth functioning. Financial regulation is
necessary to generate, maintain and promote this trust. One
reason why the public trust may be lost is that some of the
The Bank sits on the board of all banks and it counsels the
Central and State Government and all public sector institutions
on monetary and money matters. No central bank, even in the
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savers or investors or intermediaries may imprudently take too developed world, is saddled with such onerous responsibilities
much risk, which could engender defaults, bankruptcies, and and functions.
insolvencies. Thus a regulation is needed to check imprudence The RBI, as the central bank of the country, is the centre of the
w.p m

in the system. Indian Financial and Monetary System. As the apex institution,
The task of efficient regulation is rendered difficult by the very it has been guiding, monitoring, regulating, controlling, and
nature of financial assets, which are mobile, easily transferable or promoting the destiny of the IFS since its inception. It is quite
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negotiable; and also by the nature of financial markets which are young compared with such central banks as the Bank of
prone to a systemic risk. The modern trading technology and England, Riksbank of Sweden, and the Federal Reserve Board
the possibility of high leveraging enable market participants to of the US. However, it is perhaps the oldest among the central
take large stakes, which are disproportionate with their own banks in the developing countries. It started functioning from
investments. There are also frequent instances of dishonest, April1, 1935 on the terms of the Reserve Bank of India Act,

unfair, fraudulent, and unethical practices or activities of the 1934. It was a private shareholders’ institution till January 1949,
market intermediaries or agencies such as brokers, merchant after which it became a state-owned institution under the
bankers, custodians, trustees, etc. The regulation becomes Reserve Bank (Transfer to Public Ownership) of India Act,
necessary to ensure that the investors are protected; that 1948. This act empowers the central government, in

disclosure and access to information are adequate, timely, and consultation with the Governor of the Bank, to issue such
equal; that the participants measure up to the rules of the directions to it, as they might consider necessary in the public
market place; and that the markets are both fair and efficient. In interest. Further, the Governor and all the Deputy Governors
this context, it is said that fairness and efficiency are two sides of of the Bank are appointed by the Central Government.
the same coin; if the market is unfair, in the end, it is also The Bank is managed by a Central Board of Directors, four
inefficient. Local Boards of Directors, and a committee of the Central
The regulatory framework or apparatus for the financial sector in Board of Directors. The functions of the Local Boards are to
India broadly consists of the Ministry of Finance of the advise the Central Board on matters referred to them; they are
Government of India which administers the Companies Act, also required to perform duties as are delegated to them. The
1956, and the Securities Contracts (Regulation) Act, 1956; the final control of the Bank vests in the Central Board, which
Reserve Bank of India and the Board of Financial Supervision comprises the Governor, four Deputy Governors, and fifteen
(BFS) under its aegis; the Securities and Exchange Board of Directors nominated by the central government. The committee
India (SEBI), Insurance Regulatory Authority; the Governing of the Central Board consists of the Governor, the Deputy
Boards of various stock exchanges and the apex financial Governors, and such other Directors as may be present at a
institutions such as the IDBI, SIDBI, NHB and NCB. Among given meeting. The internal organisational set-up of the Bank

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26 11.621.6
has been modified and expanded from time to time in order to • To regulate the overall volume of money and credit in the


cope with the increasing volume and range of the Bank’s economy with a view to ensure a reasonable degree of price
activities. The underlying principle of the internal organisation stability.
is functional specialisation with adequate coordination. In order
Role of the Bank
to perform its various functions, the Bank has been divided and
In view of the Bank’s close contacts and intimate knowledge of
sub-divided into a large number of departments.
the financial markets, it is in a position to advise the Central and
The pattern of central banking in India was initially based on State Governments on the Quantum, timing and terms of
the Bank of England. England had a highly developed banking issue of new loans. While formulating the borrowing program
system in which the functioning of the central bank as a for the year, the Government and the Bank take into account a
banker’s bank and their regulation of money supply set the number of considerations such as the amount of Central and
pattern. The central bank’s function as ‘a lender of last resort’ State loans maturing for redemption during the year, the
was on the condition that the banks maintain stable cash ratios estimate of available resources (based on the estimated growth
as prescribed from time to time. The effective functioning of in deposits with the banks, premium income of insurance

the British model depends on an active securities market where companies and accretions to provident funds) and the
open market operations can be conducted at the discount rate. absorptive capacity of the market.
The effectiveness of open market operations however depends
In India, banks, insurance companies and provident funds are

on the member banks’ dependence on the central bank and the
statutorily required to invest a portion of their liabilities,

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influence it wields on interest rates. Later models, especially
premium income or accretions, as the case may be, in
those in developing countries showed that central banks play an
Government and other approved securities, which ensures a
advisory role and render technical services in the field of foreign
captive market for these securities, facilitating the easy
exchange, foster the growth of a sound financial system and act
absorption of new issues. The Bank tries to ensure that over a
as a banker to government.

rd. F
reasonably long period it will be neither a net purchaser of
What are the Functions and Roles of RBI securities from the market nor a net seller so that the loans
raised are absorbed by the market outside the Bank to the
Functions of the Bank
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The RBI functions within the framework of a mixed economic
system. With regard to framing various policies, it is necessary
maximum extent.
The Bank actively operates in the gilt-edged market to ensure
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to maintain close and continuous collaboration between the the success of Government loan operations. For instance, the
government and the RBI. In the event of a difference of Bank grooms the market by acquiring securities nearing maturity
opinion or conflict, the government view or position can always to facilitate redemption. If maturing stocks are held by
be expected to prevail. investors to the last, conditions in the money market are likely
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The Preamble of the RBI Act, 1934 states that “Whereas it is to be disturbed as most of the cash paid out seeks avenues of
expedient to constitute a Reserve Bank for India to regulate the reinvestment, but, in practice, all the investors are not equally
issue of bank notes and the keeping of reserves with a view to eager to wait for cash repayment on the redemption date and
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securing monetary stability in (India) and generally to operate then undertake reinvestment, as they can reinvest the proceeds
the currency and credit system of the country to its advantage”. at times of their own choosing if these were realized earlier, the
To elaborate, the main functions of the RBI are: Bank, therefore, stands ready as the stock approaches maturity
to buy all the stocks offered for sale at these terms. Thus, in
• To maintain monetary stability so that the business and
carrying out the loan operations of the Government the Bank

economic life can deliver welfare gains of a properly endeavours on the one hand to minimize the effects of such
functioning mixed economy. operations on the money market and Government securities
• To maintain financial stability and ensure sound financial market, and on the other to obtain the best possible terms for
institution so that monetary stability can be safely pursued the Government concerned. The close involvement in the

and economic units can conduct their business with market by its continuous presence and the willingness to deal in
confidence. the securities at process determined by it give the Bank a good
• To maintain stable payments system so that financial degree of flexibility when it is seeking occasions for
transactions can be safely and efficiently executed. implementing a shift in policy on prices.
• To promote the development of financial infrastructure of The timing of the issue of new loans is normally left to the
markets and systems, and to enable it to operate efficiently Reserve Bank. The Central Government and the state
i.e., to play a leading role in developing a sound financial Governments float market loans separately, but through the
system so that it can discharge its regulatory function Reserve Bank. For the management of the public debt of the
efficiently. Government, the Bank charges a commission. In addition, the
• To ensure that credit allocation by the financial system
Reserve Bank also charges for all new issues both by Central and
broadly reflects the national economic priorities and societal State Government loans, besides recovering brokerage and
concerns. expenses incurred by the Bank on account of printing of loan
notifications, telegrams, advertisements, etc.

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11.621.6 27
Treasury Bills

You must be well aware that Treasury Bills are the main
instrument of short-term borrowing by the Government, and
serve as a convenient gilt-edged security for the money market.
The qualities of high liquidity, absence of risk of default, and
negligible capital depreciation in case of sale before maturity
make them an ideal form of short-term investment for banks
and other financial institutions.
In certain countries, unlike in India, Treasury Bills are an
important tool for the central bank for influencing the level of
liquidity in the money market through open market operations.
Sale of Treasury Bills helps to absorb any excess liquidity in the
money market and, conversely, their purchase by the central

bank has the effect of relieving stringency. Since neither the
Government nor the money market wishes to hold surplus
cash, the central bank steps in and restores the equilibrium by

selling to or purchasing from the money market Treasury Bills

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(and similar other securities) accordingly as the Government
payments are larger than its receipts or vice versa. In this way, the
Government is able to borrow cheaply to meet its immediate
needs and to use its temporary surplus to by back before
maturity some of its outstanding debt.

rd. F
The Reserve Bank, as the agent of the Government, issues
Treasury Bills at a ‘discount’. These are negotiable securities and

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can be rediscounted with the Bank at any time before maturity
upon terms and conditions determined by it from time to time.
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Questions to Discuss:
1. Discuss the Organisation and Management of RBI.
2. What are the Functions of RBI?
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3. What are the roles of RBI?

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28 11.621.6

Learning Objective The fiscal operations of the Government exercise a direct and
After reading this lesson, you will understand significant impact on the monetary and credit system, which the
Bank is required to regulate. It follows that monetary and credit
• The Reserve Bank as Banker and advisor to Government
policies can be implemented more effectively if there is
• Authorities invested with RBI coordination between them and the economic policies of the
• Autonomy for Central Bank Government. Hence, the Bank takes an active interest in the
In today’s lesson, we shall discuss the management the advisory formulation of fiscal and other policies of the Government and

and promotional aspects of RBI, Treasury Bills, and finally the tenders advice calculated to promoter the attainment of the
autonomy of the Central Bank. national economic goals.
Daily operations in the gilt-edged and foreign exchange markets

The Reserve Bank as Banker to Government
and close contacts with the commercial banks and other financial

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You have been studying since childhood that The Reserve Bank
is the Central Bank of India. It is the banker to the Central institutions and with the business world in general have
Government statutorily and to the State Governments by virtue equipped the Reserve Bank with the technical knowledge of,
of agreements entered into with them. The Bank provides a full and practical experience in, these spheres which contribute
range of banking services for these Governments such as greatly to the Bank’s competence to give financial advice to

rd. F
acceptance of moneys on deposit, withdrawal of funds by Government. Like all central banks, the Bank acts as adviser to
cheques, receipt and collection of payments to Government and the Government not only on policies concerning banking and
financial matters but also on a wide range of economic issues

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transfer of funds by various means throughout India. The
Governments’ main accounts are held in the Bank. A large
number of branches of agency banks, sub-agency banks and
including those in the field of planning and resource
mobilisation. It has of course a special responsibility in respect
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Treasury agencies also undertake Government business because of policies and measures concerning new loans, agricultural
the Bank has branches/offices mainly in the State capitals and a finance, co-operative organisaton, industrial finance and
few big cities in the country. The Government revenue collected legislation affecting banking and credit.
through the agency banks is remitted to the Government The Bank’s advice is sought on certain aspects of formulation
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revenue collected through the agency banks are remitted to the of the country’s Five Year Plans, such as the financial pattern,
Government accounts at the Bank in due course. mobilisation of resources and institutional arrangements with
regard to banking and credit matters. As the agency for
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Before the establishment of the Bank, the more important

current financial transactions of the Indian Government were administration of exchange control, the Bank’s intimate
handled by the then Imperial Bank of India; the administration knowledge of the exchange markets, trade and balance of
of the public debt was the direct responsibility of the payments position places it in a vantage position to offer sound
Government although the Public Debt Offices were being technical advice to Government in evolving policies on
international finance and regulations regarding foreign trade and

managed by the Imperial Bank. Both these responsibilities in

regard to Government finance were centralised in the Reserve exchange. For the effective discharge of this advisory role, the
Bank on its formation. Further, the Bank acts as the banker not Bank has built up a research and statistical organisation.
only to the Government of India, but in view of the federal The Bank is the main channel of communication between the
Government on the one hand and the banks and financial

character of the constitution of India, also to the Governments

of the States. institution on the other. The Bank, we now know, keeps the
Government informed of the developments in the financial
Adviser to Government
markets from time to time. Thus RBI being the banker to the
The Bank has ordinary banking relationship with the
central and state governments provides to the governments all
Government, performing deposit and lending functions. It
banking services such as acceptance of deposits, withdrawal of
manages the public debt on behalf of the Government.
funds by cheques, making payments as well as receipts and
Besides, the Bank is entrusted with a wide range of statutory
collection of payments on behalf of the government, transfer
functions such as buying and selling of foreign exchange,
of funds, and management of public debt.
administration of exchange control and provision of rural
credit, the performance of which is attuned to the policies of The Bank receives government deposits free of interest, and it is
the Government in the relevant areas. It maintains close not entitled to any remuneration for the conduct of the
coordination with the Government at all levels, especially with ordinary banking business of the Government. The deficit or
the Ministry of Finance, both in the day-to-day affairs and surplus in the central government account with the RBI is
through participation in the official committees. managed by the creation and cancellation of treasury bills
(known as ad hoc treasury bills).

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11.621.6 29
As a banker to the government, the Bank can make “ways and the Bank issues notes in the following denominations: Rs 5, 10,

means advances” (i.e., temporary advances made in order to 20, 50, 100, 500 and 1000. The responsibility of the Bank is not
bridge the temporary gap between receipts and payments) to only to put currency into or withdraw it from circulation but
both the central and state governments. The maximum also to exchange notes and coins of one denomination into
maturity period of these advances is- three months. However, those of other denominations as demanded by the public. All
in practice, the gap between receipts and payments in respect of affairs of the Bank relating to note issue are conducted through
the central government used to be met by the issue of ad hoc its Issue Department. In order to discharge its currency
treasury bills, while the one in respect of the state governments functions, the Bank has 15 full-fledged issue offices and 2 sub-
is met by the ways and means advances. The arrangements in offices, and 4127 currency chests in which the stock of new and
this regard have been changed in the recent past. The ways and re-issuable notes, and rupee coins are stored. Of these, 17 chests
means advances to the state governments are subject to some were with the RBI, 2877 with the SBI and associate banks, 791
limits. These advances are of the following types: (a) normal or with nationalised banks, 423 with treasuries, and 19 with private
clean advances i.e., advances without any collateral security; (b) sector banks (these numbers are not fixed and can be varied as

secured advances, i.e., those which are secured against the pledge per the requirement).
of central government securities; and (c) special advances, i.e., The Bank can issue notes against the security of gold coins and
those granted by the Bank at its discretion. The interest rate gold bullion, foreign securities, rupee coins, Government of

charged by the Bank on these advances did not, till May 1976, India securities, and such bills of exchange and promissory

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exceed the Bank rate. Thereafter, the Bank has been operating a notes as are eligible for purchase by the Bank. The RBI notes
graduated scale of interest based on the duration of the have a cent per cent backing or cover in these approved assets.
advance. Earlier i.e., till 1956, not less than 40% of these assets were to
Apart from the ways and means advances, the state consist of gold coin and bullion and sterling/foreign securities.
governments have made heavy use of overdrafts from the RBI. In other words, the proportional reserve system of note issue

rd. F
An overdraft refers to drawals of credit by the state existed in India till 1956. Thereafter, this system was abandoned
governments from the RBI in excess of the credit (ways and and a minimum value of gold coin and bullion and foreign

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means advances) limits granted by the RBI. In other words,
overdrafts are unauthorised ways and means advances drawn by
the state governments on the RBI. The management of the
securities as a part of total approved assets came to be adopted
as a cover for note issue.
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Supervising Authority
states’ overdrafts has gradually become one of the major
The RBI has vast powers to supervise and control commercial
responsibilities of the RBI on account of the persistence of
and co-operative banks with a view to developing an adequate
large proportions of those overdrafts.
and sound banking system in the country. It has, in this field,
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The issue, management and administration of the public the following powers: (a) to issue licenses for the establishment
(central and state governments) debt are among the major of new banks; (b) to issue licenses for the setting up of bank
functions of the RBI as the banker to the government. The branches; (c) to prescribe minimum requirements regarding
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Bank charges a commission from the governments for paid-up capital and reserves, transfer to reserve fund, and
rendering this service. maintenance of cash reserves and other liquid assets; (d) to
inspect the working of banks in India as well as abroad in
respect of their organisational set-up, branch expansion,
mobilisation of deposits, investments, and credit portfolio

management, credit appraisal, region-wise performance, profit

planning, manpower planning and training, and so on; (e) to
conduct ad hoc investigations, from time to time, into
complaints, irregularities, and frauds in respect of banks; (f) to

control methods of operations of banks so that they do not

fritter away funds in improper investments and injudicious
advances, (g) to control appointment, re-appointment,
termination of appointment of the Chairman and chief
executive officers of private sector banks; and (h) to approve or
force amalgamations.
Note Issuing Authority In keeping with the recommendations of Narasimham
The RBI has, since its inception, the sole right or authority or Committee (1991), the RBI function of bank supervision was
monopoly of issuing currency notes other than one rupee notes separated from its traditional central banking function by the
and coins, and coins of smaller denominations. The issue of creation of a separate Department of Supervision (DOS) from
currency notes is one of its basic functions. Although one rupee 22 November 1993. Similarly, following the securities scam
coins and notes, and coins of smaller denominations are issued which showed the glaring weaknesses in the system for
by the Government of India, they are put into circulation only monitoring the financial sector, the Board of Financial
through the RBI. The currency notes issued by the Bank are Supervision (BFS) was set up on 16 November 1994 under the
legal tender everywhere in India without any limit. At present, aegis of the RBI to oversee the IPS. The DOS initially took over

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30 11.621.6
the inspection of commercial banks from the Department of rate of the rupee was being fixed in terms of the ‘basket of


Banking Operations and Development (DBOD) of the RBI. currencies’ till early 1990s.
Since April 1995, it has been taking steps to extend its area of The RBI is the custodian of the country’s foreign exchange
supervision over the all-India financial institutions also. In July reserves, and it is vested with the responsibility of managing
1995, it took over the supervision of non-banking financial the investment and utilisation of the reserves in the most
companies (NBFCs), and in November 1995 the registration of advantageous manner. The RBI achieves this through buying
these companies, from the Department of Financial Companies and selling of foreign exchange from and to scheduled banks,
(DFCs). The BFS has a full-time vice chairman and six other which are the authorised dealers in the Indian foreign exchange
members; the RBI Governor is its chairman. It has powers to market. The Bank also manages the investment of reserves in
supervise and inspect banks, financial institutions, and NBFCs. gold accounts abroad and the shares and securities issued by
There is five-member Advisory Council to render advice to it. foreign governments and international banks or financial
The DOS assists the BFS. institutions.
Exchange Control Authority The role of the RBI as a participant in the foreign exchange

One of the essential functions of the RBI is to maintain the market, and as the stabilizer of that market and the rupee
stability of the external value of the rupee. It pursues this exchange rate has become all the more important with the
objective through its domestic policies and the regulation of the introduction of the floating exchange rate system and the rupee

foreign exchange market. As far as the external sector is convertibility on trade, current and capital accounts (the last one

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concerned, the task of the RBI has the following dimensions: to take place in the near future). In the recent past, it has
(a) to administer the Foreign Exchange Control; (b) to choose intervened significantly to achieve exchange rate stability
the exchange rate system and fix or manage the exchange rate
Promoter of the Financial System
between the rupee and other currencies; (c) to manage exchange
Apart from performing the functions already mentioned, the
reserves; and (d) to interact or negotiate with the monetary

rd. F
RBI has been rendering ‘developmental’ or ‘promotional’
authorities of the Sterling Area, Asian Clearing Union, and
services, which have strengthened the country’s banking and
other countries, and with international financial institutions

iza D
such as the IMF, World Bank, and Asian Development Bank.
The RBI administers the Exchange Control in terms of the
financial structure. This has helped in mobilising savings and
directing credit flows to desired channels, thereby helping to
achieve the objective of economic development with social
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Foreign Exchange Regulation Act (FERA), 1947 which has been justice. It has helped in deepening and widening the financial
replaced by a more comprehensive Foreign Exchange system. As a part of its promotional role, the Bank has been
Regulation Act, 1973. The FERA is now replaced by the pre-empting credit for certain sectors at concessional rates.
Foreign Exchange Management Act (FEMA), which is
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In the money market, the RBI has continuously worked for the
consistent with full capital account convertibility and the
integration of its unorganised and organised sectors by trying
objective of progressively liberalising capital account
to bring indigenous bankers into the mainstream of the
transactions. The objective of exchange control is primarily to
banking business. In order to improve the quality of finance
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regulate the demand for foreign exchange within the limits set
provided by the money market, it introduced two Bill Market
by the available supply. This is sought to be achieved by
Schemes, one in 1952, and the other in 1970. With a view to
conserving foreign exchange, by using it in accordance with the
increasing the strength and viability of the banking system, it
plan priorities, and by controlling flows of foreign capital. In
carried out a program of amalgamations and mergers of weak
India, during most of the years since 1957, foreign exchange
banks with the strong ones. When the social control of banks

earnings have been far less than the demand for foreign
was introduced in 1968, it was the responsibility of the RBI to
exchange, with the result that the latter had to be rationed in
administer it in the country for achieving the desired objectives.
order to maintain exchange stability. This is done through
After the nationalisation of banks, the RBI’s responsibility to
exchange control, which is imposed both on receipts and
develop banking system on the desired lines increased. It has

payments of foreign exchange on trade, invisible, and capital

been acting as a leader in sponsoring and implementing the
accounts. The problem of foreign exchange shortage has been
‘Lead Bank’ scheme. With the help of a statutory provision for
so persistent and acute that the scope of exchange control in
licensing the branch expansion of banks, the RBI has been
India has steadily widened and the regulations have become
trying to bring about an appropriate geographical distribution
progressively more elaborate over the years. The Bank
of bank branches. In order to ensure the security of deposits
administers the control through authorised foreign exchange
with banks, the RBI took the initiative in 1962 to create the
Deposits Insurance Corporation.
FEMA lays down that the exchange rates used for the conduct
The RBI has rendered service in directing and increasing the
of foreign exchange business must be those, which are fixed by
flow of credit to the agricultural sector. It has been entrusted
the RBI. The arrangements or the system under which exchange
with the task of providing agricultural credit in terms of the
rate is fixed by the RBI has undergone many changes over the
Reserve Bank of India Act. 1934. The importance with which
years. Till about 1971, as a member of the IMF, India had an
the RBI takes this function is reflected in the fact that since 1955,
exchange rate system of “managed flexibility”. This
it has appointed a separate Deputy Governor in charge of rural
arrangement changed during the 1970s as a result of
credit. It has undertaken systematic studies on the problem of
international monetary crisis in 1971. Since 1975, the exchange
rural credit and has generated basic data and information in this

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11.621.6 31
area. This was first done in 1954 by conducting an All-India overseeing the safety and soundness of the banking and

Rural Credit Survey. And that was followed by studies of the financial systems. It plays an important role in building up and
All-India Rural Credit Review Committee in 1968, the maintaining confidence in the underlying stability of the IFS. In
Committee to Review Arrangements for Institutional Credit for short, the RBI helps to create and maintain a stable, efficient,
Agriculture and Rural Development in 1978, and the and well-functioning financial system in India.
Agricultural Credit Review Committee in 1986.
Autonomy for Central Bank
As a part of its efforts to increase the supply of agricultural Autonomy for Central Bank is a crucial issue. The Reserve Bank
credit, the Bank has been working to strengthen co-operative of India Act does not assure autonomy to the bank. It is true
banking structure through the provision of finance, that the Central Bank can only be independent within the
supervision, and inspection. It provides to co-operative banks government but not from the government. In US there are
(through state co-operative banks), short-term finance at a adequate safeguards to ensure that the Federal Reserve is not
concessional rate for seasonal agricultural operations and compelled to act against its own judgement. In India there have
marketing of crops. It subscribes to the debentures of Land been historic accords limiting this access of government to RBI

Development Banks. It operates the National Agricultural but they are breached in practice, RBI should not be involved in
Credit (long-term operations) Fund, and the National underwriting government securities. It acts as a principal and as
Agricultural Credit (Stabilisation) Funds through which it an agent in the securities market. The dual role of RBI as an

provides long-term and medium-term finance to co-operative issuer and regulator of debt gives rise to conflict of policies of

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institutions. It established the Agricultural Refinance debt management and monetary policy. The advisory group on
Cooperation (now known as NABARD) in July 1963 for monetary and financial policies headed by M. Narsimham
providing medium-term and long -term finance for agriculture. suggested (September, 2000) the separation of debt
It also helped in establishing an Agricultural Finance management and monetary policy functions and the setting up
Corporation. of an independent debt management office by the

rd. F
The role of the Bank in diversifying the institutional structure Government.
for providing industrial finance has been equally important. All Further the fiscal profligacy of the government is abetted by the

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the Special Development Institutions at the central and state
levels and many other financial institutions mentioned earlier
were either created by the Bank on its own or it advised and
system of pre-emption of large portion on net accrual of banks
deposits through the prescription of statutory liquidity ratio.
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The Indian banking system was operating for a long time with
rendered help in setting up these institutions. The UTI, for a high level of reserve requirements in the form of Statutory
example, was originally an associate institution of the RBI. A Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). SLR and
number of institutions providing financial and other services CRR keeps in changing form time to time as the need be. As of
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such as guarantees, technical consultancy, and so on have come date the SLR is 25% and CRR is 4-4.5%. Reduction in statutory
into being on account of the efforts of the RBI. pre-emption is constrained as long as fiscal deficit remains high.
Through these institutions, the RBI has been providing short- The Report of the Committee on the Financial System, 1991
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term and long-term funds to the agricultural and rural sectors, has pointed out that SLR should not be used to mobilise
to small-scale industries, to medium and large industries, and resources for financing budgetary deficits but as a prudential
to the export sector. It has helped to develop guarantee services measure. It has also stated that CRR should be used for
in respect of loans to agriculture, small industry, exports and pursuing monetary policy objectives.
sick units. It also co-ordinates the efforts of banks, financial In the context of globalisation of the financial system Reserve

institutions and government agencies to rehabilitate sick units. Bank needs autonomy to define benchmarks or anchors such as
The Bank has evolved and put into practice the consortium, co- inflation and money supply to guide policy and use its
operative, and participatory approach to lending among banks judgement to assess the impact of the ever changing financial
and other financial institutions. By developing the practice of environment on the design and implementation of policy.

inter-institutional participation, of expertise pooling, and of Reform of the banning system is not complete unless it
geographical presence, it has helped to upgrade credit delivery includes the Central Bank. The emphasis on market as a source
and service capability of the financial system. By issuing of financial discipline required an autonomous Central Bank,
appropriate guidelines, in 1977, regarding the transfer of loans which can strike right balance with the operation of market
accounts by borrowers, it has evolved a mutually acceptable forces. The responses would be quick and effective only if the
system of lending, so that the banking business grows in a Central Bank is autonomous.
healthy manner and without cut-throat competition. Central banks, which mandated to pursue monetary and
To preserve and enhance the stability of the banking and financial stability should enjoy autonomy in the execution of
financial system is an important part of the “promotional” role policy and be accountable for the achievement of the objective.
of the RBI. In fact, financial stability has now assumed relatively There is consensus that the monetary authority’s primary
greater importance as one of the tasks of the RBI. This is objective should be price stability, that the central bank should
evident in its work to formulate prudential norms for banks have sufficient independence to vary its operational instrument
and financial institutions, its intervention in the foreign and its main instrument is its control over short-term interest
exchange market, and its participation in the operation of rates. The profound transformation of the financial
“safety nets” i.e., the legal and organisational structure for environment had a major effect both on the relationship

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32 11.621.6
between the monetary policies across countries and their design Notes:


within the countries. Central banks while defining benchmarks
or anchors to guide policy to achieve monetary and financial
stability have to take into account the increasing constraints that
result from the growing power of markets to arbitrage across
currencies, instruments and institutions as well as across legal,
regulatory and tax jurisdictions. The increasing power of
markets put a premium on transparency to guide market
expectations, market incentives and credibility of policies. The
market orientation of the framework has to be strengthened by,
• Enlisting and upgrading the markets disciplinary mechanism
• Enlarging the domain and improving the quality of public

• Designing regulatory constraints such as capital standards so
as to make them less vulnerable to financial arbitrage

• Limiting the impact of those forms of intervention that

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provide perfection without commensurate over sight which
reduce the incentive to prudent behavior
Central bank’s incentive for stability requires supporting policies
in terms of sustainable fiscal positions and greater flexibility in
labour market. Further the effectiveness of market forces

rd. F
depends on fostering ownership structures through
privatisation, which are more responsive to market, and

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removing obstacles to the adjustment of capital and labour.
The systemic orientation has to be sharpened by upgrading
payment and settlement systems to contain the knock on effects
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of failures of institutions. A right balance between the market
and the central bank as a source of financial discipline has to be
w.p m

Regulation of the financial system and its various component
sectors occurs in almost all countries. A useful way to organise
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the many instances of regulation is to see it as having four

general forms: (1) enforcing the disclosure of relevant
information; (2) regulating the level of financial activity through
control of the money supply as well as trading in financial
markets; (3) restricting the activities of financial institutions and

their management of assets and liabilities; and (4) constraining

the freedom of foreign investors and securities firms in
domestic markets.
The most important players in financial markets throughout

the world are central banks, the Government authorities in

charge of monetary policy. Central banks’ actions affect interest
rates, the amount of credit, and the money supply, all of which
have direct impacts not only on financial markets but also on
aggregate output and inflation. To understand the role that
central banks play in financial markets and the overall economy,
we need to understand how these organizations work. Who
controls central banks and determines their actions? What
motivates their behavior? Who hold the rein of power?
Questions to Discuss:
• Discuss the advisory role of RBI.
• Discuss the authorities invested with RBI.
• Discuss the autonomy for Central Bank.

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11.621.6 33


Learning Objectives of banking, and the filling in of gaps in the financial structure
After reading this lesson, you will understand become necessary.
• Monetary policy of RBI Objectives of Monetary Policy
• Objectives of monetary policy In the present day, it is generally accepted that the main objective
of monetary policy is the promotion of economic growth with
• Scope of monetary and fiscal policies
price stability, to elaborate, monetary policy has to be directed
• Monetary management towards attaining a high rate of growth, while maintaining

• Banks and credit creation reasonable stability of the internal purchasing power of money.
• Instruments of monetary control The central bank attempts to ensure an adequate level of

liquidity to support the rate of economic growth envisaged and
• Money supply

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to assist in the fullest possible utilization of resources without
After the overview of the whole financial institutions let us generating inflationary pressures. However, it is difficult to say
now get to the functioning of the financial system. with any degree of precision as to what is adequate under a
Monetary Policy of RBI given situation. But, as a working rule, the rate of increase in
You must know that the monetary policy is regarded as an money supply has to be somewhat higher than the projected

rd. F
indispensable tool of economic management. Monetary policy rate of growth of real national income to meet the demand for
refers to the use of official instruments under the control of the money likely to arise as income grows and correspondingly the

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central bank to regulate the availability, cost and use of money
and credit with the aim of achieving optimum levels of output
and employment, price stability, balance of payments
savings component, after taking into account the degree of
monetisation in the economy, an excessive growth in liquidity
relative to the requirements of real output would result in the
dfw P
equilibrium or any other goals set by the State, an appropriate build-up of inflationary pressures.
monetary policy by adjusting money supply to the needs of A central bank has necessarily to function within the ambit of
growth, directing the flow of funds in keeping with the overall the current economic milieu of the country. If the dominant
economic priorities, and providing institutional facilities for
w.p m

emphasis is on planned development, as in a country like India,

credit in specific areas of economic activity, created a favourable monetary policy has in addition to take care of promotional
environment for economic growth. The central bank exercises aspects such as monetary integration of the country, directing
its influence on the availability and cost of credit primarily by credit flow according to policy priorities, assisting in
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affecting the reserves position of commercial banks. mobilization of the savings of the community, and promotion
The efficacy of monetary policy depends on the prevailing of capital formation and, above all, extend support to the
economic situation and structural factors like the proportion of authorities in the task of allocation of resources by assisting in
currency in money supply, size of public debt, non-monetised the maintenance of an appropriate structure of relative prices.

sector in the economy and presence of active sub-markets. Scope of Monetary and Fiscal Policies
Again, the manner in which monetary policy is operated hinges Monetary policy is but one aspect of the broader economic
on the particular needs of the situation, such as the degree of policy of a country, the other important component being fiscal
imbalance in the overall supply-demand situation, trends in policy. Both monetary and fiscal policies have repercussions on

agricultural and industrial production and the general price level, the whole economy, affecting the price level, level of economic
and the balance of payments situation. Since these conditions activity, employment and balance of payments. While monetary
are constantly changing, the authorities have to adapt to the policy influences economic trends through the cost and
circumstances the choice and mix of various techniques, putting availability of credit, fiscal policy is a more important
emphasis as required on controlling the sources of money determinant of aggregate demand in as much as it directly
supply or interest rates policy. affects the financial resources and purchasing power in the
Monetary policy also encompasses institutional changes in the hands of the public.
banking and credit structure. While the level of savings is In the developing countries the central banks have been called
basically a function of the level of income, the absence or upon to play a positive and energetic role in administering
underdeveloped state of financial institutions inhibits the monetary policy to achieve the desired economic goals. In these
effective mobilization of savings for purposes of development, countries, fiscal policy is necessarily expansionary which means
the institutionalization of savings provides the potential saver that the central bank has to provide large funds to the
with a choice of financial assets with varying degrees of safety, Government in the form of loans and advances for purposes
liquidity and yield, in this context, wider geographical and of economic growth. Resort to central bank credit for meeting
functional coverage of institutional credit facilities, especially that budgetary deficits results in an expansion of money supply and

© Copy Right: Rai University

34 11.621.6
therefore in the cash reserves of banks. With the expansion of Monetary policy refers to the use of these instruments of


bank reserves, the ability of the banking system to expand control to regulate money supply and credit with a view to
credit also increased. In such a situation, monetary policy has to influence the level of aggregate demand for goods and services.
be such as to moderate the secondary expansion that will occur
as a result of the increase in bank reserves, while at the same
time ensuring that sufficient credit facilities are made available
for meeting the genuine needs of agriculture, industry,
commerce and other productive activities. Thus, on the one
hand, the credit policy has to be evolved to meet the credit
needs of the growing economy, and, on the other, it has to be
restrictive in order to keep in check inflationary forces. Moreover,
while making any change in the structure of interest rates, public
debt policy considerations will have to be kept in view.

Therefore, the monetary and fiscal policies need to be properly
coordinated to be really effective.
Monetary Management

In recent years, the objective of monetary policy in India has

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been twofold. It has to facilitate the flow of an adequate
volume of bank credit to industry, agriculture and trade to meet
their genuine needs and provide selective encouragement to
sectors which stand in need of special assistance such as the
weaker sections of the community and the neglected sectors and

rd. F
areas in the country. Al the same time, to keep inflationary
pressures under check it has to restrain under credit expansion

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and also ensure that credit is not diverted for undesirable
purposes. As the central monetary authority, the Reserves
Bank’s chief function is to ensure the availability of credit to the
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extent that is appropriate to sustain the tempo of development Banks and Credit Creation
and promote the maintenance of internal price stability. Deposits with banks may originate in two ways- through either
‘passive’ creation or ‘active’ creation. The former occurs when
The focus of monetary policy had to be adjusted from time to
w.p m

banks open deposit accounts for customers against receipt of

time so as to soften the impact of created money on the
value either in cash or by cheques drawn on other banks. The
economy and at the same time to achieve the objectives of
immediate effect is that there is no addition to the quantum of
planned development. The first decade of the Plan era saw the
money though its distribution may undergo a change; but
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revival of the traditional weapons of monetary control; during

ultimately it serves as the base for banks to extend credit and
the second half of that decade the regulatory functions were
would thus lead to an increase in money supply. Active creation
developed. In the sixties, the problems of stabilization were
of deposits takes place through the process of lending when
replaced by a greater concern for economic growth and control
the money lent out by banks re-enters the system as deposits.
over the accompanying increases in money supply. By the 1970s

The capacity of banks to provide credit depends on their cash

and through 1980, the twin objectives of provision of credit for
reserves, comprising cash in hand and balances with the central
attaining faster economic growth and price stabilization
bank. (The amount of cash to be kept by banks will be
assumed importance. This policy has come to be known as
determined both by the legal requirements and the pattern of
‘controlled expansion’.
the inflow and outflow of cash in a bank.) When a bank

Instruments of Monetary Control extends credit, either the whole of it or a part, depending upon
One of the most important functions of a central bank is the extent of banking habit would eventually find its way to the
monetary management-regulation of the quantity of money deposit stream, either with itself or with other banking
and the supply and availability of credit for industry, business institutions. Under the fractional reserve system, banks can
and trade. The monetary or credit management activities of the create deposits by a multiple of the reserves since the payments
bank are two types: general monetary and credit management made with the proceeds of bank loans are eventually
functions- total supply of money and credit and the general redeposited with banks leading to additional reserve funds.
level of interest rates. The central bank relies on two types of
Even in the countries with a widespread banking habit, there is
instruments, the direct and the indirect, the direct instruments
a limit to the ability of banks to generate deposits, which is set
of monetary control are reserve requirements, administered
by various economic and institutional factors. In developing
interest rates and credit controls; and the indirect instrument of
countries, the scope for credit creation by banks is much less
control is open market operations.
than in countries with a well-developed banking system. While
the Reserve Bank can regulate the amount of money creation by
banks through control of their cash reserves, in practice, the
regulation of money supply is not wholly under the Bank’s

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11.621.6 35
control. It is considerably affected by the budgetary operations Treasury Bills and Government securities and the Bank’s loans

of the Government over which the Bank has no control, and advances to the State Governments. However, it should be
although the Bank ahs opportunities of tendering advice to noted that the concept of net bank credit to the Central
Government on this matter. If the Government meets its Government is not the same as the Central Government’s
budgetary deficits by borrowing from the Reserve Bank, there budgetary deficit, especially since all term borrowings, including
will be an increase in money supply, both in currency and bank the increase in the banks’ holdings of Central Government
deposits; it may be relevant to note that there is no statutory securities, are treated in the budget as resources of the
limit on the extension of credit by the Bank to Government, Government while all holding of short-term paper (Treasury
another source of variations in money supply over which the bills) including the holding of non-bank institutions enter the
Banks, influence is restricted is the country’s external payments budgetary deficit.
position. Bank credit to the commercial sector, including that
Money Supply extended to public sector commercial undertakings, represents
The total expansion of money supply depends on the creation the gross commercial and co-operative banks’ credit and

of high-powered money (reserve base) and the multiplier action investments in the commercial sector’s shares, bonds and
upon it, the components of the reserve money are currency debentures, and the Reserve Bank’s credit to the commercial
with the public, other deposits with the RBI, and bankers’ sector, viz., loans and advances to financial institutions, internal

deposits with the RBI. Money multiplier is the mean value of bills purchased and discounted, holding of capital and bonds

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the ratio of money supply or aggregate monetary resources to of financial institutions, and investments in debentures.
reserve money. It is the interacting variable between these two The net foreign exchange assets of the Reserve Bank and the
monetary aggregates. Reserve requirements consist of cash foreign exchange assets of banks together constitute the net
reserve ratio and statutory liquidity ratio. The impact of any foreign exchange assets of the banking sector. In the former are
variation in the ratio is direct, precise and certain. Reserve

rd. F
included the Bank’s holdings of foreign securities, gold coin
requirements bear on the volume of credit by affecting the credit and bullion and balances held abroad; from the total is
base of bank reserves. Altering the ratios will affect the credit- deducted the balance in IMF Account excluding the amount of

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creating capacity of banks, volume of credit and therefore of
money supply. The impact of any change in reserve ratios on
money supply depends, besides the extent of multiple credit
quota subscription in rupees, the effect of the external sector on
money supply is measured by the movement in net foreign
exchange assets. Whenever there is an increase in net foreign
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creation by banks, on the ratio of bank reserves to total assets this is an expansionary factor even as a decrease is a
reserves, which is defined as the currency with the public and contractionary factor.
bank reserves. Net bank credit to Government is determined by the
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Government’s budgetary policies, including the size of the

budgetary deficit which again depends on the actual behaviour
of revenue and expenditure during the year, as the Reserve
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Bank is not able to influence the size of the budgetary deficit, it

has to formulate its credit policy within this overall constraint.
The banking system constitutes the major source of
institutional credit. Bank credit to the commercial sector can be
influenced by the RBI’s credit policies via the capacity of banks

to create credit and thereby influence a part of aggregate demand

in the economy. As a general rule, to control the growth of
liquidity in the economy caused mainly by the Government’s
budgetary deficits, the Reserve Bank acts primarily on bank

credit to the commercial sector.

Questions to Discuss:
The three important factors affecting money supply in India are 1. What do you understand by Monetary Policy?
the net bank credit to Government, bank credit to the 2. What are the objectives of monetary policy?
commercial sector and net foreign exchange assets of the
3. Discuss the scope of monetary and fiscal policies.
banking sector.
4. What is Monetary Management?
Net bank credit to Government is composed of net Reserve
Bank credit to the Government and the holdings of 5. Discuss Money Supply in detail.
Government securities by commercial and co-operative banks.
The Reserve Bank’s net credit to Government is the sum of the
Reserve Bank’s net credit to the Central Government and net
credit to the State Governments and is arrived at after deducting
deposits of the Central and State Governments with the
Reserve Bank from the sum total of the Bank’s investments in

© Copy Right: Rai University

36 11.621.6

Learning Objectives institution by the approved brokers. In a triangular switch

After reading this lesson, you will understand operation, the selling bank’s quota (fixed on the basis of time
and demand deposit liabilities) is debited (the Reserve Bank
• Tools of monetary policy
being the purchaser). The objective behind fixing a quota for
• Instruments of general credit control switch deals is to prevent the excessive unloading of low
• Goals of monetary policy yielding securities on to the Reserve Bank. The Bank maintains
• Recent policy developments separate lists for purchase and sale transactions with reference to

its stock of securities and the dates of maturity of the different
After discussing the monetary policy in our last lesson let us
now discuss the tools of monetary policy.
REPO auction was allowed since 1992-93. Since November

What are Open Market Operations? 1999 REPOs are offered on a daily fixed rate basis to provide

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Open market operations can be continuous and flexible in signals to money market rates and impart stability to short-term
influencing bank reserves. Effects depend on the medium of interest rates by setting a floor to call rates.
operation, short bills like Treasury Bills or long-term securities,
till the initiation of several measures to promote primary and REPOs and Reverse REPOS
secondary markets in Government securities since 1992-93, the In order to activate the REPOs market so that it serves as an

rd. F
market was quite narrow. There was no choice of amount. The equilibrating force between the money market and the securities
amount was determined by the budgetary requirements and the market, REPO and reverse REPO transactions among select

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interest rate by the need to keep the cost of borrowing low. As
the corollary to the financial liberalization measures, the
automatic monetisation of the fiscal deficit was limited to Ways
institutions have been allowed since April 1997 in respect of all
dated Central Government securities besides Treasury Bills of
all maturities, a system of announcing a calendar of REPO
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and Means Advances at market related interest rates form April auctions to enable better treasury management by participants
1,1997 and development of money market and securities was introduced in January 1997.
market by way of introduction of new instruments, auction Reverse REPOs ease undue pressure on overnight call money
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system for Government securities (including repos/reverse rates. PDs are allowed liquidity support in the form of reverse
repos) and instituting a network of primary and satellite dealers REPO facility.
with a view to enabling the emergence of open market Reverse REPO transactions can be entered into by non-bank
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operations as the principal instrument of liquidity entities who are holders of SGL accounts with the Reserve
management. Bank with banks, primary dealers in Treasury Bills of all
REPOs maturities and all dated central government securities. The first
REPO and reverse REPO operated by RBI in dated step if the transaction by non-bank entites should be by way of
government securities and Treasury Bills (except 14 days) help purchase of securities eligible for REPOs from banks/primary

banks to manage their liquidity as well as undertake switch to dealers and the second step will be by way of selling back
maximize the return. REPOs are also used to signal changes in securities to banks/primary dealers. Non-bank entities are
interest rates. REPOs bridge securities and banking business. however not allowed to enter into REPO transactions with
A REPO is the purchase of one loan against the sale of banks/primary dealers. The transactions have to be effected at

another. They involve the sale of securities against cash with a Mumbai.
future buy back agreement. There are no restrictions on tenor of Interbank REPOs
REPOs. They are well established in US and spread to Euro Commercial banks and select entities can conduct REPO
market in the second half of 1980s to meet the trading demand transactions in PSU bonds and private corporate debt securities.
from dealers and smaller commercial banks with limited access These transactions provide liquidity support to the debt market
to international interbank funding. REPOs are a substitute for Delivery Versus Payment (DVP) was introduced in April 1999
traditional interbank credit. as a regulatory safeguard.
REPOs are part of open market operations undertaken to In July 1999 non-bank participants in the money market were
influence short-term liquidity. With a view to maintain an allowed to access short-term liquidity through REPOs on par
orderly pattern of yields and to cater to the varying requirements with banks.
of investors with respect to maturity distribution policy or to It may be noted that according to the international accounting
enable them to improve the yields on their investment in practices, the funds advanced by the purchaser of a security
securities, RBI engages extensively in switch operations. In a under a firm repurchase agreement are generally treated as
triangular switch, one institution’s sale/purchase of security is
matched against the purchase/sale transaction of another

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11.621.6 37
collaterised loan and the underlying security is maintained on operations, which can also be used for carrying out changes on

the balance sheet of the seller even the smallest scale. Changes in reserve requirements operate
directly and immediately by affecting the quantum of loanable
What do you Understand by Discount Policy?
resources with banks: an increase reduces the banks capacity to
Discount loans are loans from the central bank to depository
lend and a reduction in effect places funds with them. The
institution and that the discount rate is the interest rate charged
effects of changing reserve requirements are similar in some
on these loans. Discount policy, which primarily involves
respects to but different in others from those of open market
changes in the discount rate, affects reserves in the banking
operations. They are similar in that they both change instantly
system because when a discount loan is extended, the central
the reserve position of banks and set in motion secondary
bank increases a bank’s reserves by an equal amount.
forces leading to multiple expansion or contraction of credit.
In addition to its use as a tool to influence reserves in the The two instruments differ in that changes in reserve
banking system and the money supply, discounting is requirements are much more effective than open market
important in preventing financial panics. An important role of operations (and also discount rate) in situations where the
RBI is intended to be as the lender of last resort; it was to

banks have a volume of reserves far in excess of the legal
provide reserves to banks when no one else would in order to requirements or where a large expansion of credit is desired, to
prevent bank failures from spinning out of control, thereby elaborate, where large-scale and widespread liquidity exists, a rise
preventing bank and financial panics. Discounting is a

in reserve requirements will be more useful in eliminating the
particularly effective way to provide reserves to the banking

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excess reserves. Once this is done, open market operations are
system during a banking crisis because reserves are immediately more suitable as a flexible instrument to tighten or ease credit
channeled to the banks that need them most. operations, as it is selective in its application and can also be
What is the Reserve Requirement? used on a day-to-day basis. Conversely, the reserve requirements
Changes in reserve requirements affect the demand for reserves: can be lowered to bring about an increase in general liquidity in

rd. F
A rise in reserve requirements means that banks must hold the banking system, and thereafter through open market
more reserves, and a reduction means that they are required to operations the liquidity can be maintained at the desired level.

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hold less. All depository institutions, including commercial
banks, savings and loan associations, mutual savings banks,
and credit unions, are all subject to reserve requirements.
Unlike the Bank rate whose effectiveness depends, among other
things, upon the attitude of the commercial banks and the
borrowers, open market operations can be so regulated that
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Reserve requirements have been rarely used as a monetary policy bank reserves change to the level desired by the central bank. In
tool because raising them can cause immediate liquidity the final analysis, however, the use of one instrument rather
problems for banks with low excess reserves. Continually than another at any point of time is determined by the nature
of the situation and the range of influence it is desired to wield
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fluctuating reserve requirements would also create more

uncertainty for banks and make their liquidity management as well as the rapidity with which the change is required to be
more difficult, brought about. Rather, it has come it be recognized that in the
majority of circumstances, no single instrument is adequate to
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Instruments of General Credit Control meet the task; instead, all three need to be employed in
Instruments of credit control are of two types: general of appropriate combination.
quantitative and selective of qualitative. The instruments of
In India, the statutory basis for the regulation of the credit
general credit control are the Bank rate, also known as the
system by the Bank is embodied in the Reserve Bank of India
discount rate, reserve requirements and open market

Act and the Banking Regulation Act. The former confers on the
operations. All the three methods by affecting the lendable
Bank the usual powers available to central banks generally, while
resources of the commercial banks affect the total volume of
the latter provides special powers of direct regulation of the
credit and hence total money supply. In the case of selective
operations of the commercial and co-operative banks.
credit controls the impact is not so much on the total amount

of credit as on the direction of credit, i.e., on the amount that is Goals of Monetary Policy
put to use in a particular sector of the economy, and they bring Reserve Bank of India focuses on the following main six basic
to bear a restraining influence on the borrowers. goals of monetary policy:
The three instruments are designed to affect the liquidity in the • High employment
economy by acting on the quantum of bank reserves. Open • Economic growth
market operations and reserve requirements directly affect the • Price stability
reserve base while the Bank rate produces its impact indirectly
• Interest-rate stability
through variations in the cost of acquiring the reserves. The
effects of Bank rate changes are not confined to the banking • Stability of financial markets
system and the money market; they produce wider • Stability in foreign exchange markets
repercussions on the economy as a whole. However, its action is
High Employment
indirect, its influence on money and credit being through
Promoting high employment consistent with a stable price level
primary changes in short-term money rates and secondary
is a worthy goal for two main reasons: (1) the alternative
repercussions on long-term interest rates or yields; i9t is not
situation, high unemployment, causes much human misery,
also as flexible for day-to-day adjustments as open market

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38 11.621.6
with families suffering financial distress, lass of personal self- hamper economic growth. For example, the information


respect, and increase in crime (though this last conclusion is conveyed by the prices of goods and services is harder to
highly controversial), and (2) when unemployment is high, the interpret when the overall level of process is changing, which
economy has not only idle workers but also idle resources complicates decision making for consumers, businesses, and
(closed factories and unused equipment), resulting in a loss of government, not only do public opinion surveys indicate that
output (lower GDP) the public is very hostile to inflation, but also a growing body
Although it is clear that high employment is desirable, how of evidence suggests that inflation leads to lower economic
high should it be? At what point can we say that the economy is growth. The most extreme example of unstable prices is
at full employment? At first, it might seem that full hyperinflation, such as Argentina, Brazil, and Russia have
employment is the point at which no worker is out of job, that experienced in the past. Many economists attribute the slower
is, when unemployment is zero. But this definition ignores the growth that these countries have experienced to their problems
fact that some unemployment, called frictional with hyperinflation. Further, inflation may strain a country’s
unemployment, which involves searches by workers and firms social fabric: Conflict may result because each group in the

to fund suitable matchups, is beneficial to the economy. For society may compete with other groups to make sure that its
example, a worker who decides to look for a better job might be income keeps up with the rising level of prices.
unemployed for a while during the job search. Workers often Interest-Rate Stability

decide to leave work temporarily to pursue other activities Interest-Rate stability is desirable because fluctuations in interest

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(raising a family, travel, returning to school), and when they rates can create uncertainty in the economy and make it harder to
decide to reenter the job market, it may take some time for plan for the future, fluctuations in interest rates that affect
them to fund the right fob. The benefit of having some consumers’ willingness to buy houses, for example, make it
unemployment is similar to the benefit of having a nonzero more difficult for consumers to decide when to purchase a
vacancy rate in the market for rental apartments. house and for construction firms to plan how many houses to

rd. F
Another reason that unemployment is not zero when the build. Upward movements in interest rates generate hostility
economy is at full employment is due to what is called toward central banks like RBI and lead to demands that their

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structural unemployment, a mismatch between job
requirements and the skills or availability of local workers.
Clearly, this kind of unemployment is undesirable.
power be curtailed.
Stability of Financial Markets
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Financial crises can interfere with the ability of financial markets
Nonetheless, it is something that monetary policy can do little to channel funds to people with productive investment
about. opportunities, thereby leading to a sharp contraction in
The goal for high employment should therefore not seek an economic activity. The promotion of a more stable financial
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unemployment level of zero but rather a level above zero system in which financial crises are avoided is thus an important
consistent with full employment at which the demand for labor goal for a central bank.
equals the supply of labor. This level is called the natural rate The stability of financial markets is also fostered by interest-rate
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of unemployment. stability because fluctuations in interest rates create great

Economic Growth uncertainty for financial institutions. An increase in interest rates
The goal of steady economic growth is closely related to the produces large capital losses on long-term bonds and
high-employment goal because businesses are more likely to mortgages, losses that can cause the failure of the financial
invest in capital equipment to increase productivity and institutions holding them. In recent years, more pronounced

economic growth when unemployment is low. Conversely, if interest-rate fluctuations have been a particularly severe problem
unemployment is high and factories are idle, it does not pay for for savings and loan associations and mutual savings banks.
a firm to invest in additional plants and equipment. Although Stability in Foreign Exchange Markets
the two goals are closely related, policies can be specifically aimed

With the increasing importance of international trade to the

at promoting economic growth by directly encouraging people Indian economy, the value of the rupees relative to other
to save, which provides more funds for firms to invest, in fact, currencies has become a major consideration for the RBI. A rise
this is the stated purpose of so-called supply-side economics in the value of the rupee makes Indian industries less
policies, which are intended to spur economic growth by competitive with those abroad, and declines in the value of the
providing tax incentives for businesses to invest in factories and rupee stimulate inflation in India. In addition, preventing large
equipment and for taxpayers to save more, there is also an active changes in the value of the rupee makes it easier for firms and
debate over what growth role monetary policy can play in individuals purchasing or selling goods abroad to plan ahead.
boosting growth. Stabilizing extreme movements in the value of the rupee in
Price Stability foreign exchange markets is thus viewed as a worthy goal of
Over the past few decades, policymakers in India have become monetary policy,
more aware of the social and economic costs of inflation and Conflict Among Goals
more concerned with a stable price level as a goal of economic Although many of the goals mentioned are consistent with
policy. The price stability is desirable because a rising price level each other-high employment with economic growth, interest-
(inflation) creates uncertainty in the economy, and that may rate stability with financial market stability-this is not always the

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11.621.6 39
case. The goal of price stability often conflicts with the goals of • Fiscal-monetary relationship has been reformed in a major

interest-rate stability and high employment in the short run way by abolishing the system of automatic monetisation of
(but probably not in the long run). For example, when the fiscal deficit, which was taking place through the issuance of
economy is expanding and unemployment is falling, both ad hoc treasury bills. This has been achieved through the
inflation and interest rates may start to rise, if the central bank signing of two agreements between the GOI and the RBI.
tries to prevent a rise in interest rates, this may cause the • Interest rates structure has been simplified and deregulated.
economy to overheat and stimulate inflation. But is a central
• Far-reaching changes in the external sector of the economy
bank raises interest rates to prevent inflation, in the short run
have been effected. Substantial elimination of imports and
unemployment may rise, the conflict among goals may thus
exchange controls, introduction of market-determined
present central banks like RBI with some hard choices.
exchange rate system, rupee convertibility, encouragement to
FDI, and greater access to external capital markets are some
of these changes.

The goals of monetary policy include a stable price level,
economic growth, high employment, stable interest rates, and
predictable and steady currency exchange rates. Unfortunately,

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monetary policies involve difficult trade-offs, and policies that
help to achieve one goal may make another less attainable.
The conduct of monetary policy involves actions that affect the
RBI’s balance sheet. Open market purchases lead to an
expansion of reserves and deposits in the banking system and

rd. F
hence to an expansion of the monetary base and the money
supply. An increase in discount loans leads to an expansion of

iza D reserves, thereby causing an expansion of the monetary base

and the money supply. The three basic tools of monetary policy
are open market operations, discount policy, and reserve
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Recent Policy Developments requirements. Open market operations are the primary tool.
Although the above-given account of the long-term evolution
of monetary policy has referred to certain recent changes, a brief Because predicting the Reserve Bank’s actions can help managers
critical update of the RBI policy will be useful for purposes of of financial institution predict the course of future interest
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study. rates, which has a major impact on the financial institutions’

profitability, such managers value the services of RBI watchers,
Major Changes experts on Central Bank behavior.
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• The recent monetary policy, particularly the one announced in

Questions to Discuss:
April 1997 and October 1997 can be said to have ushered in
the following changes: 1. What are Open Market Operations?

• It has encouraged greater market orientation in the financial

2. What are the instruments of general credit control?
sector by empowering banks with greater operational 3. Discuss the goals of monetary policy.

flexibility. Although the RBI will continue to prescribe 4. Discuss the recent policy developments.
prudential guidelines, it has now moved out of
• The borrowers also have been empowered to reinforce

marketisation, and this is bound to change the relationship

between borrowers and bankers.
• The interest rates are now sought to be emphasised as
potential instruments for influencing the liquidity in the
system. The Bank rate is being made an important signal and
reference rate to define determine the stance of monetary
policy and the cost of funds ill the economy.
• The policy is directed to integrate further the money market,
the government securities market, and the forex markets.
• The government securities market is being made an active
segment of the IPS so that the conduct of monetary policy
could be rendered effective.

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40 11.621.6


i al
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rd. F
iza D
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w.p m
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11.621.6 41


Learning objectives The SEBI was established on April 12, 1988 through an
After reading this lesson, you will understand administrative order, but it became a statutory and really
powerful organisation only since 1992. The CICA was repealed
• Securities contracts (regulation) act, 1956
and the office of the CCI was abolished in 1992, and the SEBI
• Securities and exchange board of India was set up on 21 February 1992 through an ordinance issued on
• Objectives and regulatory approach 30 January 1992. The ordinance was replaced by the SEBI Act
• Powers, scope, and functions on 4 April 1992. Certain powers under certain sections of SCRA

and CA have been delegated to the SEBl. The regulatory powers
Discussion on SEBI is important for our discussion. It is one
of the SEBI were increased through the Securities Laws
of most important regulatory authority in India. It is gaining
(Amendment) Ordinance of January 1995, which was

more importance day by day with new issues cropping up.
subsequently replaced by an Act of Parliament. The SEBI is

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Securities Contracts (Regulation) Act, 1956 under the overall control of the Ministry of Finance, and has its
The objective of the Securities Contracts (Regulation) Act head office at Mumbai. It has now become a very important
(SCRA) is to regulate the working of stock exchanges or constituent of the financial regulatory framework in India.
secondary market with a view to prevent undesirable The philosophy underlying the creation of the SEBI is that
transactions or speculation in securities, and thereby to build up

rd. F
multiple regulatory bodies for securities industry mean that the
a healthy and strong investment market in which public could regulatory system gets divided, causing confusion among
invest with confidence. It empowers the GOI to recognise and market participants as to who is really in command. In a

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derecognise the stock exchanges, to stipulate laws and by-laws
for their functioning, and to make the listing of securities on
stock exchanges by Public Limited Companies (PULCOs)
multiple regulatory structure, there is also an overlap of
functions of different regulatory bodies. Through the SEBI,
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the regulation model which is sought to be put in place in India
mandatory. It prohibits securities transactions outside the is one in which every aspect of securities market regulation is
recognised stock exchanges. It lays down that all contracts in entrusted to a single highly visible and independent
securities except spot delivery contracts can be entered into only organisation, which is backed by a statute, and which is
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between and through the members of recognised stock accountable to the Parliament and in which investors can have
exchanges. It prescribes conditions or requirements for listing trust.
of securities on the recognised stock exchanges. It empowers
Constitution and Organisation
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the GOI to supercede the governing bodies of stock exchanges,

to suspend business on recognised stock exchanges, to declare The SEBI is a body of six members comprising the Chairman,
certain contracts illegal and void under certain circumstances, to two members from amongst the officials of the ministries of
prohibit contracts in certain cases, to license the security dealers, the central government dealing with finance and law, two
and to lay down penalties for contravention of the provisions members who are professionals and have experience or special
knowledge relating to securities market, and one member from

of the Act. It is administered by the Ministry of Finance,

Department of Economic Affairs, GOI. the RBI. All members, except the RBI member, are appointed
by the government, who also lays down their terms of office,
Securities and Exchange Board of India tenure, and conditions of service, and who can also remove any
Genesis member from office under certain circumstances. The central

The year 1991 witnessed a big push being given to liberalisation government is empowered to supersede the SEBI in public
and reforms in the Indian financial sector. For sometime interest, or if, on account of grave emergency, it is unable to
thereafter, the volume of business in the primary and secondary discharge its functions or duties, or if it persistently defaults in
securities markets increased significantly. As a part of the same complying with any direction issued by the government, or if
reform process, the globalisation or internationalisation of the its financial position and administration deteriorates.
Indian financial system made it vulnerable to external shocks. The work of the SEBI has been organised into five operational
The multi-crore securities scam rocked the IFS in 1992. All these departments each of which is headed by an executive director
developments impressed on the authorities the need to have in who reports to the Chairman. Besides, there is a legal
place a vigilant regulatory body or an effective and efficient department and the investigation department. The departments
watchdog. It was felt that the then existing regulatory have been divided into divisions. The various departments and
framework was fragmented, ill coordinated, and inadequate and the scope of their activities are as follows:
that there was a need for an autonomous, statutory, integrated
(i) The Primary Market Policy, Intermediaries, Self-Regulatory
organisation to ensure the smooth functioning of the IFS. The
Organisations (SROs), and Investor Grievance and Guidance
SEBI came into being as a response to these requirements.
Department. It looks after all policy matters and regulatory

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42 11.621.6
issues in respect of primary market, registration, merchant Table 1: Details of Intermediaries Registered


bankers, portfolio management services, investment
advisers, debenture trustees, underwriters, SROs and
investor grievance, guidance, education, and association.
(ii) The Issue Management and Intermediaries Department: It
is responsible for vetting of all prospectuses and letters of
offer for public and right issues, for coordinating with the
primary market policy, for registration, regulation and
monitoring of issue-related intermediaries.
(iii) The Secondary Market Policy, Operations and Exchange
Administration, New Investment Products and Insider
Trading Department: It is responsible for all policy and
regulatory issues for secondary market and new investment Objectives and Regulatory Approach

products, registration and monitoring of members of stock The overall objective of the SEBI, as enshrined in the Preamble
exchanges, administration of some of the stock exchanges, of the SEBI Act, 1992 is “to protect the interests of investors
market surveillance and monitoring of price movements and in securities and to promote the development of, and to

insider trading and EDP and SEBI’s data base. regulate the securities market and for matters connected

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therewith or incidental thereto”. To elaborate, the SEBI
(iv) The Secondary Market Exchange Administration,
regulates stock exchanges and securities industry to promote
Inspection and Non-member Intermediaries Department: It
their orderly functioning. It protects the rights and interests of
looks after the smaller stock exchanges of Guwahati,
investors, particularly individual investors, and guides/educates
Magadh, Indore, Mangalore, Hyderabad, Bhubaneshwar,
them. It prevents trading malpractices and aims at achieving a

rd. F
Kanpur, Ludhiana and Cochin. It is also responsible for
balance between self-regulation by securities industry and its
inspection of all stock exchanges, and registration, regulation
statutory regulation.
and monitoring of non-member intermediaries such as sub-
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(v) Institutional Investment (Mutual Funds and Foreign
Having regard to the emerging nature of the securities markets
in India, the SEBI necessarily has the twin task of regulation
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Institutional Investment), Mergers and Acquisitions, and development. Its regulatory measures are always meant to
Research and Publications, and International Relations and be subservient to the needs of the market development.
IOSCO Department: It looks after policy, registration, Underlying those measures is the logic that rapid and healthy
regulation and monitoring of Foreign Institutional market development is the outcome of well-regulated
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Investors (FIls), domestic mutual funds, mergers and structures. In this spirit, the SEBI endeavours to create an
substantial acquisitions of shares, and IOSCO (International effective surveillance mechanism and encourage responsible and
Organisation of Securities Commissions) membership, accountable autonomy on the part of all players in the market,
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international relations, and research, publication and Annual who are expected and required to discipline themselves and
Report of SEBI. observe the rules of the market. The self-regulation and
regulation by exception are thus the comer stones of its
(vi) Legal Department looks after all legal matters under the regulatory framework. The SEBI believes that self-regulation
supervision of the General Counsel. can work only if there is an effective regulatory body overseeing

(vii) Investigation Department carries out inspection and the activities of self-regulatory organisations.
investigation under the supervision of the Chief of The SEBI also aims at facilitating an efficient mobilisation and
Investigation: allocation of resources through the securities markets,
The SEBI has regional offices at Kolkata, Chennai and Delhi. It stimulating competition, and encouraging innovations. Its

has also formed two non-statutory advisory committees regulation is expected to be flexible, cost -effective and
namely, the Primary Market Advisory Committee and Secondary confidence- inspiring. To investors, the SEBI provides a high
Market Advisory Committee with members from market degree of protection of their rights and interests through
players, recognised investor associations, and other eminent adequate, accurate, and authentic information and disclosure of
persons. such information on a continuous basis. To issuers, it provides
SEBI is a member of IOSCO, an international body a market place in which they can confidently raise all the finance
comprising of security regulators from over 100 countries. It they need in an easy, fair, and efficient manner. To the market
participates in the Development Committee of IOSCO, which intermediaries, it offers a competitive, professionalised and
provides a platform for regulators from emerging markets to expanding market with adequate and efficient infrastructure so
share their views and experiences. that they can render better and more responsible service to the
investors and issuers.

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11.621.6 43
Table 2: Exchange wise Brokers Registered with SEBI As said earlier, with the repeal of the ClCA, all matters related to

the issue of capital are now governed by the guidelines issued

by the SEBI. Similarly, as a result of the delegation of certain
powers under the SCRA to the SEBl, the latter can conduct
inquiries into the working of the stock exchanges which have to
-submit their annual reports to the SEBl and seek its approval
for amending their rules and bye-laws; it can direct them to
amend their bye-laws and rules including reconstitution of their
governing boards/councils; and it is empowered to license
security dealers operating outside their jurisdiction.
Consequent on the amendments to the SEBl Act in 1995, the
regulatory powers over corporate in the issuance of capital,
transfer of securities and other related matters are now vested in

the SEBI. The amendments also provide for the deletion of
the existing provision relating to disqualification of a member
of the SEBl Board on his being appointed as a director of a

company. The SEBl has also been empowered to demand

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explanations, to summon the attendance and call for
documents from all categories of market intermediaries in order
to enable it to investigate irregularities, impose penalties, and
initiate prosecution. The SEBl has also been empowered now
to notify its regulations and file complaints in courts without

rd. F
the prior approval of the GOI.
However, in the exercise of its powers and in performing its
Powers, Scope, and Functions
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The scope of operations of the SEBI is very wide; it can frame
functions, the SEBl is bound by such directions on questions
of policy as the GOl may give in writing from time to time.
Although it has the opportunity to express its views before any
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or issue rules, regulations, directives, guidelines, norms in
respect of both the primary and secondary markets, direction is given, the decision of the GOI is final in every case.
intermediaries operating in these markets, and certain financial Questions to Discuss:
institutions. It has powers to regulate (i) depositories and
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1. Discuss the constitution and organization of SEBI.

participants, (ii) custodians, (iii) debenture trustees, and trust
deeds, (iv) FIls, (v) insider trading, (vi) merchant bankers, (vii) 2. Discuss the objectives and regulatory approach of SEBI
mutual funds, (viii) portfolio managers, and investment 3. What are the powers, scope, and functions of SEBI?
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advisers, (ix) registrars to issue and share transfer agents, (x)

stock brokers and sub-brokers, (xi) substantial acquisition of
shares and takeovers, (xii) underwriters, (xiii) venture capital
funds, and (xiv) bankers to issues. The SEBl can issue
guidelines in respect of (a) information disclosure, operational

transparency, and investor protection, (b) development of

financial institutions, (c) pricing of issues, (d) bonus issues, (e)
preferential issues, (f) financial instruments, (g) firm allotment
and transfer of shares among promoters.

The SEBl is empowered to register any agency or intermediary

who may be associated with the securities market and none of
them shall buy, sell or deal in securities except under and in
accordance with the conditions of a certificate of registration
issued by the SEBI. However, the GOI is empowered to
exempt any person or class of persons from registration with
the SEBI. The SEBl can suspend or cancel a certificate of
registration issued by it to anyone, after giving him a reasonable
opportunity of being heard. The SEBl Act lays down the civil
and criminal penalties for contravention of the Act; anyone who
contravenes or attempts to contravene or abets contravention
of the provisions of the Act or of any rules or regulations
made thereunder, is punishable with imprisonment or fine or

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44 11.621.6

Learning objectives • Bankers to an issue and portfolio managers have to be

After reading this lesson, you will understand registered with the SEBI. There were 77 bankers to issue
who were thus registered as of 31, March 1996. Similarly,
• Highlights of SEBI’s performance
there were 13 registered and 100 permitted portfolio
• Appraisal of SEBI’s work managers at the end of March 1996.
Let us move ahead with our discussion on SEBI. Let us now
Secondary Market and Intermediaries
discuss highlights and appraisal of SEBI’s work.

• The governing boards and various committees of stock
Highlights of Sebi’s Performance exchanges (SEs) have been recognised, restructured and
Since the enactment of the SEBl Act in 1992, financial broad-based.
institutions, agencies, and market intermediaries mentioned

• Inspection of all 22 SEs has been carried out to determine,

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above are now being governed by the guidelines, rules, and
inter alia, the extent of compliance with the directives of the
regulations notified by the SEBI from time to time. Due to lack
of space, it is not possible to present their exhaustive list here.
We give below only the major policy measures and reforms • Computerised 0r screen-based trading has been achieved on
introduced by the SEBl during 1992 to 1996. almost all exchanges except some of the smaller ones.

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• Corporate membership of SEs is now allowed, encouraged,
Primary Securities Market
and preferred. The Articles of Association of SEs have been
• The issues of capital by companies no longer require any

pricing it. iza D

consent from any authority either for making the issue or for
amended so as to increase their membership. All the SEs
have been directed to establish either a clearing house or a
clearing corporation.
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• Efforts have been made to raise the standards of disclosure • The Bombay Stock Exchange (BSE) has been asked to reduce
in public issues and enhance their transparency. The SEBI trading period or settlement cycle from 14 to 7 days for B
has accepted and implemented almost all the group shares.
recommendations of Malegam Committee appointed by it
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• A process through which investor grievances against brokers

in 1994-95 in this connection.
may find redressal through a complaint to the SEBI has
• The offer document is now made public even at the draft been put in place.
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• All the recommendations of the Dave Committee for

• Companies making their first public issue are eligible to do improving the working of the OTCEI have been accepted.
so only if they have three years of dividend-paying track
• The SEs have been instructed to set up independent market
record preceding an issue. Those not meeting this
surveillance departments. The SEBI has strengthened its
requirement can still make an issue if their projects are
own investigation and enforcement machinery.

appraised by banks or FIs with minimum 10 per cent

participation in the equity capital of the issuer, or if their • In accordance with the recommendations of G.S. Patel
securities are listed on the OTCEI (Over-the-Counter Committee, BSE has been allowed to introduce a revised
Exchange of India). carry forward system (CFS) of trading. Other SEs can
introduce forward trading only with the prior permission of

• For issues above Rs 100 crore, book-building requirement

the SEBI. Transactions are not allowed to be carried forward
has been introduced.
for more than 90 days now. The shares received by financiers
• The pricing of preferential allotment has to be at market funding carry forward transactions have to be deposited and
related levels, and there is a five-year lock- in period for such kept in the safe custody of the clearing house of the stock
allotments. exchange or its authorised agent. Every member is required
• In case of proportionate allotment scheme, a minimum of to keep books and records of the source of finance with the
50 per cent of the net offer to the public is to be reserved for sub accounts being maintained in the clearing house. The
individual investors applying for securities not exceeding scrip-wise carry forward position has to be disclosed to the
1000 securities, and the remaining part can be allotted market. The SEs are required to introduce the ‘twin track’
to applications for more than 1000 securities. system which will segregate transactions into carry forward
• Initially, the underwriting of issues to public was made and cash transactions, and each one of the former will be
mandatory, but now this stipulation has been removed. identified with a transaction identification number till its
During 1995-96, the SEBI granted registration to four final settlement.
underwriters, bringing their total number to 40. • The brokers are required to ensure segregation of client
account and own account.

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11.621.6 45
• The capital adequacy norms of 3 per cent for individual schemes are required to be kept with an independent custodian.

brokers and 6 per cent for corporate brokers introduced. ‘I’here has to be an arms-length relationship between the
• Both the brokers and sub-brokers have been brought within trustees, the asset management company, and the custodian.
the regulatory fold for the first time now; and the concept of The SEBI (Mutual Funds) Regulations, 1993 were revised to
the dual registration of stock brokers with the SEBI and the provide for portfolio disclosure, standardisation of accounting
SEs has been introduced. The total number of registered policies, valuation norms for determining net asset value and
brokers and sub-brokers was 8,746 at the end of March pricing.
1996, of which 1917 were corporate members. The UTI has been organised under the UTI Act, 1963, and it
• Penal action can now be taken directly by the SEBI against has evolved as a distinct institution. Therefore, certain special
any member of a stock exchange for violation of any dispensations have been provided to it under the SEBI
provision of the SEBI Act. regulatory framework. Subject to this, the UTI also has been
brought under the SEBI since July 1994. As a result, new
• It has been made mandatory for the stock” brokers to
schemes of the UTI also now fall under the jurisdiction of the
disclose the transaction price and brokerage separately in the

contract notes issued by them to their clients.
• The daily margin and additional margin for volatile scrips are Miscellaneous

now levied on a weekly and marked-- to-market basis. • FIls are also required to be registered with the SEBI. The

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• The SEs have amended their Listing Agreements such that total number of them so registered were 367 as of 31 March
the issuers have now to provide shareholders with cash flow 1996.
statements in a prescribed format, along with the complete • It is required that the capital of companies to be registered as
balance sheet and profit and loss statement. depositories must be Rs 100 crore. Similarly custodians are
• The trading hours in almost all the SEs have now been required to have a net worth of Rs 50 crore, and they are to

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increased from 21/2 hours to 3 hours per day. get their systems and procedures evaluated externally.
• Compulsory audit of the brokers’ books and filing of the • Venture capital funds (VCFs) allowed to invest in unlisted

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audit reports with the SEBI has now been made mandatory.
• A system of market making in less liquid scrips on selected
companies, to finance turnaround companies, and to provide
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SEs has been introduced. • As per the approved modified takeover code recommended
by the Bhagawati Committee, the minimum public offer of
• Insider trading has been prohibited and such trading has
20 per cent purchase, when the threshold limit of 10 per cent
been made a criminal offence punishable in accordance with
equity is crossed, is made mandatory. Those in control are
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the provisions of the SEBI Act.

permitted to 2 per cent of shares per annum upto a
• Registrars to Issues (RI) and Share Transfer Agents (STA) maximum of 51 per cent. The acquirers have to deposit a
have now been classified into two categories: Category I with certain value of cash and assets in an escrow account. The
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a minimum net worth requirement of Rs 6 lakh who can escrow deposits have to be higher for conditional public
carry on the activities both as RI and STA, and category II offers unless the acquirer agrees to buy a minimum of 20 per
with a minimum net\worth requirement of Rs 3 lakh who cent.
can carry on anyone of these activities. There were 209 RI and
STA in Category I and 125 in Category II at the end of Investor Protection Measures
The SEBI has introduced an automated complaints handling

March 1996.
system to deal with investor complaints. To create an awareness
• Till end-August 1997, merchant bankers (MBs) were
among the issuers and intermediaries of the need to redress
classified into four categories, each with different investor grievances quickly, the SEBI has been issuing
responsibilities and commensurate with capital requirements. fortnightly press releases publishing the names of the

With effect from September 1997, such a classification has companies against whom maximum number of complaints
been abolished and there will be only one entity now, have been received. To help investors in respect of delay in
namely, merchant bankers. A system of penalty points for receiving refund orders in case of oversubscribed issues, a facility
MBs for defaults committed by them has been introduced. It in the form of stockinvest has been introduced. To ensure that
is provided that they can be suspended or deauthorised after no malpractice takes place in the allotment of shares, a
a maximum of 8 penalty points. The MBs have to fulfill representative of the SEBI supervises the allotment process. It
capital adequacy requirements also. During 1995-96, 231 MBs has also accorded recognition to several genuine, active investor
were granted registration, while registration of nine MBs was associations. It issues advertisements from time to time to
cancelled. The number of MBs was 1,012 in 1995-96 and 790 guide and enlighten investors on various issues related to the
in 1994-95. securities market and of their rights and remedies.
Mutual Funds
As on 31 March 1996, 26 mutual funds (MFs) excluding the
UTI were registered with the SEBI. MFs are required to have a
board of trustees or trustee company separate from the asset
management company, and securities belonging to the various

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46 11.621.6
The complaints received by the SEBI are categorised in five There are many examples of this. The SEBI’s rejection of the


types: Malegam Committee’s recommendation that new companies
• Type I: Non-receipt of refund orders/allotment letters/ should never be allowed to get listed on stock exchanges is one
stockinvests. such example. Its dispensing with the requirement of the
vetting of public and rights issues is another example. The
• Type II: Non-receipt of dividend.
dispensing with the requirements of minimum promoters’
• Type III: Non-receipt of share certificates/bonus shares. contribution and lock-in in the case of a company whose shares
• Type IV: Non-receipt of debenture certificates/interest on are listed on a stock exchange for at least three years is yet
debentures/redemption amount of debentures/ interest on another example. The appointment of another panel (J.R.
delayed payment of interest. Verma panel) by the SEBI on the carry forward system within a
• Type V: Non-receipt of annual reports, rights issue forms/ matter of one year of the presentation of the report by the G.S.
interest on delayed receipt of refund orders/ dividends. Patel Committee on the same subject, because of the
recalcitrance and pressures imposed by the stockbrokers, best
Appraisal of Sebi’s Work

reflects the fallibility, weaknesses, and the failure of SEBI. The
How has the SEBI performed so far? Has it been effective? The Verma panel reversed the recommendations of the Patel
SEBI’s task is no doubt challenging, complex and difficult, and Committee and recommended the production of virtually the
it needs to be fully supported in its efforts. But there are certain

old carry forward or badla system of trading. There have been
aspects of its working which need improvement and correction.

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instances of issues and other market activities, which the SEBI
1) The SEBI’s Annual Report, 1995-96 claims an increasing and ought not to have allowed but did, although it knew about the
a very high success rate in resolving investor complaints. But malpractices involved in them. The allotment of shares by
the reality is different. The market surveys conducted by L.C. Sterling Tea, and making of a right issue by New World Medical
Gupta revealed that 90 per cent of the respondent-investors India Ltd. are recent instances.

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felt that the system of dealing with investor complaints was 4) The regulatory ineffectiveness of the SEBI in certain cases
not effective; 85 per cent of shareholders felt that they were has been due to its concentration on symptoms rather than

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not adequately protected; and 70 per cent of investors
indicated that they had actually suffered because of weak
investor protection. Price rigging, a serious menace to the
the root causes. The present settlement or delivery system is
highly conducive for manipulative operations and unhealthy
speculation. The SEBI has kept on tinkering with the trading
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investors, has, in fact, become more common in recent years. laws instead of doing away with such an outdated delivery
2) On reading the rules, regulations, guidelines, directions and system.
norms issued by the SEBI, one doubts whether one is living The SEBI’s failure appears to be partly deliberate also. There is a
in the “liberalised” or “prudential regulation as opposed to
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feeling among market watchers that, as in many other countries,

statistic control” environment at all. It is difficult to believe the SEBI as a regulator has been rather soft and unduly
that “self-regulation” and “regulation by exception” are really favourable to the securities industry; it has been more corporate-
the corner-stones of the SEBI’s regulatory philosophy. The
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friendly than investor-friendly.

number of rules, etc. prescribed by the SEBI has become too
large; it has been adding to, and changing them too often 5) It is imperative that the SEBI should become more effective,
and in a back and forth fashion. This has created a veritable efficient, socially accountable, and small-investor-friendly. It
maze of a plethora of regulations. This has led to a very has often complained of having insufficient authority and
high level of uncertainty and confusion. As L.C. Gupta has powers.

rightly said, guidelines have grown by successive additions of Summary

clarifications and further clarifications to clarifications. In the Before the SEBI became a statutory body, the framework for
process, the guidelines have become incomprehensible. regulating the securities market or industry comprised of
According to some, they are so chaotic and confusing that it Companies Act, 1956, Securities Contracts (Regulation) Act,

is difficult for anybody to determine what rules are currently 1956, and Capital Issues (Control) Act, 1947 .The SEBI was set
in force. As a result, SEBI officials may wield undue power up in 1988 through an administrative order, and it became a
by providing their own interpretation of the rules. statutory body in 1992. The SEBI is governed by a six-member
3) There is a widespread feeling in the financial markets that the Board of Governors appointed by the GOI and RBI.
SEBI is not really serious about reforming the system and Operationally, it is divided into seven departments. Its head
protecting the individual and small investors. It has quite office is at Mumbai and regional offices are at Delhi, Kolkata
often failed to penalise the people responsible for causing and Chennai.
abnormal price fluctuations on the stock market. There has Its objectives are to protect the investors, and to regulate the
been a lack of will, dithering and hesitancy on the part of financial system in order to bring about its healthy
SEBI to strike against the wrong doers. Even certain well-- development. Self-regulation and regulation by exception are
publicised market manipulations have gone unpunished. said to be the cornerstones of its policies. It seeks to increase
the efficiency of mobilisation and allocation of resources
through the securities market.

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11.621.6 47
It has wide powers to issue rules, regulations, and guidelines in

respect of both the primary and secondary securities markets, a

wide variety of intermediaries operating in these markets, viz.,
brokers, merchant bankers, underwriters, bankers to issues, etc.,
and certain financial institutions such as mutual funds.
Questions to Discuss:
1. Discuss the highlights of SEBI’s performance.
2. Appraise the work of SEBI.

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48 11.621.6


Learning objectives Theoretical Basis of Banking Operations
After reading this lesson, you will understand Commercial banks ordinarily are simple business or commercial
concerns which provide various types of financial services to
• Introduction
customers in return for payments in one form or another, such
• Theoretical basis of banking operations as interest, discounts, fees, commission, and so on. Their
• Functions of the commercial banks and the services rendered objective is to make profits. However, what distinguishes them

by them from other business concerns (financial as well as
• General structure and methods of commercial banking manufacturing) is the degree to which they have to balance the
principle of profit maximisation with certain other principles.

• Employment of funds by commercial bankers
In India especially, banks are required to modify their

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Commercial banks are the oldest, biggest, and fastest growing performance in profit making if that clashes with their
financial intermediaries in India. They are also the most obligations in such areas as social welfare, social justice, and
important depositories of public saving and the most promotion of regional balance in development. In any case,
important disbursers of finance. Commercial banking in India compared to other business concerns, banks in general have to
is a unique system, the like of which exists nowhere in the

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pay much more attention to balancing profitability with
world. The truth of this statement becomes clear as one studies liquidity. It is true that all business concerns face liquidity
the philosophy and approaches that have contributed to the constraint in various areas of their decision-making and,

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evolution of the banking policy, programmes and operations in
India. This however is too big a subject to be discussed here in
detail. We will therefore confine ourselves to presenting only an
therefore, they have to devote considerable attention to liquidity
management. But with banks, the need for maintenance of
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liquidity is much greater because of the nature of their liabilities.
outline of the said philosophy and approaches, and discussing Banks deal in other people’s money, a substantial part of which
the actual working of banks in detail. is repayable on demand. That is why for banks, unlike other
Commercial banks are organised on a joint stock company business concerns, liquidity management is as important as
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system, primarily for the purpose of earning a profit. They can profitability management.
be either of the branch banking type, as we see in most of the This is reflected in the management and control of reserves of
countries, with a large, network of branches, or of the unit commercial banks. They are expected to hold voluntarily a part
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banking type, as we see in the United States, where a bank’s of their deposits in the form of ready cash, which is known as
operations are confined to a single office or to a few branches cash reserves; and the ratio of cash reserves to deposits is
within a strictly limited area. Although the commercial banks known as the (cash) reserve ratio. As banks are likely to be
attract deposits of all kinds-Current, Savings and Fixed-their tempted not to hold adequate amounts of reserves if they are
resources are chiefly drawn from current deposits, which are left to guide themselves on this point, and since the temptation

repayable on demand. So they attach much importance to the ‘may have extremely destabilizing effect on the economy in
liquidity of their investments and as such they specialise in general, the Central Bank in every country is empowered to
satisfying the short-term credit needs of business other than prescribe the reserve ratio that all banks must maintain. The
the long-term. Central Bank also undertakes, as the lender of last resort, to

The banking system in India works under the constraints that supply reserves to banks in times of genuine difficulties. It
go with social control and public ownership. The public should be clear that the function of the legal reserve
ownership of banks has been achieved in three stages: 1955, requirements is two-fold: to make deposits safe and liquid, and
July 1969, and April 1980. Not only the public sector banks but to enable the Central Bank to control the amount of checking
also the private sector and foreign banks are required to meet deposits or bank money which the banks can create. Since the
targets in respect of sectoral deployment of credit, regional banks are required to maintain a fraction of their deposit
distribution of branches, and regional credit-deposit ratios. The liabilities as reserves, the modem banking system is also known
operations of banks have been determined by Lead Bank as the “fractional reserve banking”.
Scheme, Differential Rate of Interest Scheme, Credit Another distinguishing feature of banks is that while they can
Authorization Scheme, inventory norms and lending systems create as well as transfer money (funds), other financial
prescribed by the authorities, the formulation of the credit institutions can only transfer funds. In other words, unlike
plans, and Service Area Approach. other financial institutions, banks are not merely financial
intermediaries. This aspect of bank operations has been
variously expressed. Banks are said to create deposits or credit or
money, or it can be said that every loan given by banks creates a

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11.621.6 49
deposit. This has given rise to the important concept of deposit There may also be leakages in the form of cash holding when

multiplier or credit multiplier or money multiplier. The import the banks make loans. The process moves rather slowly and
of this is that banks add to the money supply in the economy, with jerks, and not as promptly and smoothly as implied.
and since money supply is an important determinant of prices, Subject to such qualifications, there is no doubt that modem
nominal national income, and other macro-economic variables, banks can create money in the process of their working.
banks become responsible in a major way for changes in
Functions of the Commercial Banks and the Services
economic activity. Further, as indicated in chapter one, since
banks can create credit, they can encourage investment for some Rendered by Them
time without prior increase in saving. The two essential functions of commercial banks may best be
summarized as the borrowing and lending of money. They
Let us briefly discuss the basis and process of creation of
borrow money by taking all kinds of deposits. Deposits may be
money by banks. In modem economies, almost all exchanges
received on current account whereby the banker incurs the
are affected by money. Money is said to be a medium of
obligation of paying legal tender on demand, or on fixed
exchange, a store of value, a unit of account. There is much
deposit account whereby the banker incurs the obligation of

controversy as to what, in practice in a given year, is the measure
paying legal tender after the expiry of a fixed period, or on
of supply of money in any economy. We do not need to go
deposit account hereby the banker undertakes to pay the
into that controversy here. Suffice it to say that every one agrees
customer an agreed rate of interest on it in return for the right

that currency and demand deposits with banks are definitely to

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to demand from him an agreed period of notice for
be included in any measure of money supply. Thus, apart from
withdrawals. Thus a commercial banker whether it is through
the currency issued by the government and the Central Bank,
current account or fixed deposit account, mobilizes the savings
the demand or current or checkable deposits with banks are
of the society. Then he provides this money to those who are in
accepted by the public as money. Therefore, since the loan
need of it by granting overdrafts or fixed loans or by
operations of banks lead to the creation of checkable deposits,

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discounting bills of exchange or promissory notes. Thus the
they add to the supply of money in the economy. To
primary function or a com-mercial banker is that of a broker
recapitulate, the money-creating power of banks stems from the

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fact that modem banking is a fractional reserve banking, and
that certain liabilities of banks are accepted (used) by the public
as money.
and a dealer in money. By discharging this function efficiently, a
commercial banker renders very valuable service to the
community by increasing the productive capacity of the country
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and thereby accelerating the pace of economic development. He
The process of money creation works as follows. Assume that gathers the small savings of the people, thus reducing to the
the legally required reserve ratio is 10 per cent and that banks are lowest limits idle money. Then he combines these
maintaining just that ratio. Assume further that a bank in the smallholdings in amounts large enough to be profitably
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economy receives a brand new input of Rs. 1,000 of reserves employed in those enterprises where they are most called for
either as a deposit or as proceeds of a sale of government bond and most needed. Here, he makes capital effective and gives
to the Central Bank or in some other form. There is thus a industry the benefits of capital, both of which rise would have
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creation of Rs. 1,000 of bank money, but there is yet no remained idle. Take for instance, the practice of discounting
multiple expansion of money. If banks were required to keep bills. By converting future claims into present money, the
100 per cent cash reserve balances, no bank would be in a commercial banker bridges the time element between the sale
position to create extra money out of a new deposit of Rs.l,000 and the actual payment of money. This will enable the seller to
with it. catty on his business without any hindrance and the buyer will

But since a bank is required to hold only 10 per cent of its get enough time to realise the money.
deposits as cash reserves, it now has Rs. 900 as excess reserves, Thus we have seen that a banker receives deposits, which he has
which it can utilise to invest or to give a loan. Assume that the to repay according to his promise, and makes them affordable
bank gives a loan of Rs. 900, and the borrower who takes the to those people who are really in need of them. He is actually

loan in cash or cheque deposits it either with the same bank or distributing his deposits between the borrowers and his own
with some other bank. Either way, there has been a creation of vaults. Herein lies the most delicate of the functions of
money and the total amount of bank money created at this commercial bankers.
stage is Rs. 1,000 + Rs. 900 = Rs. 1,900. This process of
Besides these two main functions a commercial banker
creation can continue till no bank anywhere in the system has
performs a variety of other functions, which may be grouped
reserves in excess of the required 10 per cent reserve, and the
under two main heads viz., the agency services and the general
total money supply created in the economy is Rs. 10,000. The
utility services.
ratio of new deposits to the original increase in reserves is called
the money multiplier or credit multiplier or deposit multiplier. Agency Services
This multiplier will be equal to the reciprocal of the required A commercial bank provides a range of investment services.
reserve ratio. Customers can arrange for dividends to be sent to their bank
The process of creation of bank money does not work in and paid directly into their bank accounts, or for the bank to
practice to the full capacity or to the full potential as has been detach coupons from bearer bonds and present them for
described above. Banks may have a reserve ratio, which is higher payment and to act upon announce-ments in the Press of
than the required reserve ratio. drawn bonds, coupons payable, etc. Orders for the purchase or

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50 11.621.6
sale of stock exchange securities are executed through the banks’ General Utility Services


brokers who will also give their opinions on securities or lists These services are those in which the banker’s position is not
of securities. Similarly, banks will make applications on behalf that of an agent for his customer; They include the issue of
of their customers for allotments arising from new capital credit instruments like letters of credit and travellers’ cheques,
issues, pay calls as they fall due (that is, subscriptions to capital the acceptance of bills of exchange, the safe custody of
issues made over a period), and ultimately obtain the share valuables and documents, the transaction of foreign exchange
certificate or other documents of title. On certain agreed terms business, acting as a referee as to the respectability and financial
the banks will allow their names to appear on ap-proved standing of customers and providing specialised advisory
prospectuses or other documents as bankers for the issue of service to customers.
new capital; they will receive applications and catty out other By selling drafts or orders and by issuing letters of credit,
instructions. circular notes, travellers’ cheques, etc., a commercial banker is
A commercial bank undertakes the payment of subscriptions discharging a very important function. A banker’s draft is an
premia, rents and collection of cheques, bills, promissory notes order, addressed by one office of a bank to any other of its

etc., on behalf of its customers. It also acts as a correspondent branches or by anyone bank to another, to pay a specified sum
or representative of its customers, other banks and financial to the person concerned. A letter of credit is a document issued
corporations. by a banker, authorizing some other banker to whom it is

Most of the commercial banks have an executor and trustee addressed, to honour the cheques of a person named in the

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depart-ment; some may have affiliated companies to deal with document, to the extent of a stated amount in the letter and to
this branch of their business. They aim to provide, therefore, a charge the same to the account of the grantor of the letter of
complete range of trustee, executor or advisory services for a credit. A letter of credit includes a promise by the issuing banker
small charge. The business of banks acting as trustees, to accept all bills to the limits of credit. When the promise to
accept is conditional on the receipt of the documents of title to

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executors, administrators, etc., has continuously expanded with
considerable usefulness to their customers. By appointing a goods, it is called a documentary letter of credit. Where the
bank as an executor or trustee of his Will the customer secures promise is unconditional it is called a clean letter of credit.

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the advantage of continuity, and avoids having to make
changes; impartiality in dealing with beneficiaries and in the
exercise of discretions; and the legal and specialised knowledge
Letters of credit may again be classified as revocable and
irrevocable. A revocable letter of credit is one, which can be
cancelled at any time by the issuing banker. But the banker will
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pertaining to executor and trustee services. When a person dies still be liable for bills negotiated before cancellation. An
without making a Will the next-of-kin can employ the bank to irrevocable letter of credit is, one, which cannot be cancelled
act as administrator and to deal with the estate in accordance before the expiry of the period of its currency. ‘Circular letter of
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with the rules relating to intestacies. Alternatively, if a testa-tor Credit’ is generally intended for travellers who may require
makes a Will but fails to appoint an executor, or if an executor money in different countries. They may be divided into
is unable or unwilling to act, the bank can usually undertake the traveller’s letters of credit and guarantee letters pf credit. A
travellers letter of credit carries the instruction of the issuing
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adminis-tration with the consent of the persons who are

immediately concerned. Banks will act solely or jointly with bank to its foreign agents to honour the beneficiary’s drafts,
others in these matters, as also in the case of trustee for stocks, cheques, etc., to a stated amount, which it under-takes to meet
shares, funds, properties or other investments. Under a on presentation. While issuing a guarantee letters of credit, the
declaration of trust, a bank undertakes the supervision of banker secures a guarantee for reimbursement at an agreed rate

invest-ments and distribution of income; a customer’s of interest or he may insist on sufficient security for the grant
investments can be trans-ferred into the bank’s name or control, of the credit. There is yet another type which is known as
thus enabling it to act immediate-ly upon a notice of rights ‘Revolving Credit’. Here the letter is so worded that the amount
issue, allotment letters, etc. Alternatively, where it is not desired of credit available automatically reverts to the original amount
after the bills negotiated under them are duly honoured.

to appoint the bank as nominee, these services may still be

carried out by appointing the bank as attorney. Where business Circular Notes are cheques on the issuing banker for certain
is included in an estate or trust, a bank will provide for its round sums in his own currency. On the reverse side of the
management for a limited period, pending its sale to the best circular note is a letter addressed to the agents specifying the
advantage as a going concern or transfer to a beneficiary. name of the holder and referring to a letter indication in his
Private companies wishing to set up pension funds may hands, containing a specimen signature of the holder. The note
appoint a bank as custodian trustee and investment adviser, will not be honoured unless the letter of indication is
while retaining the administration of the scheme in the hands presented. Travellers’ cheques are documents similar to circular
of the management of the fund. notes with the exception that they are not accompanied by any
letter of indication. Circular cheques are issued by banks in
Most banks will undertake on behalf of their customers the
certain Coun-tries to their agents abroad. These agents sell them
prepara-tion of income tax returns and claims for the recovery
to intending visitors to the country of the issuing bank.
of overpaid tax. They also assist the customers in checking of
assessments. In addition, to the usual claims involving personal Another important service rendered by a modern commercial
allowances and relief’s, claims are prepared on behalf of bank is that of keeping in safe custody valuables such as
residents abroad, minors, charities, etc. negotiable securities, jewellery, documents of title, wills, deed-

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11.621.6 51
boxes, etc. Some branches are also equipped with specially All these money transmission services have particular regard to

constructed strong rooms, each containing a large number of the developments in computerised book-keeping, which the
private steel safes of various sizes. These may be used by non- banks in some countries have already introduced. Some banks
customers for a small fee as well as by regular customers. Each are reported to be experi-menting with the use of electronic
licensee is provided with the key of an individual safe and thus machines, which will scan cheques and dispense notes or coins,
not only obtains protection for his valuables, but also retains thus saving time at the counter.
full personal control over them, The safes are accessible at any
Overseas Trading Services
time during banking hours and often longer.
Recognition of overseas trade has led modem commercial
For shopkeepers and other customers who handle large sums banks to set up branches specializing in the finance of foreign
of mon-ey after banking hours, ‘night safes’ are available at trade and some banks in some countries have taken interest in
many banks. Night safes take the form of a small metal door in export houses and factor-ing organisations. Assisted by banks
the outside wall of the bank, accessible from the street, behind affiliated to them in overseas territo-ries, they are able to provide
which there is a chute connecting with the bank’s strong room. a comprehensive network of services for foreign banking

Customers who require this service are provided with a leather business, and many transactions can be carried through from
wallet, which they lock before placing in the chute. The wallet is start to finish by a home bank or its subsidiary. In places where
opened by the customer when he calls at the bank the next day banks are not directly represented by such affiliated

to credit the contents into his account. undertakings, they have working arrangements with

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Another function of great value, both to bankers and to correspondents so that the banks are in a position to undertake
businessmen, is that of a referee as to the respectability and foreign banking business in any part of the world.
financial status of the customer. The banks provide more than just a means for the settlement
Among the services introduced by modern commercial banks of debts between traders both at home and abroad for the

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during the quarter of a century or so, the bank giro and credit goods they buy and sell; they are also providers of credit and
cards deceive special mention. The bank giro is a system by enable the company to release the capital which would otherwise
which a bank customer with many payments to make, instead be tied up in the goods exported. The following is an outline

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of drawing a cheque for each item, may simply instruct his bank
to transfer to the bank accounts of his creditors the sum due
of some of the services provided by banks for overseas traders.
For centuries past the bill of exchange has been one of the chief
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from him, and he writes one cheque debiting his account with means of settlement in trade. Its function is to enable a seller or
the total amount. Credit advices containing the name of each exporter of goods to obtain cash as soon as possible after the
creditor with the name of his bank and branch will be cleared dispatch of goods, and yet enable the buyer or importer to
through the ‘credit clearing’ of the clearing house, which defer payment until the goods reach him, or later.
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operates in a similar way as for the clearing of cheques.

There are many ways in which trade may be financed with bills.
Even non-customers of a bank for a small charge may make use Two common ways are:
of this facility. A direct debiting service is also operated by some
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1. The exporter will draw a bill on the importer, or, by

banks. This service is designed to assist organisations, which
arrangement between the parties, on the importer’s bank, for
receive large num-ber of payments on a regular basis. A creditor
the amount of the export-er’s invoice for the goods, and to
is thereby enabled with the prior approval of the debtor, to
the bill attach the shipping documents which will convey title
claim any money due to him direct from the debtor’s bank
to the goods (usually an invoice, marine insur-ance policy,
account. To some organisations, for example, insur-ance

and the ship owner’s receipt for the goods for the carriage,
companies, which receive, say, six equal sums on six dates in a
called a bill of lading). The exporter will sell (negotiate) the
year, the scheme is only an extension of the standing order
bill with the documents to local bankers, who with the
facility; but for the public utilities and traders which send out
documents and thus, in effect, the goods in their possession,
invoices for valuable amounts at differing times, the scheme is

will be willing to pay the exporter practi-cally the full amount

an entirely new one.
of his invoice and bill; they will immediately forward the bill
Credit cards are introduced for the use of credit-worthy and documents to their banking correspondents or agents in
customers. Users are issued with a card on production of which the importer’s country, to be presented to the importer, or
their signature is accepted on bills in shops and establishments the import-er’s bank as the case may be, for payment if the
participating in the scheme. The banks thereby guarantee to bill is payable on demand, or for acceptance if the bill is a
meet the bill and recover from the cardholder through a single term bill.
account presented periodically. In some cases users are required 2. The importer’s bank, at his request, will arrange for its
to pay a regular subscription for the use of the service as well. banking correspondents or agents in the exporter’s country
An extension of the scheme allows the repayment of large to accept a term bill drawn on them by the exporter, and to
sums (subject to a maximum) over a period at interest. be accompanied by specified shipping documents mentioned
Some banks are opening budget accounts for credit worthy in the first example. (Such an arrange-ment is an example of
custom-ers. The bank guarantees to pay, for a specific charge, ‘opening credit’, which is mentioned below). When the bill is
certain types of annual bills (for example, fuel bills, rates etc.) accepted, it will be returned to the exporter, who can either
promptly as they become due, whilst repayments are spread keep it until the period of the bill expires and then claim
over a 12-monthly period from the customer’s current account.

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52 11.621.6
payment from the accepting bank, or, as is more likely in In case where it is not possible to arrange a documentary credit


practice, sell the bill to his own or other The accepting bank, and the arrangement is for payment to be made only when the
upon accepting the bill will detach the shipping docu-ments goods have been sold, a bank can usually undertake the dispatch
and send them to the importer’s bank. of the shipping documents and arrange the goods to be
If a bill is payable on demand, the importer, or his bank on his warehoused and insured in the name of a correspondent bank,
behalf if the bill is drawn on them, has to pay the whole sum pending delivery of the goods in part or in whole to the
when the bill is presented. exporter’s agent against payment. The correspondent bank will
then remit proceeds of sales as and when they are made by the
If the bill is drawn payable at a later date, for example, three
agent. Exporters who are dealing With first-class agents may be
months after presentation, it is, upon presentation, accepted by
prepared to ship their goods on open account. In such cases,
the importer if it is drawn on him, or by his bankers on his
the exporter usually sends the documents directly by air mail to
behalf if it is drawn on them by special arrangements. But the
the consignee, who acts as his agent for tile sale of the goods.
importer is not called upon to pay until the three months are
Remittances, in order to avoid the inconveniences of collection,

may be by a cheque on an Indian bank or by a telegraphic
Usually the arrangement between the buyer and seller of the transfer.
goods will be that the shipping documents which accompany
the bill are to be detached upon payment or acceptance of the Information and other Services

bill, by whoever pays or accepts it namely, the importer or a As part of their comprehensive banking services, many banks

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bank on his behalf. The documents thus become available to act as a major source of information on overseas trade in all
the buyer, so that he can take delivery of the goods when the aspects. Some banks produce regular bulletin on trade and
ship arrives, re-sell them in the ordinary way, and from the economic conditions at home and abroad, and special reports
proceeds recoup himself or his bank, or make funds available to on commodities and markets. In some cases they invite
enquiries for those wishing to extend their foreign trade, and are

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meet the bill when it matures.
able through their correspondents to furnish the names of
An overseas buyer may arrange through his bank in the home
reputa-ble and interested dealers of goods and commodities

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coun-try to open a documentary credit in favour of the seller.
This is an undertaking that the bank will honour drafts drawn
in accordance with the terms of credit, if accompanied by
and to advise on the appointment of suitable agents. For
businessmen travelling abroad letters of introduction,
indicating the purpose of journey taken, can be issued
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stipulated shipping documents, insurance policies, etc. and
addressed to banking correspondents in the various centres it is
presented not later than the date of expiry of the credit. The
proposed to visit. In this way it is often possible to establish
terms usually cover the nature, price and quantity of the goods,
new avenues of business. On request, banks obtain for
the methods of shipment, the documents to be attached and
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customers, for business purposes, confidential opinions on the

the date by which shipment must be effected. The credit or may
financial standing of companies, firms or individuals at home
undertake payment of a sight draft or acceptance of a term draft
or overseas.
and it may be expressed either in home currency or in foreign
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currency, this depending on the condition of sale. It may be Commercial bank furnish advice and information outside the
either revocable or irrevocable. The former may be cancelled at scope merely of trade. If it is desired to set up a subsidiary or
any time, but the latter cannot be cancelled without the consent branch overseas (or for an overseas company to set up in the
of both parties, and therefore provides much greater protection home country) they provide detailed information on local legal
to the exporter. requirements on company formation, tax requirements,

exchange control and insurance, and they help to estab-lish

If, say, a foreign importer has no account with an Indian bank,
contact with local banking organisations.
he will open the credit with his local bank. The exporter may,
however, prefer to receive a corresponding advice that the credit To sum up, the service rendered by a modem commercial bank
is opened from an Indian bank. Consequently, it is usual for the is of inestimable value. It mobilizes the scattered savings of the

foreign bank to instruct its Indian banking correspondent to community and redistributes them into more useful channels.
advise the credit to the exporter. As an additional safeguard, an It enables large pay-ments to be made over long distances with
Indian exporter may require his bank not only to advise but minimum expenses. It consti-tutes the very life blood of an
also to undertake responsibility by adding its confirmation. advanced economic society. In the words of Walter Leaf: “The
This is known as a ‘confirmed credit’. Having received the banker is the universal arbiter of the world’s econo-my,”
advice, on shipment of the goods, the exporter must lodge the General Structure and Methods of Commercial
documents within the time allowed by the credit. If the
documents are in order as stipulated in the credit, the exporter
will then receive immediate payment if it pro-vides for sight Certain Sound Commercial Banking Principles
payment; if it calls for a bill drawn payable after sight, the bank Just as in the case of any other commercial enterprise, the
will accept the bill, which will then be available for discount. If commer-cial banks also strive to earn a profit. But is profitability
for any reason the exporter in unable to present the document everything, which a banker should pay attention to? Can a
he must request the importer to instruct bank to extend or commercial banker employ his funds in a risky manner in
amend the credit. anticipation of wild fall profits? The answer is definitely in the
negative. He is a custodian of other’s surplus funds. Therefore

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11.621.6 53
while earning a profit he should never forget the fact that he is a via media between liquidity and profitability while selecting his

doing business with others funds, which he acquires be-cause assets.

of his credit. We have seen that these deposits are either
Employment of Funds by Commercial Bankers
repayable on demand or after the expiry of a fixed period. In
Generally, the following are the important items seen on the
either case he must be ready to meet the liabilities as and when
asset side of the Balance Sheet of a bank.
necessary and, as such, he has many outstanding contracts for
the future delivery of money. • Cash in hand.
• Money at call and short notice.
In case of failure, he will suffer in his credit on which the very
foundation of his business stands. Not only will he feel the • Bills discounted.
shock of such a failure, but also it will be transmitted to the • Investments.
other links of the banking organisation, thereby precipitating • Advances to customers.
nation-wide bank failures. So banker should always bear in
mind that he is guardian of a very delicate mecha-nism, which These items are given in the order of liquidity.

paves the way for future economic development and. which, if The first item appearing on the asset side of bank’s balance
disturbed, will create monetary disequilibria with all the evil sheet is cash in hand, including cash reserve at the central bank
effects incidental thereto. Obviously, a banker should take the and demand deposits with other banks. This is the most liquid

necessary precautions 10 keep his assets as ‘liquid’ as possible. of all assets. From the point of view of profitability, a banker is

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But what is meant by liquidity? tempted to minimise his cash holdings; while from the point
By liquidity we mean the capacity to produce cash on demand. of view of liquidity, he is tempted to maximise his cash
No doubt the most liquid asset is cash in the vaults of a bank. holdings. To maintain more resolves than what is necessary is
It is necessary for a banker to keep a certain percentage of the to impair the profits. The English bankers usually maintain a
cash ratio of 8 per cent while, in India, a higher cash ratio is

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deposits in the form of liquid cash as reserve, either in his own
vault or with his bank, generally the central bank. But such desirable owing to the undeveloped and unpredictable nature
liquid cash does not earn anything and it is purely idle money, of the money market.

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intended to provide the necessary liquidity by meeting the
immediate withdrawals of deposits. As a rule, successful
banking is dependent on the capacity of these reserves to meet
A banker is generally guided by experience in deciding what
propor-tion of his deposits in cash will enable him readily to
meet all demands. In addition to the minimum requirements
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the immediate requirements. When liquidity is provided by indicated by experience, a good banker must necessarily allow
liquid cash, a banker should invest his excess money in. some for unpredictable needs. In this con-nection certain important
assets, which are liquid in nature and at the same time, which considerations influencing the cash resolves of a banker may be
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earn an income. pointed out.

Briefly, we may explain the liquid assets as those, which can be In the first place, if the customers are highly banking minded,
turned into, cash quickly and without loss, to meet the the need for liquid cash will be small because in that case
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customer’s claims. But if an asset is to be turned into cash depositors will seldom demand the payment of legal tender
quickly, it must be shift able in nature, i.e. the liquidity of an currency and will content themselves by the transfer of rights
asset depends on the question of shifting it to the central bank which the bank can do by mere book entries. Secondly the
or to others willing to supply cash. For instance if a blinker habits of the customers, and the business conditions of the
holds a first class bill of exchange, among his other assets, locality have an important bearing of the cash reserves. Certain

which satisfies the eligibility rules of the central bank, it can be businesses carried on by the depositors may make heavy
rediscounted with the central bank, when the banker is short of occasional de-mands which the banker will have to meet with
funds. A government security satisfies the quality of an idle adequate provision of liquid cash. Thirdly, it is also dependent
asset, viz. shift ability because it is in great demand in the stock on the resolves kept by other banks of the locality. If certain

exchange. But liquidity implies not only shift ability but also banks are keeping higher amounts of resolves, other banks will
shift ability without loss. To take an example, the ordinary be compelled to increase their cash ratio in their bid for
shares of an industrial concern may be shift able but only at a popularity. Further the nature of accounts and the size of
discount. Here shiftability is possible only at a loss and hence average deposits also influence the resolves. For instance, if the
the asset cannot be considered as a sound banking asset. accounts are of a fluctuating nature, a higher cash resolve may be
The conclusion that we arrive at from the above discussion is required. So also the resolves of a bank having only a few large
that commercial bankers, while employing their funds, should deposits will be generally large because of the chance of heavy
pay regard both for profitability and liquidity. And liquidity in demands. On the other hand, if the bank has a large number
its turn is dependent on shiftability without loss. It is a point of small sized deposits, the danger of large withdrawals by any
to be remembered always that liquidity should not be sacrificed individual customer will be less and hence it need not keep a
at the alter of profitability. At the same time no less important large amount of liquid cash. Again, the presence of a bankers’
is it to remember that to maintain excessive liquidity is to clearing house greatly reduces the need of liquid cash to be kept
sacrifice earnings, without which banking operations cannot be by a bank because he has only to provide for the difference
carried on successfully. A good banker would, therefore, follow between the cheques drawn by him on other banks. Lastly, the

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54 11.621.6
banker has to take into account probable receipts of cash by the


bank and probable demands upon it, in the near future.
Thus the ratio of liquid cash to deposits, which a banker
should maintain is dependent upon a number of
considerations. It varies from place to place and from banker to
banker. Therefore, no hard and fast rule can be laid down as to
the exact cash ratio, which a banker should maintain. He has to
give due consideration to the various factors dis-cussed above
and has to decide himself the amount of liquid cash which he
should maintain. In this connection, it may be pointed out that
commercial bankers, in most countries, are required to maintain
a minimum reserve of liquid cash, through legislation.
Questions to Discuss:

1. What is the theoretical basis of banking operations?
2. Discuss the functions of the commercial banks and the

services rendered by them.

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3. Discuss the general structure and methods of commercial
4. Discuss the employment of funds by commercial bankers.

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11.621.6 55


Learning objectives Need for Credit

After reading this lesson, you will understand Just as there are two reasons for the banks to extend the credit
function, there are also two reasons for the demand for credit.
• Need for lending
Firstly, on the demand side of the economy are the consumers
• Need for credit of goods and services who require funds basically for acquiring
• Types of credit certain assets like consumer durables. And secondly, on the
• Nature of Credit supply side, the need for credit arises from the corporate in the

manufacturing, trading and services sectors. These corporate
• Security Offered for Loans
basically require funds for long-term investment as well as for
• Purpose of Loan day-to-day operations. Thus the need for credit arises from the

Need for Lending supply side as well as the demand side of the economy. Thus,

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Having raised the funds the banks will have to ensure that the at any point of time, in the credit market, there will always be
same will be deployed into proper avenues so that they sustain some players to extend credit and a few others who will be
profitably. The two major applications of banking funds are seeking credit. However, to ensure that the borrowing and
credit accommodation and investments in securities. Of these, lending takes place in the credit market, the needs of the

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the former has evolved as the prime function of the banks both borrower should be met by the lender. In order to facilitate this,
due to the regulatory prescriptions as well as for profitable different types of credit facilities have originated in the credit
sustenance. market.

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According to Section 6 of the Banking Regulation Act, 1949, the
business of banking is defined as follows:
Types of Credit
Most of the credit facilities that are offered in the credit market
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“Banking means accepting for the purpose of lending or are in the form of loans. A loan is a broad term used to explain
investment of deposits of money from the public, repayable the different types of short/medium and long-term credit
on demand or otherwise, and withdrawable by cheque, draft, facilities extended in the credit market. Irrespective of their
order or otherwise.” nature, all loans are contractual agreements entered into by the
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borrower of the funds with the lender of the funds. The

Thus, as per the statute, all banking firms will have to
agreement states the terms and conditions such as loan
necessarily perform the role of a lending organisation. While
amount, repayment period, rate of interest, terms of
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other financial institutions and NBFCs also share the corporate

repayment, nature of security, penal provisions for breach of
finance activity along with banks, there is, however, a marked
contract, etc.
difference in the credit facilities offered by each type of these
intermediaries. Depending on their need for credit, the borrower will select the
type of credit facility that suits their cash flow requirement and
The other major reason of the lending function is to add value
that which is a low cost option. To meet the varied

to the bank. By lending the funds mobilized by it, a bank will

requirements of the borrower, banks have also developed a
be in a position to earn spreads to sustain profitably.
variety of credit facilities. The development of these credit
Profitability through lending will be obtained if the bank is in a
facilities essentially depends on three parameters: Purpose of
position to take and manage credit risk that arises on account of
credit, Nature of credit and Security offered.

the quality of the borrower and liquidity risk that may arise by
borrowing short and lending long in order to attain greater As mentioned earlier, the credit requirement arises from both
spreads. Further, the spreads earned in this activity will also be the demand and the supply side of the economy. The loans
exposed to risks arising both from interest rates and the that are extended to the supply side can be classified, as
exchange rates. commercial loans while the demand side loans will be
individual loans. Commercial loans are extended for two
Thus, while lending, the bank should essentially try to balance
purposes: Firstly, to acquire fixed assets and secondly, for the
its spreads and the risk levels. The significance of the lending
purpose of maintaining/running the business. Likewise, there
activity to the banking business can further be explained by the
are broadly three purposes for the individual loans:
fact that a shrinkage in the credit asset portfolio leads to greater
consumption, acquisition of durables and housing finance.
impact on the NII of the bank when compared to the
This classification of the credit facilities into commercial and
shrinkage in any other asset in its portfolio.
individual credit facilities is simple and broad but it does not
The need for lending thus arises both due to the regulatory help understand the critical aspects of the lending activity. To
prescriptions as well as for profitability purpose. Having enable such understanding, we shall examine the loans as
understood the need for lending, let us also look into the need described by the banks in their annual reports. Banks present
for credit. their entire advances in three different ways based on the nature

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56 11.621.6
of credit, the type of security and the purpose of the loan. normally seen in trading concerns and manufacturing concerns,


Using these parameters, there will be further classification of the which may have a retail outlet, which is more an exception. This,
banks’ advances, which are examined here. however, is not possible in the normal course and may happen
when there is a geographical distance existing between the seller
Nature of Credit
and the buyer. In such circumstances, there will be a time lag
On considering the nature of the loan, the advances of banks
before the buyer actually receives the goods, thereby leading to a
can be further classified into the following three types:
time gap between the time goods are dispatched and the
• Installment Credit payment is received. Thus, it can be observed that even a cash
• Operating Credit sale will result in receivables for the seller. Funding of these
• Receivable Finance receivables through internal sources by the company may not be
feasible, especially due to the volume of funds required for
Installment Credit:
extending such credit.
In this type of finance, once the credit amount is decided, the
bank will disburse the amount either at one go or in stages All receivables, created either due to cash or credit transactions,

depending on how a project gets implemented. The repayment will lock the funds of the firm. Banks offer receivable finance
process, which is generally on installment basis, will commence facility, which imparts liquidity to these receivables. When there
after the entire credit amount is disbursed. The installments can is a payment lag due to the geographical consideration, the bank

be monthly, quarterly, half-yearly or annual payments. The acts as an intermediary, collecting funds from the buyer on

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frequency of the installment depends on the cash flow stream behalf of the seller. Such facility will be fee-based since the bank
of the borrower. Based on this repayment schedule, the tenor does not actually extend any credit and only enables the
of the credit facility is decided. This forms the base for the collection of funds. This does not result in extending credit.
classification of the loans into short, medium or long-term When bank extends credit, it will instead of collecting funds
from the buyer and passing it over to the seller, will actually

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loans. When the tenor is less than three years, it is a short-term
loan. Such loans are generally extended to households for the provide credit for the sale and will collect the funds from the
purchase of consumer durables. When the tenor ranges from 3- buyer at a later point of time. This is the fund based receivables

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5 years, it is a medium-term loan’ which is generally required by
the small and medium-sized firms for acquiring fixed assets.
financing facility offered by the bank.
When receivable finance is extended either for cash sales or credit
sales, there will be a few essential documents for bill financing
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And in cases where the repayment period exceeds 5 years then a
long-term loan facility that is extended to large corporate/ viz. bill of exchange document of title to goods (lorry/rail way
projects for the acquisition of fixed assets during project receipt, airway bill), invoice, etc.
implementation stage. Bill of Exchange (B/E)
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Operating Credit: In most of the cases, when credit is sought through receivable
Unlike the installment credit, the operating credit is for meeting finance, a B/E will be created. A B/E is a negotiable
the financial requirements of the daily operations. Since the firm instrument. In terms of Section 5 of the Negotiable
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cannot know its exact requirements on any given day, the bank Instruments Act, 1881, a B/E is an instrument in writing
provides an operating account (current account) after deciding containing an unconditional order, signed by the maker (in this
on the credit limit. The firm can withdraw from this account case the seller), directing a certain person (in this case the buyer)
using a cheque facility as and when it requires the funds. The to pay a certain amount of money only to, or to the order of, a
repayment mechanism for such credit facility is also different certain person (in this case a bank) or to the bearer of the

from the installment credit. The firm will repay into the same instrument.
current account as and when it has surplus cash. Generally, this Lorry Receipt (LR)/Railway Receipt (RR)/Airway Bill
credit is extended for a period of 1-2 years, but since the firms These documents are evidences of dispatch of goods and
are going concerns, this credit facility may actually be rolled over

holders of these documents are entitled to take delivery of the

every year. This makes the operating credit a permanent credit underlying goods. These are also sometimes known as quasi-
facility. The forms of credit that can be categorised here are the negotiable instruments.
cash credit facility and the overdraft facility. The major
distinction between these two credit facilities is that the cash Invoice
credit facility is sanctioned against inventory while the overdraft The invoice that has been raised for the sale transaction indicates
facility is generally against any other security. the value of the underlying goods.

Receivable Finance: The requirement or non-requirement of each of the above

The other type of credit is receivable finance where the firm gets mentioned documents depend on the type of receivable finance
credit in the form of bill finance. Sale transactions of a firm are that is being offered. Further, depending on the key documents
generally either in cash or credit form. In credit sales, as it is involved in bill finance, the bills can be classified into two types
observed, payment will be made at a predetermined time after — Demand Bills and Usance Bills. When there is a demand
the sale has actually taken place. This results in the creation of bill, it means payment is to be made on demand. When the sale
receivables for the selling firm. In cash sales, it is, however, is on a credit basis, the amount is payable on a specified due
considered that the payment will be made immediately as in the date, it will usually involve a Usance Bill. If the specified due
case of an over-the-counter sale. Such sale transactions are date is after the bill date (every bill will be dated), the terms of

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11.621.6 57
payment is known as “Days After Date” and if the specified guarantee of a bank/government are categorised as “Advances

date is after the bill is presented to the buyer, then the terms of covered by Bank/Government Guarantees” and hence are not
payment will be known as “Days After Sight”. Within this reported under unsecured loans category.
broad classification, depending on the mode of financing, bills
Secured Advances:
can be further categorized as:
Secured advances on the other hand, have impersonal security
• Clean Bills i.e. the security has to be a tangible asset against which the loan
• Documentary Bills is to be granted. Primary Security is an asset against which the
• Supply Bills loan is given and Collateral Security is a security, which is given
in addition to the existing primary security. These primary and
Clean Bills: collateral securities can be movable or immovable assets and
In transactions where the seller would have already delivered the depending on the same the charge created on the security may
goods and the documents to the buyer, the seller can avail the vary.
receivables finance facility using the Clean Bill. The seller can avail Charge on the movable properties can be created in the

this facility without any supporting documents. Since the following five different ways:
delivery of goods and documents has already taken place, it
• Pledge
implies that the transaction would have been on credit basis.

Hence, a Clean Demand B/E can be raised in this case. • Hypothecation

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• Assignment
Documentary Bill:
In certain cases, the seller would have only dispatched the goods • Banker’s Lien
without transferring the document of title for goods and/or • Set-Off
invoice, etc. In such cases, the seller can avail the bill finance A brief discussion on each of these methods of creating a

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facility through the Documentary Bill. To suit the cash and charge on security is followed hereunder.
credit sales, a Documentary B/E can be either a Documentary

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Demand Bill or a Documentary Usance Bill. When the
transaction is a cash sale, the Documentary Demand Bill is used
in which case the buyer has to pay the bank the amount and
According to Section 172 of the Indian Contract Act, 1872,
pledge is defined as: “Pledge is a contract whereunder deposit
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collect the documents. In the case of a credit sale, using the of goods is made a security for a debt and the right to property
Documentary Usance Bill, the buyer collects the documents first vests in the pawnee so far as it is necessary to secure the debt.”
without payment by accepting the bill. On the due date of the In other words, a pledge arises when the lender or the pledgee
bill, the buyer has to pay to the bank the bill amount. In both takes possession of the goods or bearer securities for extending
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the cases the seller avails the finance from the bank. a credit facility to the borrower or the pledgor. The pledgee can
retain the possession of the goods until the pledgor repays the
Supply Bill: entire debt amount and in case of a default, the pledgee has the
A Supply Bill is used in a buyers market i.e. when the buyer is a
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right to sell the goods in his possession and adjust its proceeds
large corporation or a government body; the seller has to first towards the amount due.
deliver the goods without raising the B/E. After the buyer is
The delivery of goods in a pledge can be either by actual delivery
satisfied with the quality of the goods, then the invoice has to
or constructive delivery. In the former case, the pledgor will
be raised. The documents like B/E and LR/RR will not be
handover the physical possession of the goods to the pledgee.

available in this case. In the absence of such supporting

Such type of lending is done by the pawn broker. In the case of
documents, the seller can avail the receivable finance facility by
constructive delivery, there is symbolic delivery of goods, i.e. for
providing the evidence of the delivery of the goods.
example, the pledgee may be given possession of the key to the
The classification discussed above is based on the nature of store in which the pledged goods are present or there may be a

loan. The second parameter that is used for classifying the loans transfer of the bill of lading. Such type of lending is usually
is the security of the loan. Security for the loans can be personal considered by a bank.
or impersonal. Based on the type of security, all advances made
While lending against pledge, the bank always maintains a
by the banks to any type of borrower can be classified into
margin between the value of the goods and the amount of
unsecured or secured advances.
credit allowed. For instance, if the bank is extending a credit of
Security Offered for Loans Rs.l lakh against the pledge of goods, then the value of the
Loans are generally c1assified into secured or unsecured loans. goods pledged should be more than Rs.l lakh. Further, in a
The features of these two types of loans are discussed below: pledge transaction, the underlying goods are usually either the
Unsecured Advances: raw material or the work-in-process or the finished goods.
When the advance given by the bank has a personal security of These would be required by the borrower in the regular course
any individual or the borrower with or without a guarantor, it of business. In such a case the borrower needs to take prior
will be c1assified as an unsecured advance. In the absence of any approval from the bank to withdraw any goods that are pledged
tangible security, though personal security is given by an with the bank since the goods will be in the custody of the
individual by way of an obligation for repayment, the loans are bank. In addition to this, the borrower will also have to submit
treated as unsecured. However, all those loans that have the

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58 11.621.6
statements to the bank for additions or withdrawals made to Thus, a bank has the right to retain all forms of securities or


these goods that represent the pledge transactions. negotiable instruments deposited by or on behalf of the
debtor in the ordinary course of its banking business and use
the proceeds of the same towards adjusting the debt obligation
Hypothecation is also a way of creating a charge against the
of the borrower.
security of movable assets much similar to pledge. However,
pledge is a charge, which is defined by law whereas Set-off:
hypothecation is not. In case of pledge, the assets are in the Set-off can be treated as the right of lien, the only distinction
custody of the lender, real or constructive, whereas in case of being that lien relates to goods or any other property on which
hypothecation the assets are in the custody of the borrower. the bank as a creditor has a right, while a set-off is a lien on any
Hypothecation is to be registered under Section 125 of the amount of the debtor that is due from the bank. Simply put,
Indian Companies Act, 1956 when the hypothecator is a set-off is a legal right by which the bank as a creditor is allowed
company, while no such provision exists in case of charges by to use its own debt obligation (i.e. amount that the bank is
way of pledge. In case of Hypothecation, the goods are not allowed to set-off against the repayment of the credit facility it

kept under the lock and key of the banker. The borrower, had offered to the debtor). Such right exists when the amount
however, will have to submit a statement on the goods of the debts are certain, when the parties are the same and when
indicating the additions and withdrawals of the same to the there is no contract, express or implied to the contrary.

bank. All the above mentioned methods of offering security are

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In addition to the fact that the bank does not have the related to movable assets. However, apart from movable assets,
possession of the goods under Hypothecation, it is also a fact there can also be immovable properties that are offered as
that there is no statutory status given to a Hypothecation security. The process of offering immovable, as security is
transaction. In this regard, it is, however, to be noted that known as Mortgage.

rd. F
Hypothecation has a close link to floating charge. While there is Mortgage
no law governing the Hypothecation of goods, Section According to Section 58 of the Transfer of Property Act, 1882, a
125(4)(f) of the Companies Act, 1956 that refers to the Floating

iza D
Charge on undertaking or any property, may be related to
Hypothecation. As per this Section, floating charge, creates an
mortgage is defined as follows: “Mortgage is the transfer of an
interest in specific immovable property for the purpose of
securing the existing or future debt, or the performance of an
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immediate charge on the property charged but however, allows engagement which may give rise to pecuniary liability.” Thus
the borrower to use the property for its business just as in the through a mortgage, the interest and the rights on the
case of Hypothecation. This makes the charge in Hypothecation mortgaged property are transferred from the mortgagor
transaction similar to the type of floating charge. (borrower) in favor of the mortgagee (bank). The principal and
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Assignment: the interest amount that has been secured for is known as
Assignment is a charge in case of an “Actionable Claim” which mortgage-money. There are essentially, six ways of
is defined under Section 3 of the Transfer of Property Act, 1882 mortgaging:
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as follows: • Simple Mortgage

“Actionable claim means a claim to any debt, other than a debt • Mortgage by Conditional Sale
secured by mortgage of immovable property or by
• Usufructory Mortgage
Hypothecation or pledge of movable property, or to any
• English Mortgage

beneficial interest in movable property not in the possession,

either actual or constructive, of the claimant, which the civil • Equitable Mortgage
courts recognise as affording grounds for relief, whether such • Anomalous Mortgage
debt or beneficial interest be existent, accruing, conditional or
Of the different types of mortgages mentioned above, simple

contingent. “
mortgage and equitable mortgage are the most important.
Assignment is a charge created on assets such as receivables,
A simple mortgage takes place without delivering possession of
debtors, etc. For example, policyholders can take a loan against
the mortgaged property. This type of mortgage binds the
the Life Insurance policy from a bank. In such cases, the LIC
mortgagor to pay the mortgage-money expressly or impliedly,
policy is assigned by the policyholder to the bank. If a bank
and in case of any failure to repay the amount, the mortgagee
finances a firm against book debts, then such book debts are
has the right to sell the mortgaged property and use the
assigned to the bank.
proceeds of the same towards the payment of the mortgage-
Lien: money. Such a mortgage is created through a document known
Banker’s Lien is a general lien and is defined under section 171 as “Deed of Mortgage” and is usually registered with the
of the Indian Contract Act, 1872 as follows: “Bankers, factors, Registrar of Assurances.
wharfingers, attorneys and policy-brokers, may, in the absence An equitable mortgage arises when a mortgagor delivers to the
of contract to the contrary, retain as a security for a general creditor the documents of title to immovable property, in order
balance of account, any goods bailed to them; but no other to create a security on the same at certain places, which are
persons have a right as a security for such a balance, goods notified, in the official gazette. It will be necessary to deliver the
bailed to them, unless there is an express contract to that effect.” documents at these specified places by the borrower to the

© Copy Right: Rai University

11.621.6 59
creditor irrespective of location of the property and residential For the above mentioned sectors, the RBI has issued guidelines

status of the borrower or lender. Equitable mortgage is also for the amount of financing that have to be done for various
known as mortgage by deposit of title-deeds. sectors. Apart from such guidelines, RBI has identified the
Having discussed the classification of loans based on the sectors where the financing facility offered is much less than
security offered, we now proceed towards the last type of what is required and set targets for the banks to meet while
classification of advances as given in a bank’s balance sheet financing these sectors. While there were many neglected sectors,
which is based on the purpose of the loan. it was primarily the agricultural and the SSI sector that were of
major concern. India being an agrarian economy and with most
Purpose of Loan of its population living in the rural and semi-urban areas, the
There are basically three purposes for which the banks extend development of the agricultural and the SSI sectors was crucial
their loans and based on these purposes the sectorial for the economic development of the nation. Considering this,
classification of banks’ advances are made. Ever since the RBI has set targets as follows:
nationalisation, the banks have been providing financial
• Agricultural Sector: The advances given to the agricultural
assistance to the neglected sectors of the economy. Accordingly,

sector are classified into direct and indirect advances and the
the RBI has laid down specific guidelines to direct funding for
combined target for these two types of advances was set at
these sectors. Apart from this, advances are also made to the
18 percent.
public sector units. Based on such advances, the sectorial

classification of loans has accordingly been made as under: • SSI Sector: While there is no target set for the advances to

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be made for the SSI sector as a whole, there is a sub-target of
• Priority Sector
40 percent set for the advances made to the cottage
• Public Sector
industries, khadi and village industries, artisans, tiny
• Banking Sector industries (plant and machinery outlay up to Rs.25 lakh) or

rd. F
• Others other SSI units availing credit up to Rs25 lakh.
Priority Sector Advances The other guidelines issued by the RBI that govern the priority
sector lending to various sectors are given below.

iza D
In order to channelise the flow of credit to certain key sectors of
the economy, the RBI, in the credit policy for 1967-68, has
identified the priority sectors. Initially, the priority sector
As mentioned above, the advances made to the agriculture
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comprised of agriculture, exports and small-scale industries sector are of two types -direct and indirect. Direct loans include
(SSI). Following this, banks were given a target of one-third of both short-term and medium-term loans. For the short-term,
the outstanding credit to the priority sector by the end of farmers are given credit against Pledge/Hypothecation of
March, 1979. Subsequently, in 1985, the floor for the priority agricultural produce (including warehouse receipts) for a period
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sector advances was set at 40 percent and within this target, a not exceeding 6 months. The credit amount involved, for such
sub-target of 10 percent is set for the weaker sections. The RBI’s crop loans is Rs.1 lakh. The medium-term loans are extended
definitions for the priority sector and the weaker sections within for the purpose of the purchase of agricultural implements and
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this priority sectors are given below: machinery, development of irrigation potential, reclamation and
• Priority Sector - Agriculture., Small-Scale Industries SSI), land development schemes, construction of farm buildings and
Transport, Retail trade, Small Business, Professional and structures, etc., construction and running of storage facilities,
Self-Employed persons, Education, Housing and production of irrigation charges, etc.

Consumption. Other types of direct advances made to the farmers include the
Within this classification, the RBI has also defined the weaker following:
sections as follows: • Short-term advances made to cultivators of traditional
• Small and marginal farmers with land holding of 5 acres or plantations (tea, coffee, rubber and spices) irrespective of the

less, landless laborers, tenant farmers and share croppers; size of holdings would be treated as direct agricultural
• Artisans or small industrial activity viz. manufacturing,
advances under priority sector.
processing and servicing in villages and small towns with a • Advances granted for development of sericulture and for
population not exceeding 50000 involving utilisation of grainages under sericulture.
locally available natural resources and/or human skills. • Advances up to Rs.5 lakhs granted for financing distribution
Individual credit requirement should not exceed Rs.25000 to of input such as cattle feed, poultry feed, etc.
be considered as part of the weaker sections; Apart from the above mentioned direct loans, the RBI has also
• Scheduled Castes and Scheduled Tribes; specified certain indirect loans that are to be categorized as
• Beneficiaries of Differential Interest Rate (DRI) scheme; priority sector. The indirect advances in agriculture have,
• Self-Employment Program for Urban Poor (SEPUP);
however, been restricted to 4.5 percent of the overall target of
18 percent set for the agricultural sector. Within this upper limit
• Beneficiaries of Integrated Rural Development Program
of 4.5 percent, the banks can give indirect agri-loans to
(IRDP). organisations/boards/individuals providing fertilizers,
electricity, spraying operations, etc. In addition to this, indirect
finance includes loans given to co-operative marketing societies,

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60 11.621.6
co-operative banks lending for such societies, agri-industries exclusively for financing of housing irrespective of the loan size


corporations, agricultural finance corporations, etc. per dwelling unit will be reckoned for inclusion under private
sector advances. Loans up to Rs.50, 000 for repairing of houses.
Small-Scale Industries
All firms, which have a total outlay for the plant and machinery RRBs
not exceeding Rs.3 crore, and Rs.25 lakh fall into the category of The net funds provided by the bank to the RRBs will also be
SSI and Tiny sector respectively. Apart from the target considered as a priority sector advance.
mentioned above for the related activities of the SSI sector, the Investments
indirect credit in this sector will be given to agencies assisting in Bank’s investments in special bonds issued by certain specified
the supply of inputs and marketing of outputs of artisans, institutions such as SFCs/SIDCs, REC, NABARD and NHB
village and cottage industries and to government sponsored would be reckoned as a part of priority sector advances under
corporations/organisations providing funds to the weaker the appropriate sub-head subject to certain conditions.
Finance extended to state electricity boards for systems
Retail Trade

improvement scheme in the rural areas under special project
Advances granted to (i) private retail traders dealing in essential agriculture (SI-SPA) was classified as indirect finance to
commodities (fair price shops) and consumer cooperative stores agriculture under priority sector.
and (ii) other private retail traders with credit limits not

During February 1999, RBI had introduced the advances made

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exceeding Rs.5 lakh.
to food and agro-processing industries and investments in
Services (small Business venture capital into the priority sector lending.
The advances made to the firms providing services (other than Loans to the software industries (having credit limit not
professional services) will be covered here. The original cost exceeding Rs.1 crore from the banking system).
price of the equipment used and the working capital limits of

rd. F
The above mentioned guidelines give the priority sector
such firms should not exceed more than Rs.10 lakh and Rs.5
advances that arc to be made by the scheduled commercial banks
lakh respectively. Further, the aggregate of these shall not exceed
more than Rs.1 lakh.
Transport iza D (SCBs) only. The RBI has issued separate guidelines for the
priority sector advances of foreign banks. From July 1993,
foreign banks are required to make 32 percent of their net bank
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Advances given to the road transport operators coming under credit to the priority sectors. The definition of priority sector to
this category will be given to the extent of financing ten vehicles. foreign banks also includes the export credit. Within the overall
Bank credit to NBFCs for the purpose of on-lending to small target set for the priority sector, a sub-target of 10 percent is set
road and water transport operators (fleet of vehicles. not more for SSI and export credit. The shortfall, if any, in meeting the 10
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than 10) is also considered as priority sector. This implies that if percent target will have to be made by depositing the same with
a company XYZ Travels Ltd. has a fleet of nine vehicles and the Small Industries Development Bank of India (SIDBI).
takes credit for its 10th vehicle from a bank, then the credit
Public Sector/Banking Sector/Other Sectors
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extended by the bank for financing this vehicle will be

The other sectorial classifications are based on the constitution
considered as a priority sector advance for the bank. Having
of the borrowers and these include the loans extended to the
purchased this 10th vehicle, XYZ Travels Ltd. has taken credit
public sector, the banking sector and others. The residual of the
from the bank for the purchase of yet another vehicle. The
advances, after lending to priority, public and banking sectors
credit advancement made by the bank for this vehicle will,

will appear in the category of others. Thus, advances that are

however, not be a priority sector advance since XYZ Travels Ltd.
extended to individuals, private corporates and all other
already has a fleet of 10 vehicles and the finance is taken for the
institutions will be classified here.
11th vehicle.
By classifying the total advances in the above mentioned ways
Professional and Self-Employed Individuals

i.e. based on the nature, security and purpose, the bank will be
In the individual category, the total advances given to
in a better position to analyze its loan profile from various
professionals and self-employed, whose borrowing limits do
angles. This kind of classification helps the reader of a balance
not exceed Rs. 5 lakh of which not more than Rs. l lakh for
sheet to understand the bank better.
working capital purpose are covered. However, in case of
professionally qualified medical practitioners (setting up practice Having decided on the type of credit it will be offering, the bank
in rural and semi-urban areas), the borrowing limit shall not will then have to take crucial decisions regarding the loan
exceed Rs.l0 lakh, of which, the working capital should not be appraisal and disbursal, loan pricing and other loan
more than Rs.2 lakh. Within the above ceiling, the medical components. Once the bank decides on the type of credit
practitioner will also be given an advance for the purchase of advances it will be making, the loan appraisal and disbursal
one motor vehicle. follows. We shall now try to get an insight into these aspects of
Direct housing loans only up to Rs.5 lakh in rural/semi-urban
areas and up to Rs.l0 lakh in urban and Metropolitan areas, are
treated as priority sector advances. All investments in bonds
issued, by NHB/Housing and Urban Development Authority

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11.621.6 61
Loan Appraisal and Disbursal While the total working capital requirement of the borrower is

All the types of advances that are made by the bank, which are Rs.55 lakh, there will be the margin amount which is to be
discussed above, will be debt finances. And prior to the brought-in by the borrower. To arrive at this margin money, the
disbursal of any amount as advances, the bank should be well bank will have to first arrive at Maximum Permissible Bank
aware of the cash requirements of the borrower and the type of Finance (MPBF).
advance it should make in order to suit such requirement of the The three methods that can be used to assess the credit amount
borrower. This type of appraisal differs greatly from the initial are
appraisal that the bank conducts while deciding on the approval
of the loan. The initial appraisal basically involves an analysis of Turnover Method
the market, technological, financial, managerial analysis and Based on the forecasts made for the turnover of the firm, a
suggests the bank the feasibility of making any advances with percentage of the same will be taken as the amount to be
such analysis. Once the bank decides to sanction the loan financed for the working capital.
proposal, the other critical issues that need to be catered to are Earlier, banks were to assess the credit requirements of

the decisions relating to the way of financing, i.e. which mode borrowers with fund based working capital up to Rs.l crore
of funding will suit the clients cash requirements and the from the banking system in a simplified method of fixing a
manner in which the amount has to be disbursed. limit of minimum of 20 percent of the assessed turnover with

Firms basically need bank funds as project finance or as working a minimum margin of 5 percent to be brought in by the

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capital. Project finance is generally used for financing, long-term borrowers. Now the method can be adopted for fund based
assets of the firm. Consider the following illustration: working capital liability of Rs.5 crore.
Cash Budget Method
Project details of LLG Steels Ltd.: (Rs. lakh)
Land 125.00 This method assesses the requirement of the funds by the firm

rd. F
Site Development
at various periods and then decides on the MPBF. This method
Plant and Machinery 25.00 suits the seasonal industries. Based on the seasonality, banks
Pre-operative Expenses 5.00
can set the peak and non-peak limits for the bank finance.
iza D
The above figures show the total financial requirement for the
Tandon Committee Method
Tandon gave three methods of assessing the MPBF, which are
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project, which the firm submits, to the bank. In any type of as follows:
lending activity, banks do not fund the entire amount required
by the borrower. They require the borrower to bring in some Method I 0.75 (CA - CL)
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amount as the margin money. In case of the financing, of the Method II 0.75 (CA) - CL
long-term assets, this margin will be normally 25 percent of the
Method III 0.75 (CA - CCA) – CL
total amount for each type of asset that the bank is willing to
finance. Thus in the above illustration, as the bank will be
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financing, land, site development, building and plant and Core current assets are to be financed by the long-term sources
machinery, the margin money will be Rs.60 lakh (240 x 0.25). of the borrowers.
The balance of the amount i.e. Rs.180 lakh will be provided by CA and CL are Current Assets and Current Liabilities
the bank as a term loan and/or lease finance. Having decided on respectively and CCA are the Core Current Assets.

the loan amount, the same will be disbursed in lumpsum on

Till the recent past, banks were required by the RBI to use the
an installment basis depending on the project requirement.
Tondon Committee’s method II for assessing the MPBF.
Similar type of appraisal is also conducted by banks while However, banks are now free to adopt their own policy to
deciding on the amount of the working capital. The borrower assess the MPBF. Hence, banks can use any of the above three

will make projections of the market demand, etc. and arrive at approaches depending on tile nature of the business and the
the amount of working capital it requires at a particular level of size of the firm and assess the MPBF.
production. Consider the working capital requirement of LLG
Assuming that the current liabilities of LLG Steels Ltd. are
Steels Ltd.:
Rs.25 lakh the MPBF using the Tandon Committee’s method
Rs. lakh
II will be as follows:

Inventory 20.00
Debtors 8.00 The Current Assets = Rs.55 lakh
Receivables 5.00
Cash 10.00
Others 12.00
The Current Liabilities = Rs.25 lakh
55.00 MPBF = 0.75(CA) - CL = 0.75(55) - 25
= 16.25
The decision relating to the amount to be financed will be
followed by the method of financing, the same. Financing, of
the working capital will be through cash credit (CC), working
capital demand loan (WCDL) and/or bill financing,

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62 11.621.6
mechanisms. In a CC approach, there will be a lot of uncertainty


for the bank about the cash inflows and outflows and so will be
the case with the interest income. To avoid this and to gain,
better control over the flow of credit, RBI had, in April 1995,
introduced the loan system of delivery of credit for borrowers
with working capital (fund based) limit of Rs.l0 crore. Since it is
a short-term loan, which has a minimum repayment/maturity
period of 15 days, it is also known as the Working Capital
Demand Loan (WCDL). The bifurcation of the working capital
finance into CC and Loan component will be in the ratio of
Questions to Discuss:
1. What is the need for lending and need for credit?

2. What are the types of credit?
3. Discuss the nature of credit?

4. What is the security offered for Loans?

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5. Discuss the purpose of Loan.
6. Systems Hardware Ltd. Has submitted its project report for
getting credit facility from the Dhan Bank Ltd. The following
are the details relating to project finance and working capital

rd. F
requirements of the firm:
Rs in Lakh
Site development
Plant and machinery
Pre-operative expenses
iza D
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Total 270.00

The working capital requirement of the Company is as given

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Rs in Lakh
Inventory 45.00
Debtors 15.00
Receivables 10.00
Cash 10.00
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Others 8.00
Total 78.00

1. Assess the margin amount that the company has to bring in

for its project and the amount of bank finance for the same.

2. Assess the Maximum Permissible Bank Finance (MPBF)

using the second method of Tandon Committee (current
liabilities are Rs. 30 lakh).
3. Give the details of the means of finance for the working

capital, if the actual bill finance required is Rs. 5 lakh.


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11.621.6 63


Learning Goals: multifarious objectives like profitability, liquidity, volume of

After reading this lesson, you will be understand business, risk levels, etc. there will be prioritization of objectives
while drafting the policy. But due to certain conflicting
• Need for a Loan Policy
situations, reconciliation/trade-off between different objectives
• Components of a Loan Policy. may become necessary. Further, in the case of certain objectives,
Lending is a crucial activity for a bank as it enables it to sustain there will be regulatory prescriptions like the capital adequacy
profitably. But to sustain profitably, prudent decisions need to’ norms. Thus, while setting the loan objectives in. the policy,

be taken both prior to and after sanctioning the credit. These adherence to the regulatory prescriptions will also be an
decisions generally relate to the amount of credit to be extended important consideration. By stating the related regulatory
during a financial year, the industries to focus on, the aspects in the policy, the loan officers will be fully aware of the

geographical spread, the type of credit to offer, the type of importance of the policy measures. .

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proposals to finance, the disbursal mechanism, the collateral
Volume and Mix of Loans
value, the method of pricing, the repayment schedule, the
The policy should specify the targeted composition of the loan
monitoring process, etc. These macro and micro level
portfolio, such composition being in terms of industry/
considerations of the lending activity contribute to the
location/size/ interest rate/security. Decisions regarding the

rd. F
achievement of the bank’s objectives. The bank’s management
loan portfolio will depend on the size of the bank, the credit
should thus, ensure that lending decisions fall in line to
requirements in its operational areas and the expertise available
subserve the bank’s overall objectives.
Need for a Loan Policy
iza D
While lending decisions are crucial for the bank, it is neither
with the bank. In an agrarian type of economy most of the
loan demands may come from the farmers. Likewise, if the
bank size is small, it may have to put a limit to individual loan
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feasible nor desirable for the top management to review and proposals to be in proportion to its total loan portfolio.
clear every single loan proposal that the -bank receives. This Generally, exposure levels, which the banks can have for the
arises not only due to the process involved in such an activity various types of borrowers, are given by the apex regulatory
but also due to the numbers. Furthermore, for most of the body. While fulfilling the, regulatory prescription it is desirable
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loan proposals, whichever industry they may belong to, the to develop more detailed limits within the bank.
modus operandi remains the same - analyzing, selecting,
Geographical Spread
sanctioning and monitoring. Hence, the, top management
There will be various locations from where a bank conducts its
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needs to set the standards. Standards relating to the exposure

operations. Of these locations, some may be weak credit
limits for individual / company / industry, credit quality of the
demand areas with a considerably high deposit potential and
borrowers, lending rate, risk level, etc. enable decentralized
vice versa. While operating in any area, the bank should have the
decision-making by the lending officers.
requisite funds and expertise to meet the credit demands. The
To enable such decision-making, there should actually be a

policy should thus, state the key trade areas of the bank for
policy document that carefully specifies the dos and don’ts while extending credit. Further, within the trade areas, there may be
sanctioning the loan proposals. As loan proposals differ widely certain areas with a primary focus and a few others, which may
from each other, there cannot be a strict methodology for be given the secondary focus. Such a classification may also
accepting or rejecting the proposals. Instead, guidelines can be

enable the bank to switch on to the secondary trade areas when

given within the loan policy for the decision makers to enable the chief trade areas are not active.
them to screen out loans, which can be outrightly rejected, loans
that can be sanctioned without any involvement of the top Loan Evaluation Procedures
management and proposals that require a certain amount of The policy document shall specify a process for eva1uation of
top level decision-making. Discussed below are a few loan proposals, which will enable uniform evaluation across
considerations that the loan policy may address. areas/people. Evaluation involves a careful selection of the
borrowers by understanding their creditworthiness. While
Components of a Loan Policy evaluating the proposal, banks should not only assess the
When a bank is developing its loan policy, there will be certain ability of the client to payback the loan but also their willingness
significant issues, which it needs to incorporate in the policy. to repay. Banks need to consider the following variables while
Discussed below are a few considerations that the loan policy evaluating a loan proposal:
may address.
Industry Prospects
Loan Objectives To study the prospects of the industry, an industry level credit
The first step to framing a loan policy is formulating the analysis needs to be performed which most importantly
objectives of the lending activity. Due to the presence of includes a study of the following:

© Copy Right: Rai University

64 11.621.6
• Industry cycles limits, which are generally set, based on the responsibility and


• Threat from substitutes the experience of the loan officer should be done diligently. Too
Iowa limit will lead to a situation where a major part of the
• Shifts in consumer demands
senior management’s time is spent on smaller quantum of
• Regulatory environment loans. In contrast to this situation, the risk of the bank may
Operational Efficiency increase when loan sanction powers are too high. Inexperienced
The company level credit rating is conducted to assess the officers may commit the bank to undesirable loans.
operational efficiency of the client company. The critical aspects Credit Files
that are to be evaluated in this process fall into the following The details regarding the borrower are not only essential during
categories: the loan appraisal time but they are also required throughout
• Operating margins the tenor of the loan. This is essential especially since there may
• Stability and growth of market share always be a probability of default or a change in the risk-return
profile of the customer. Continuous evaluation is possible with
• Access to key raw materials

the help of a credit file, which keeps track of the historical record
• Benefit from economies of scale of the borrower. In this context, the loan policy can specifically
Financial Efficiency mention the inputs required for maintaining the credit files for

Repayment of the loan by the clients depends greatly on their varying types of loans. The credit file maintained for a borrower

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financial soundness. Hence, financial analysis becomes an should reveal all the parameters considered while accepting the
imperative part of credit risk analysis. It includes an analysis of proposal. It is useful to keep a record of any specific events/
the following: experiences which indicate whether the decision taken for
• Financial leverage granting such a loan was sound or not. The contents of the
credit file should include all details of the borrower including

rd. F
• Coverage ratios
detailed financial statements and analysis, collateral provided
• Cost of capital and the value of the same, details of compensating balances,
• Ability to raise funds
• Working capital management iza D etc. Moreover, since most of the customers are not one time
borrowers, it will be all the more necessary for the bank to
maintain such credit files of the customers.
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• Interest rate risk management
Lending Rates
Management Evaluation
The interest charged should reflect the credit risk present in the
While the above mentioned factors assess the ability of the
credit disbursal. The major issue will thus be to adjust the rate
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client to repay, the management evaluation to a certain extent,

charged to the risk perception. For this, the loans can be
throws light on the willingness of the client to repay. Thus,
classified into different risk groups based on the risk involved.
evaluation of management includes a study on the performance
Having done this, the policy should then state the returns a
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of the promoter, top management and also the performance of

particular loan should be giving at a particular level of risk. The
group companies under the same management.
policy should also state the risk level at which no credit can be
Fundamental Analysis extended. In addition to this, the policy should also give
Here, the fundamental factors that influence the working of the guidelines for selecting a floating or a fixed rate of interest.
client company are analyzed. These factors are listed below: A loan policy will actually be a function of the size of the bank.

• Capital structure Hence, apart from the above mentioned considerations,

• Asset/liability position. Asset quality depending on the bank’s own requirements, there may be
several other issues/parameters that may be included in its loan
• Profitability
policy. Given below are some of the other issues/parameters

• Sensitivity to interest rate structures, tax policies, etc. that the loan policy may contain:
Above is the broad classification of the various parameters used
to evaluate a loan proposal. The parameters used for evaluating
• Type and extent of collaterals
will vary depending on the type of the borrower, the nature of
the project and the purpose of funds. The list provided above • Compensating balances 2 / margin.
is not an exhaustive one and depending on the loan proposal, • Statutory limits for different types of loans
the bank will select the evaluating variables. Once a broad list of • Monitoring mechanism
such parameters is identified, the loan policy may also specify
• Loan-Deposit ratio
benchmarks so that uniform evaluation can be ensured.
• Incentive schemes for the loan officers.
Loan Administration
• Loan repayment pattern
Efficient administration is the key to the success of the lending
policy. And for improving its efficiency, the authority of the • Communication practices
loan executives should be clearly stated as also their • Extension of renewals of past-due installment loans
responsibilities. The loan policy should state the sanctioning (rescheduling the loan)
powers of the loan officers regarding the credit limits. The credit

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11.621.6 65
• Loan-loss reserves

• Consumer laws and regulations

• Role of credit department
• Role of recovery department
Having drafted the loan policy, adequate measures should also
be taken to ensure that the policy is being effectively used in the
lending activity. For this, there need to be loan committees,
which review the loan policy from time to time and also, assess
the performance of the credit departments. These committees
should meet frequently to assess the loan policy, to assess the
loan proposals beyond a threshold limit and also those loan
proposals that do not comply with ‘the normal credit

standards. It will have to suggest measures to cope with certain
grey areas and find a solution to the critical questions relating to
a bad loan before it drifts into an undesirable and

uncontrollable situation

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By listing the lending parameters, defining responsibilities and
having in place a proper system of checks and balances, the loan
policy does provide a framework for bank lending. In addition
to this, a good loan policy should have two other features -

rd. F
firstly, it has to establish the credit culture for the bank and
secondly, it has to be contemporary. If a loan policy is able to

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establish a credit culture for the bank, then it will also enable a
new entrant into the organization to understand the procedures
of the bank easily. And due to the dynamic operating
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environment, there may be certain changes in the bank
objectives, the pricing methodologies practiced, the exposure
levels, etc. and all these require a revision in the loan policy.
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Hence, the loan policy needs to be contemporary so as to suit

the changing lending environment.
Questions to Discuss:
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1. What is the need for a Loan Policy?

2. Discuss the components of a Loan Policy.

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66 11.621.6

Learning Goals: However, one issue that arises during such computation is
After reading this lesson, you will be understand whether to use the average cost of funds or the marginal cost
of funds. This becomes a fairly simple issue if the liabilities and
• Objectives of loan pricing
the assets of the bank are examined. If we consider a bank’s
• Cost plus loan pricing model balance sheet, the liabilities of the bank will be deployed into
Being the purveyors of credit, primary activity of banks is various assets including advances and investments. In certain
lending. Apart from ensuring proper application of the surplus situations when the bank does not have suitable deployment

funds mobilized, lending also enables these banks to maintain opportunity by way of loans or investments, it will temporarily
profitability. Deployment of funds should be at a rate that deploy the same into the money market and will utilize the
covers the cost of funds and leaves a margin to the lender after same for the future credit proposals. Along with these funds,

meeting the expenses. This margin should on one hand cover incremental deposits will also be used for offering credit. When

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the risks a bank is exposed to due to their lending activity and the funds deployed in the money market are used for extending
on the other hand provide certain income. Pricing thus has an the credit, then it is desirable for the bank to consider the
implication on the profitability and the sustenance of the bank. average costs of funds while pricing the loans. This is basically
While a bank can adopt a pricing policy for greater margins, it due to the fact that various sources of funds would have been

rd. F
may, however, have an adverse affect on their business volume. used for the deployment into the money market. An average
A bank needs to thus, adopt a pricing policy that ensures cost of funds will be essential since in a declining interest rate
profitability while increasing the business volumes. Arriving at scenario, by considering only the marginal cost of funds, the

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such a price level is difficult for the simple reason that there are a
number of factors, both internal and external to the bank that
influences such a decision. The aspects related to loan pricing
higher interest rates on the banks funds will eat into the
profitability of the bank.
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Alternatively, if the bank does not have any surplus funds
that are discussed in this lesson can be broadly categorised into deployed into the money market, then the future credit
the following: requirements will have to be funded using the incremental
• Determinants of loan pricing deposits only. Under such circumstances the incremental or the
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• Methodologies of loan pricing marginal cost of funds can be used while assessing the loan
price. Thus, in loan pricing, the use of the average cost of funds
Objectives of Loan Pricing and the marginal cost of funds will depend on the composition
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Prior to deciding the price of any product, it is essential to first of asset-liability position.
identify the objective the price of the product should attain for
the firm i.e. should it ensure high returns, higher business or Risk-Reward
should it just enable a break even. Similar is the case when the The relation between risks and returns will have to be
bank decides to fix its loan price. Banks generally have three considered taking three different loan attributes- the tenor of
the loan, the credit risk of the customer and the size of the

major objectives in loan pricing-

loan. Form the theories of interest rates, it can be understood
• Maintain margins
that the interest rates increase with the increase in the tenor of
• Balance risk-reward profile the loan. Thus, loans with longer maturity are charged a higher
• Ensure market rates interest rate when compared to the loans maturing in the short-

Margins ensure profitability, the balanced risk-reward profile term. This is due to the fact that the risk involved in lending foe
ensures sustenance, and the market rate ensures the presence of longer periods is greater when compared to the lending for
the bank in the market. While all the three objectives are shorter periods. Considering this, if a bank would like to earn
important and interrelated, prioritizing them, however, will be a greater returns, it would have to lend for longer periods. But for
policy decision to be taken by the bank. this, the bank should also have funds with marching maturity.
However, the sources of funds for a bank do not generally
include long-term funds. In such cases, the bank may borrow
To ensure margins, the bank should have surplus income after
short and lend long, which may lead to an enhanced level of
having met its cost of funds and cost of servicing. For this
risk. Due to the presence of this risk, the bank should decide on
purpose, the bank can ascertain the cost of its funds, add the
a level of risk-reward that it is prepared to accept and then
overall cost of servicing to which it can add the necessary
decide on the maximum tenor of its loans.
margins it would like to maintain for taking the risk and to earn
a profit. The total of this will give the rate at which the loan has The second major attribute that influences the risk, reward
to be priced. proportion of the bank is the credit risk involved in the lending
function. All loans have a certain element of risk involved in
them due to the probability of default. The level of risk,

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11.621.6 67
however, varies for each borrower, moving upwards from Market Rates:

sovereign debt to corporate debt. Due to the presence of this The last factor that affects the loan pricing decision is the market
risk, the returns will also vary, with greater returns being rate. If the rates charged by the bank are higher than the market
attached to higher risk levels. This linkage between the credit risk rates, then it will lose its business to those offering cheaper
and the returns highlights the need for the bank to first decide rates. On the other hand, if it lowers its rates below the market
on the level of risk-reward it would prefer to maintain. Having rates, then though the volume of the business may increase,
laid down the tolerable risk level and the approximate returns but the lower returns will reduce its profitability. To prevent loss
for the same, the bank can accept or reject the loan proposals of business and lower profits, thee bank should ensure that
based on the risk they are exposed to. loan prices remain close to the prevailing interest rate structure
Apart from the above mentioned attributes, the size of the in the market.
loan also influences the risk-reward ratio. While the affect of Considering the various factors influencing the loan pricing
term to maturity and the credit risk on the risk-reward ratio decision of the bank and the alternatives in pricing, the bank
could be clearly observed, the same may not be possible in the will next have to develop loan pricing model. If the objective of

case of the size of the loan. The key issues to be considered the bank is to earn spreads, then the pricing model will first
here will be the relationship, the servicing costs and the risk focus on the cost analysis of the bank and then ensure that the
involved have with the size of the loan. price charged covers its costs and leaves a margin. Similarly,

Considering the servicing costs, as the size of the loan increases, when the risk-reward objective is set as the top priority, the

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these costs come down as it will be cheaper to service a single customer evaluation and a price that reflects the risk involved by
loan account of Rs. 10 lakh each. Loans which are made in small extending such credit becomes essential. And finally, if the
denominations and which involve greater clerical and bank’s chief objective is market presence, then it will ensure that
management time, carry high cost per rupee of loan extended its rates move in tandem with the rates of the other players in
the market. However, this cannot be pursued irrespective of its

rd. F
and vice versa. Example of this can be a credit card facility where
the time involved for management is greater than the tem loan. ability to sustain.
Compensation for this high service costs are the high interest However, prudence lies in actually integrating these three

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rates charged for the credit card facility. On the other hand, loan
of larger denominations will take comparatively lesser time for
management and may be a useful proposition. However, the
objectives and emerging with a price that not only covers the
banks’ lending costs and gives a return on it, but also ensures
that the bank is able to sustain the risk level taken and at the
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greater exposure to one client will result in higher risk. To same time keeps itself close to the prevailing market rates.
understand this, consider the Capital Structure theories. It can Discussed below is a pricing model that uses various
be recalled form the traditional approach of capital structure that approaches to build in these three objectives. The basic model
w.p m

the gains on account of increased leverage will be higher than of the cost plus pricing is used to arrive at the loan price. Within
the increased cost of equity thus having a positive impact on the this, various methods of assessing the risk premium and the
value of the firm up to a particular level of leverage. Thus the required profit margin are discussed. Following this approach,
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ratio of debt to equity, which does not adversely affect the value the bank can build in a pricing methodology that ensures a
of the firm, will be safe for the creditor/bank. The bank can price, which covers the costs and the risks and leaves a profit
lend to a single customer as long as this degree of leverage is margin.
maintained. However, if the debt amount goes beyond this
level for the firm, then the credit risk for the bank will rise. The Cost Plus Loan Pricing Model
This model basically focuses on arriving at a loan price that

rise in the credit risk will again lead to a rise in the servicing
costs, which have actually been falling due to the size of loan. ensures a certain margin after covering the cost of the funds,
This is basically due to the fact that with the size of the loan operations costs, cost of servicing. The process involved in
being large and the credit risk increasing, the bank will have to arriving at a contractual rate based on this model consists of the
following steps:

mare closely monitor such loans. Thus, the higher returns

which are expected due to the fall in the servicing costs will be • Arrive at cost of funds
off-set by the ruse in the credit risk, thus, the impact of the size • Assess the servicing costs
of the loan on the risk-reward ratio of the bank will have to be • Quantify the credit risk and set premium
examined both from the point of view of the company (capital
• Assess the profit margin that ensures the targeted ROE
structure) and the bank.
• Relate the rate to a reference rate (Prime Rate)
Thus, the bank’s risk-reward ratio, as discussed above, depends
on the term to maturity of the loan, the credit risk of the loan • Ensure market presence.
and the size of the loan. The returns and the risks of the bank The word margin, however, connotes differently depending on
will undergo a change due to the changes that take place in these how the bank can segregate its costs and other risks. And
three attributes of the loan. This requires the bank to have a depending on what the word margin means to the bank the
continuous monitoring on the risk level and the returns in pricing methodology varies slightly. The basic relationship,
order to remain within the prescribed framework. however, is given as follows:

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68 11.621.6
Loan Price = Cost of funds + Margin………(1) Operating and Servicing Costs


These costs represent the other expenses that represent the
Cost of Funds:
burden for the bank and comprise of the costs incurred while
While assessing the cost of funds apart from deciding on the
servicing deposits, extending loans and other services. These
average cost of funds and the marginal cost of funds, the bank
vary depending on the nature of the loan, the cash flow pattern,
will also have to assess the same considering the average cost of
and the maturity. All the administration cost incurred by the
funds vs. the cost of pooled funds (funds having the same
bank while the loan is still live viz., salaries, costs incurred in
interest rate). This decision depends on the ability of the bank
creating and perfecting a security interest in collateral, costs
to identify the liabilities that are deployed into a particular asset.
incurred on documentation for security interest in collateral,
In other words, if the bank is not in a position to identify the
costs in establishing and managing the records, collection costs,
source from which the funds are used to extend a particular
etc. will be considered here. Similar servicing costs are involved
credit facility, then the average cost of funds will be the suitable
both for deposits and other services. While the servicing costs
option. However, if the bank can clearly segregate its liabilities,
for other services maybe recovered from the fee income received
then it can pool funds with similar maturities and fund a credit

from such services, the servicing costs of deposits will also have
proposal with a similar maturity. The cost of funds will thus be
to be met from the interest income.
the average cost of pooled funds and not the average cost of
total funds. This approach to assessing the cost of funds will Risk Premium

enable price matching as well as maturity matching. However it Risk margin will be set after considering the different types of

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may not be possible to adopt a pooled funds approach in risks the loan is exposed to. For a proper assessment of this,
respect of all sources of funds. It is, therefore, desirable to risk unbundling becomes essential. Provisions are generally
adopt this pooled funds approach at least in respect of high made to tackle the risk element in the assets.
cost funds so that the price decided on the basis of average Profit Margin
funds does not result in reduction of spreads. Further, in the

rd. F
After considering all the costs involved with the lending activity
case of average cost of funds, the bank cannot use the same rate as well as adjusting for the risk the bank will then look towards
for loans of differing tenors.

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While the price arrived based on the average cost of funds
results in a flat yield curve, it is not always seen in the market
including a profit margin. This margin would depend on the
returns it would like to earn from the lending activity.
Having considered the various components that the bank’s
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and it will not be in tune with the concept of upward sloping margin can comprise of; it can be observed that the margin
yield curve. Therefore, it is possible to change margins at mentioned in Eq.(1) is set to meet the other expenses
different rates to address this problem. (operating ,and the servicing costs), the provisions for risk and a
Thus, it can be observed that in the pooled cost of funds residue which forms the profit margin. Since the cost of funds
w.p m

approach the margins are fixed. However, when the average cost represent the interest expenses, the margin will not require to
of funds is considered, the margins for loans with higher meet them. Thus, when a bank is unable to segregate its other
maturities will be less while the margins for the loans of lower expenses and quantify its risks, this type of loan pricing can be
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maturities will be higher. To avoid such fluctuations in the adopted. Based on the type of security, the nature of the loan
actual margins when the average cost of funds is considered, the and the purpose for which the funds are borrowed, the bank
bank will have to set margins based on the tenor of the loan can set a range for the margins to be included in pricing. The
instead of having a fixed margin for loans of differing upper end margins can be used for loans with higher maturities,
maturities i.e. set higher margins for loans with higher more risk, etc. and vice versa.

maturities. Sometimes, the bank will be able to identify its operating and
Margins servicing costs and build it into its pricing model as a percentage
The word margin is used in a very broad sense in the above to the size of the loan. The loan price can then be assessed as

expression. Consider the following equation: follows:

PBT = (Interest Income - Interest Expenses) + (Other Loan Price = Cost of funds + Costs of Servicing +
Income - Other Expenses) – Provisions….(2) Margin.…..(3)
From the above equation it can be observed that it is from the The loan price as per the above equation will have the margins
interest income that the bank’s PBT and provisions arise and that should contribute to the profit margin after making
also that it is from this income that the bank meets its interest provisions for risks.
expenses and the Burden, which is the difference between the Moving one step ahead in arriving at the price, the bank will try
other income and the other expenses. Thus, it implies that the to quantify the risk it has taken while extending the loan. If the
interest income includes margins. Depending on the break up, risk is identified then the provisioning required for the risks can
which the bank will have for its loan price, the composition of also be assessed.
the margins will differ. Before proceeding towards a discussion
on the different connotations of the word margin, it would be
useful to understand the following:

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11.621.6 69
When the bank is able to do so, then the pricing model can be While the probabilities can be assessed from the past data, the

further disintegrated as follows: recovery rate can be computed by considering the guarantees and
Loan Price = Cost of Funds + Cost of Servicing + value of collaterals attached to the loan. The recovery rate refers
Provisions for Risk + Profit Margin..…(4) to the percentage of the outstanding balance that can be
recovered by measures such, as enforcement securities, legal
Here the margin will be solely to meet the profits of the bank.
action, etc.
This can, be arrived at based on the Return on Equity, which the
bank would expect to maintain. When a default is expected from a loan, the bank will adjust the
recovered amount towards the principal. Thus, based on the
In its very basic framework, the cost plus pricing method
probability of payment and recovery -rate, the expected rate
discussed above is based only on the costs and since costs set
when the bank expects the payment of interest as well as the
the floor for pricing, the interest rate arrived at that first stage
principal amount, will be
(using (Eq. (3)) can be considered as the Hurdle Rate. This is
the rate below which a bank cannot offer any credit if it has to Expected Return = P1(r) + P2 P (1 + r) x R ………….(6)
remain profitable. To arrive at this hurdle rate, estimation of P

costs, expenses incurred and expected returns become essential.
However, by assessing the risk premium and the required P2 = Probability of default
P = Principal component
returns, the bank can actually improvise on its pricing approach.

R = Recovery rate.
But to arrive at this price, the bank should be able to quantify its

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risks and also decide on the required margin. In the above formula, P1(r) gives the returns using the
Discussed below is the procedure by which the bank can contractual rate and the probability of total repayment of the
gradually build a loan price that incorporates all parameters i.e. loan in the normal course of payment while the second part i.e.
the cost of funds, cost of servicing, risk premium and the P2{ [P(l + r) x R]/P – 1 } gives the returns using the recovery

rd. F
profit margin. The loan price using the Eq. (3) can be obtained rate and the probability of default. The expected rate when there
simply by assessing the cost of funds and its servicing costs and is only principal repayment will be assessed as follows:

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adding the margin amount. The profit margin, which the bank
sets, should enable the bank to earn its required ROE. When
the ROE is met then the price charged which is known as the
Expected Rate = P1(r) + P2 (R - 1)…………….(7)
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Contractual Rate will become the expected return for that loan.
However, the bank will earn this expected return as long as there In the above equation, the second part i.e. P2 (R - 1) gives the
is no default in the repayment of the loan. In case there is a principal that is recovered.
default, the contractual rate will not give the bank the expected
w.p m

It is now understood that while pricing a loan proposal, it is

return. If the bank has to reach the targeted ROE, then the risk essential for the bank to adjust the contractual rate so that it
should be quantified to arrive at a contractual rate that in turn reflects the creditworthiness of the client. The bank should
gives the bank the expected rate. thus, build into its pricing, mechanism probability of default.
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Quantifying Risk Premium Such an exercise will, to a certain extent, reduce the loss in return
Generally, while performing the financial appraisal for the due to defaults. From the above equations, for a given
proposal, the internal rate of return (IRR) is calculated. If the contractual rate, the expected returns from the proposal can be
payments are made regularly by the clients, then the expected assessed by considering the probability of the repayment/

rate of return will be equal to the contractual rate. default and the recovery rate. Using this approach, it is also
possible to decide the contractual rate to be offered once the
required rate is determined. The required rate, which includes
Expected Return = P1(r)……………………………..(5)
the cost of funds, transaction costs and the spreads, can be used

as the expected rate.

r = Contractual Rate
Questions to discuss:
PI = Probability of repayment
1. Which of the following approaches (A) Average cost of
funds (B) Pooled cost of funds should be used for financing
In the above case, since the payments are made regularly by the a 3 year loan proposal of Rs. 10 crore in order to maintain a
clients, P1 will be equal to one. margin of 4 percent over the cost of funds? Given below are
However, there will always be some uncertainty attached to the details of its liabilities portfolio.
future cash flows. This uncertainty attached to future cash flows. Amount Maturity (year) Interest rate (%)
This uncertainty relates mainly to the amount of cash inflows (Rs.crore)
25 - -
and the timing of the cash flows. In such uncertain situations, 40
the bank can arrive at the probability of repayment/default and 20
also the extent of recovery in case of a default. 140

2. Zenith Finance Ltd. assessed its cost of funds to be 15.75

percent. Further, the transaction cost for sanctioning a credit

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70 11.621.6
proposal is 0.5 percent. On this cost, it expects to maintain 2


percent as spreads. A proposal is received by the company for
financing a loan for Rs.950 lakh. The credit department in
their appraisal report have given the probability of
repayment as 0.95. However, on default, the recovery rate is
expected to be only 85 percent. From this information,
compute the expected rate of financing. Further based on the
creditworthiness of the client, what do you think the
contractual rate should be?
3. Venus Financials Ltd. had received a loan proposal for Rs. 12
crore. The contractual rate for the loan is 22 percent. In case
of a default, VFL expects to recover 90 percent of the
principal. If the probability of repayment is 0.9, then what

will be the expected return for VFL? Based on the answer
you get, assess the rate at which the loan should have been
financed to get a return of 22 percent.

4. L&M Bank Ltd. has received a 4-year loan proposal from a

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Deep Mines Ltd., which has a A+ credit rating, attracting a
risk premium of 2 percent. The PLR for a 2-year loan of the
bank is at 13.5% and the implicit forward rate for two years
form now is 15 percent. If the bank follows a prime-time

rd. F
pricing method, what should be the loan price?

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11.621.6 71


Learning objectives Further, international rating agencies like, Standard & Poor have
After reading this lesson, you will understand lowered India’s credit rating to sub-investment grade. Such
negative aspects have often outweighed positives such as
• Introduction
increasing forex reserves and a manageable inflation rate.
• Indian Economy and NPAs
Under such a situation, it goes without saying that banks are no
• Global Developments and NPAs exception and are bound to face the heat of a global downturn.
• Meaning of NPAs One would be surprised to know that the banks and financial

• Why such a huge level of NPAs exists in Indian banking institutions in India hold non-performing assets worth Rs.
system (IBS)? 1,10,000 crores. Bankers have realized that unless the level of
NPAs is reduced drastically, they will find it difficult to survive.

• Why NPAs have become an issue for banks and financial

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institutions in India? Global Developments and NPAs
• RBI Guidelines on income recognition (interest income on The core banking business is of mobilizing the deposits and
NPA) utilizing it for lending to industry. Lending business is generally
encouraged because it has the effect of funds being transferred
• Accounting Standard 9 (AS 9)
from the system to productive purposes, which results into

rd. F
• Are RBI guidelines on NPAs and ICAI Accounting Standard economic growth.
9 on revenue recognition, consistent with each other?
However lending also carries credit risk, which arises from the

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• RBI guidelines on classification of bank advances
• How to classify bank advances, if recovery is highly unlikely?
failure of borrower to fulfill its contractual obligations either
during the course of a transaction or on a future obligation.
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• Credit Risk and NPAs A question that arises is how much risk can a bank afford to
• Public Trust and NPAs take? Recent happenings in the business world - Enron,
WorldCom, Xerox, Global Crossing do not give much
• How important is credit rating in assessing the risk of
confidence to banks. In case after case, these giant corporates
default for lenders?
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became bankrupt and failed to provide investors with clearer

• Usage of financial statements in assessing the risk of default and more complete information thereby introducing a degree
for lenders of risk that many investors could neither neither anticipate nor
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• Can Universal Banking solve the problem of NPA for DFIs? welcome. The history of financial institutions also reveals the
• Capital Adequacy Ratio (CAR) of RBI and Basle Committee fact that the biggest banking failures were due to credit risk.
on Banking Supervision (BCBS) Due to this, banks are restricting their lending operations to
• Excess Liquidity? secured avenues only with adequate collateral on which to fall
back upon in a situation of default.

• High cost of funds due to NPAs

• Conclusion Meaning of NPAs
An asset is classified as non-performing asset (NPAs) if dues in
Introduction the form of principal and interest are not paid by the borrower
It’s a known fact that the banks and financial institutions in

for a period of 180 days. However with effect from March 2004,
India face the problem of swelling non-performing assets default status would be given to a borrower if dues are not paid
(NPAs) and the issue is becoming more and more for 90 days. If any advance or credit facilities granted by bank to
unmanageable. In order to bring the situation under control, a borrower becomes non-performing, then the bank will have
some steps have been taken recently. The Securitisation and to treat all the advances/credit facilities granted to that borrower
Reconstruction of Financial Assets and Enforcement of as non-performing without having any regard to the fact that
Security Interest Act, 2002 was passed by Parliament, which is an there may still exist certain advances / credit facilities having
important step towards elimination or reduction of NPAs. performing status.
Indian Economy and NPAs Why such a Huge Level of NPAs Exists in the Indian
Undoubtedly the world economy has slowed down, recession is
at its peak, globally stock markets have tumbled and business Banking System (IBS)?
itself is getting hard to do. The Indian economy has been much The origin of the problem of burgeoning NPAs lies in the
affected due to high fiscal deficit, poor infrastructure facilities, quality of managing credit risk by the banks concerned. What is
sticky legal system, cutting of exposures to emerging markets by needed is having adequate preventive measures in place namely,
FIIs, etc. fixing pre-sanctioning appraisal responsibility and having an
effective post-disbursement supervision. Banks concerned

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72 11.621.6
should continuously monitor loans to identify accounts that Therefore complying with AS 9, interest income is not


have potential to become non-performing. recognized based on uncertainty involved but is recognized at a
subsequent stage when actually realized thereby complying with
Why NPAs have become an Issue for Banks and
RBI guidelines as well.
Financial Institutions in India?
In order to ensure proper appreciation of financial statements,
To start with, performance in terms of profitability is a
banks should disclose the accounting policies adopted in respect
benchmark for any business enterprise including the banking
of determination of NPAs and basis on which income is
industry. However, increasing NPAs have a direct impact on
recognized with other significant accounting policies.
banks profitability as legally banks are not allowed to book
income on such accounts and at the same time banks are forced RBI Guidelines on Classification of Bank Advances
to make provision on such assets as per the Reserve Bank of Reserve Bank of India (RBI) has issued guidelines on
India (RBI) guidelines. provisioning requirement with respect to bank advances. In
Also, with increasing deposits made by the public in the terms of these guidelines, bank advances are mainly classified

banking system, the banking industry cannot afford defaults by
borrower s since NPAs affects the repayment capacity of banks. Standard Assets
Further, Reserve Bank of India (RBI) successfully creates excess Such an asset is not a non-performing asset. In other words, it

liquidity in the system through various rate cuts and banks fail carries not more than normal risk attached to the business.

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to utilize this benefit to its advantage due to the fear of Sub-standard Assets
burgeoning non-performing assets. It is classified as non-performing asset for a period not
RBI Guidelines on Income Recognition (interest exceeding 18 months

Income on NPAs) Doubtful Assets

rd. F
Banks recognize income including interest income on advances Asset that has remained NPA for a period exceeding 18 months
on accrual basis. That is, income is accounted for as and when it is a doubtful asset.
is earned.
iza D
The prima-facie condition for accrual of income is that it should
not be unreasonable to expect its ultimate collection. However,
Loss Assets
Here loss is identified by the banks concerned or by internal
auditors or by external auditors or by Reserve Bank India (RBI)
dfw P
NPAs involves significant uncertainty with respect to its inspection.
ultimate collection. In terms of RBI guidelines, as and when an asset becomes a
Considering this fact, in accordance with the guidelines for NPA, such advances would be first classified as a sub-standard
w.p m

income recognition issued by the Reserve Bank of India (RBI), one for a period that should not exceed 18 months and
banks should not recognize interest income on such NPAs until subsequently as doubtful assets.
it is actually realized. It should be noted that the above classification is only for the
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What does Accounting Standard 9 (AS 9) on Revenue purpose of computing the amount of provision that should
be made with respect to bank advances and certainly not for the
Recognition Issued by ICAI say? purpose of presentation of advances in the banks balance sheet.
The Accounting Standard 9 (AS 9) on ‘Revenue Recognition’
The Third Schedule to the Banking Regulation Act, 1949, solely
issued by the Institute Of Chartered Accountants of India
governs presentation of advances in the balance sheet.

(ICAI) requires that the revenue that arises from the use by
others of enterprise resources yielding interest should be Banks have started issuing notices under the Securitisation Act,
recognized only when there is no significant uncertainty as to its 2002 directing the defaulter to either pay back the dues to the
measurability or collectability. bank or else give the possession of the secured assets

mentioned in the notice. However, there is a potential threat to

Also, interest income should be recognized on a time
recovery if there is substantial erosion in the value of security
proportion basis after taking into consideration rate applicable
given by the borrower or if borrower has committed fraud.
and the total amount outstanding.
Under such a situation it will be prudent to directly classify the
Are RBI guidelines on NPAs and ICAI Accounting Standard 9 advance as a doubtful or loss asset, as appropriate.
on revenue recognition consistent with each other?
RBI Guidelines on Provisioning Requirement of Bank
In view of the guidelines issued by the Reserve Bank of India
(RBI), interest income on NPAs should be recognised only Advances
when it is actually realised. As and when an asset is classified as an NPA, the bank has to
As such, a doubt may arise as to whether the aforesaid further sub-classify it into sub-standard, loss and doubtful
guidelines with respect to recognition of interest income on assets. Based on this classification, bank makes the necessary
NPAs on realization basis are consistent with Accounting provision against these assets.
Standard 9, ‘Revenue Recognition’. For this purpose, the Reserve Bank of India (RBI) has issued guidelines on
guidelines issued by the RBI for treating certain assets as NPAs provisioning requirements of bank advances where the recovery
seem to be based on an assumption that the collection of is doubtful. Banks are also required to comply with such
interest on such assets is uncertain.

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11.621.6 73
guidelines in making adequate provision to the satisfaction of Banks do rely on credit rating agencies to measure credit risk and

its auditors before declaring any dividends on its shares. assign a probability of default.
In case of loss assets, guidelines specifically require that full Credit rating agencies generally slot companies into risk buckets
provision for the amount outstanding should be made by the that indicate company’s credit risk and are also reviewed
concerned bank. This is justified on the grounds that such an periodically. Associated with each risk bucket is the probability
asset is considered uncollectible and cannot be classified as of default that is derived from historical observations of
bankable asset. default behavior in each risk bucket.
Also in case of doubtful assets, guidelines requires the bank However, credit rating is not foolproof. In fact, Enron was
concerned to provide entirely the unsecured portion and in case rated investment grade till as late as a month prior to it’s filing
of secured portion an additional provision of 20%-50% of the for Chapter 11 bankruptcy when it was assigned an in-default
secured portion should be made depending upon the period status by the rating agencies. It depends on the information
for which the advance has been considered as doubtful. available to the credit rating agency. Besides, there may be
For instance, for NPAs which are upto 1-year old, provision conflict of interest, which a credit rating agency may not be able

should be made of 20% of secured portion, in case of 1-3 year to resolve in the interest of investors and lenders.
old NPAs upto 30% of the secured portion and finally in case Stock prices are an important (but not the sole) indicator of the
of more than 3 year old NPAs upto 50% of secured portion credit risk involved. Stock prices are much more forward looking

should be made by the concerned bank. in assessing the creditworthiness of a business enterprise.

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In case of a sub-standard asset, a general provision of 10% of Historical data proves that stock prices of companies such as
total outstandings should be made. Enron and WorldCom had started showing a falling trend
many months prior to it being downgraded by credit rating
Reserve Bank Of India (RBI) has merely laid down the
minimum provisioning requirement that should be complied

rd. F
with by the concerned bank on a mandatory basis. However, Usage of Financial Statements in Assessing the Risk
where there is a substantial uncertainty to recovery, higher of Default for Lenders

Credit Risk and NPAs iza D

provisioning should be made by the bank concerned. For banks and financial institutions, both the balance sheet and
income statement have a key role to play by providing valuable
dfw P
Quite often credit risk management (CRM) is confused with information on a borrower’s viability. However, the approach
managing non-performing assets (NPAs). However there is an of scrutinizing financial statements is a backward looking
appreciable difference between the two. NPAs are a result of approach. This is because, the focus of accounting is on past
past action whose effects are realized in the present i.e. they performance and current positions.
w.p m

represent credit risk that has already materialized and default has The key accounting ratios generally used for the purpose of
already taken place. ascertaining the creditworthiness of a business entity are that of
On the other hand managing credit risk is a much more debt-equity ratio and interest coverage ratio. Highly rated
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forward-looking approach and is mainly concerned with companies generally have low leverage. This is because; high
managing the quality of credit portfolio before default takes leverage is followed by high fixed interest charges, non-payment
place. In other words, an attempt is made to avoid possible of which results into a default.
default by properly managing credit risk. Capital Adequacy Ratio (CAR) of RBI and Basle
Considering the current global recession and unreliable

Committee on Banking Supervision (BCBS)

information in financial statements, there is high credit risk in
Reserve Bank of India (RBI) has issued capital adequacy norms
the banking and lending business.
for the Indian banks. The minimum CAR, which the Indian
To create a defense against such uncertainty, bankers are expected Banks are required to meet at all, times is set at 9%. It should be

to develop an effective internal credit risk models for the taken into consideration that the bank’s capital refers to the
purpose of credit risk management. ability of bank to withstand losses due to risk exposures.
How important is credit rating in assessing the risk of default To be more precise, capital charge is a sort of regulatory cost of
for lenders? keeping loans (perceived as risky) on the balance sheet of banks.
Fundamentally Credit Rating implies evaluating the The quality of assets of the bank and its capital are often closely
creditworthiness of a borrower by an independent rating agency. related. Quality of assets is reflected in the quantum of NPAs.
Here objective is to evaluate the probability of default. As such, By this, it implies that if the asset quality were poor, then higher
credit rating does not predict loss but it predicts the likelihood would be the quantum of non-performing assets and vice-
of payment problems. versa.
Credit rating has been explained by Moody’s a credit rating Market risk is the risk arising due to the fluctuations in value of
agency as forming an opinion of the future ability, legal a portfolio due to the volatility of market prices.
obligation and willingness of a bond issuer or obligor to make Operational risk refers to losses arising due to complex system
full and timely payments on principal and interest due to the and processes.

© Copy Right: Rai University

74 11.621.6
It is important for a bank to have a good capital base to Therefore, quite often corporates prefer to raise funds through


withstand unforeseen losses. It indicates the capability of a commercial papers (CPs) where the interest rate on working
bank to sustain losses arising out of risky assets. capital charged by banks is higher.
The Basel Committee On Banking Supervision (BCBS) has also With the enactment of the Securitisation and Reconstruction of
laid down certain minimum risk based capital standards that Financial Assets and Enforcement of Security Interest Act,
apply to all internationally active commercial banks. That is, 2002, banks can issue notices to the defaulters to pay up the
bank’s capital should atleast be 8% of their risk-weighted assets. dues and the borrowers will have to clear their dues within 60
This infact helps bank to provide protection to the depositors days. Once the borrower receives a notice from the concerned
and the creditors. bank and the financial institution, the secured assets mentioned
The main objective here is to build a sort of support system to in the notice cannot be sold or transferred without the consent
take care of unexpected financial losses thereby ensuring healthy of the lenders.
financial markets and protecting depositors. The main purpose of this notice is to inform the borrower that
either the sum due to the bank or financial institution be paid
Excess liquidity? no Problem, but no Lending Please

by the borrower or else the former will take action by way of
!!! taking over the possession of assets. Besides assets, banks can
One should also not forget that the banks are faced with the also takeover the management of the company. Thus the

problem of increasing liquidity in the system. Further, Reserve bankers under the aforementioned Act will have the much

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Bank of India (RBI) is increasing the liquidity in the system needed authority to either sell the assets of the defaulting
through various rate cuts. Banks can get rid of its excess companies or change their management.
liquidity by increasing its lending but, often shy away from such But the protection under the said Act only provides a partial
an option due to the high risk of default. solution. What banks should ensure is that they should move

rd. F
In order to promote certain prudential norms for healthy with speed and charged with momentum in disposing off the
banking practices, most of the developed economies require all assets. This is because as uncertainty increases with the passage
of time, there is all possibility that the recoverable value of asset

iza D
banks to maintain minimum liquid and cash reserves broadly
classified into Cash Reserve Ratio (CRR) and the Statutory
Liquidity Ratio (SLR).
also reduces and it cannot fetch good price. If faced with such a
situation than the very purpose of getting protection under the
dfw P
Cash Reserve Ratio (CRR) is the reserve which the banks Securitisation Act, 2002 would be defeated and the hope of
have to maintain with itself in the form of cash reserves or by seeing a must have growing banking sector can easily vanish.
way of current account with the Reserve Bank of India (RBI), Conclusion
computed as a certain percentage of its demand and time
w.p m

To conclude with, till recent past, corporate borrowers even after

liabilities. The objective is to ensure the safety and liquidity of defaulting continuously never had any real fear of bank taking
the deposits with the banks. any action to recover their dues despite the fact that their entire
On the other hand, Statutory Liquidity Ratio (SLR) is the assets were hypothecated to the banks. This is because there was
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one which every banking company shall maintain in India in the no legal Act framed to safeguard the real interest of banks.
form of cash, gold or unencumbered approved securities, an However with the introduction of Securitisation Act, 2002
amount which shall not, at the close of business on any day be banks can now issue notices to their defaulters to repay their
less than such percentage of the total of its demand and time dues or else make defaulters face hard and tough actions under

liabilities in India as on the last Friday of the second preceding the aforementioned Act. This enables banks to get rid of sticky
fortnight, as the Reserve Bank of India (RBI) may specify from loans thereby improving their bottomlines. Also a hallmark of
time to time. a good business is approaching it with a fresh, new perspective
A rate cut (for instance, decrease in CRR) results into lesser and requires management that is fully awake, fully alive and of

funds to be locked up in RBI’s vaults and further infuses greater course fully focused on making things better.
funds into a system. However, almost all the banks are facing Also, the passing of the Securitisation Act, 2002 came as a
the problem of bad loans, burgeoning non-performing assets, bonanza for investors in banking sector stocks that in turn
thinning margins, etc. as a result of which, banks are little resulted into an improvement in their share prices.
reluctant in granting loans to corporates.
Questions to Discuss:
As such, though in its monetary policy RBI announces rate cut
1. NPAs of the bank as on 31/03/2004 are as follows:
but such news are no longer warmly greeted by the bankers.
Assess the amount of Provisioning the bank has to make as on
High Cost of Funds due to NPAs 31/03/2004
Quite often genuine borrowers face the difficulties in raising
funds from banks due to mounting NPAs. Either the bank is Nature of Asset
Amount (Rs Lakh)
reluctant in providing the requisite funds to the genuine Sub -standard
Doubtful asset(secured)

borrowers or if the funds are provided, they come at a very high -1 Year
-1 -3Years
cost to compensate the lender’s losses caused due to high level -more than 3 Years
of NPAs.

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11.621.6 75


Learning objectives made market related. At the same time, the RBI helped create an
After reading this lesson, you will understand array of other market related financial products. At the next
stage, the interest rate structure was simultaneously rationalized
• Introduction
and banks were given the freedom to determine their major
• Reforms rates.
• Cash reserve ratio As a result of these developments, RBI could use OMO as an
• Reduction in CRR effective instrument for liquidity management including to curb

• Flexibility in the treatment of CRR short-term volatilities in the foreign exchange market. Another
important and significant change introduced during the period
• Statutory liquidity requirement (SLR)
is the reactivation of the Bank Rate by initially linking it to all

• Statutory liquidity ratio of regional rural banks other rates including the Reserve Bank’s refinance rates (April

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The core business of banks is mobilising the deposits and 1997). The subsequent introduction of fixed rate repo
utilising the same for credit accommodation. However, it (December 1997) helped in creating an informal corridor in the
should be taken into consideration that the banks are not money market, with the repo rate as floor and the Bank Rate as
allowed to use the entire amount for extending credit. In order the ceiling. The use of these two instruments in conjunction

rd. F
to promote certain prudential norms for healthy banking with OMO enabled RBI to keep the call rate within this
practices, most of the developed economies require all banks to informal corridor for most of the time. Subsequently, the
maintain minimum liquid and cash reserves. As such, banks are introduction of Liquidity Adjustment Facility (LAF) from June

iza D
required to ensure that these statutory reserve requirements are
met before directing on their credit plans.
2000 enabled the modulation of liquidity conditions on a daily
basis and also short term interest rates through the LAF
dfw P
Statutory reserve requirements could broadly be classified into window, while signaling the stance of policy through changes in
the Bank Rate.
• Cash Reserve Ratio (CRR) and
• Statutory Liquidity Ratio (SLR). Reforms
w.p m

It has been possible to reduce the statutory preemption on the

Cash Reserve Ratio (CRR) is the one which the banks have
banking system. The Cash reserve Ratio (CRR), which was the
to maintain with itself in the form of cash reserves or by way
primary instrument of monetary policy, has been brought
of current account with the Reserve Bank of India (RBI),
down from 15.0 per cent in March 1991 to 5.5 per cent by
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computed as a certain percentage of its demand and time

December 2001. The medium-term objective is to bring down
liabilities. The objective is to ensure the safety and liquidity of
the CRR to its statutory minimum level of 3.0 per cent within a
the deposits with the banks.
short period of time. Similarly, Statutory Liquidity Ratio (SLR)
On the other hand, Statutory Liquidity Ratio (SLR) is the has been brought down from 38.5 per cent to its statutory
one which every banking company shall maintain in India in the minimum of 25.0 per cent by october 1997

form of cash, gold or unencumbered approved securities, an

It has also been possible to deregulate and rationalise the
amount which shall not, at the close of business on any day be
interest rate structure. Except savings deposit, all other interest
less than such percentage of the total of its demand and time
rate restrictions have been done away with and banks have been
liabilities in India as on the last Friday of the second preceding

given full operational flexibility in determining their deposit and

fortnight, as the Reserve Bank of India (RBI) may specify from
lending rates barring some restrictions on export credit and
time to time.
small borrowings. The commercial lending rates for prime
In the pre reform period prior to 1991, given the command and borrowers of banks has fallen from a high of about 16.5 per
control nature of the economy, the Reserve Bank had to resort cent in March 1991 to around 10.0 per cent by December 2001
to direct instruments like interest rate regulations, selective credit
control and the cash reserve ratio (CRR) as major monetary CRR
instruments. These instruments were used intermittently to Effective date (i.e. the fortnight beginning from)
neutralize the monetary impact of the Government’s budgetary CRR on net demand and time liabilities (per cent)
operations. The administered interest rate regime during the September 18, 2004
earlier period kept the yield rate of the government securities 4.75
artificially low. The demand for them was created through
intermittent hikes in the Statutory Liquidity Ratio (SLR). The October 2, 2004
task before the Reserve Bank of India was, therefore, to 5.0
develop the markets to prepare the ground for indirect However, the effective CRR maintained by scheduled primary
operations. As a first step, yields on government securities were (urban) co-operative Banks on total demand and time liabilities

© Copy Right: Rai University

76 11.621.6
shall not be less than 3.00 per cent, as stipulated under the commencing from December 1,1999 to January 31,2000. It is


Reserve Bank of India Act, 1934. clarified here that the cash in hand which will be counted for
Interest on cash balances maintained with Reserve Bank of CRR purposes, during the above period cannot be treated as
India under Cash Reserve Ratio eligible asset for SLR purposes simultaneously.(iii) As already
indicated, for operational convenience, the maintenance of CRR
At present, scheduled primary (urban) co-operative banks are
by banks is being lagged by two weeks. As such, for
paid interest at the Bank Rate on eligible cash balances
maintaining CRR during the fortnight beginning January 1,
maintained with Reserve Bank under proviso to Section 42 (1)
2000, the NDTL base would be December 17, 1999. With the
and 42 (1A) of the Reserve Bank of India Act, 1934. It has now
leverage of two weeks available, banks should not have any
been decided that with effect from fortnight beginning
problem in complying with the CRR requirement around the
September 18, 2004, the scheduled primary (urban) co-operative
century date change. Nevertheless, any bank that expects a special
banks will be paid interest at the rate of 3.5 per cent per annum
problem in meeting its CRR obligations at the end of the year
on eligible cash balances maintained with the Reserve Bank of
can approach the RBI for appropriate relaxation/assistance
India under CRR requirement.

Cash Reserve Ratio - Reduction and Rationalisation
Reduction in CRR
The Reserve Bank has been pursuing its medium-term
Among the unrealized medium-term objectives of reforms in
objective of reducing Cash Reserve Ratio (CRR) to the statutory

monetary policy, the most important is reduction in the
minimum level of 3.0 per cent. Taking into account the

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prescribed CRR for banks to its statutory minimum of 3.0 per
progress achieved in the areas of enforcing prudential standards
cent. The movement to 3.0 per cent can be designed in three
and operationalising the LAF, RBI has reduced CRR from 11.0
possible ways, viz., the traditional way of pre-announcing a
per cent in August 1998 to 5.0 per cent in June 2002 while
time-table for reduction in the CRR; reducing CRR as and when
withdrawing certain exemptions. Further, the modalities of
opportunities arise as is being done in recent years; and as a one-

rd. F
CRR maintenance have been rationalised with the introduction
time reduction from the existing level to 3.0 per cent under a
of a lagged (by one fortnight) maintenance system. In addition,
package of measures. In the initial years, the first approach was
RBI is remunerating the eligible CRR balances maintained by

iza D
effective but had to be abandoned when the timetable had to be
disrupted to meet the eruption of global financial uncertainties
and pressures on forex market. Hence, the second approach of
banks at the Bank Rate. As a further step in this direction of
moving towards the statutory minimum level of CRR, it is
dfw P
lowering CRR when opportunities arise has been adopted, and
now it has been brought down to 5.5 percent. However, if it is To reduce CRR from 5.0 per cent to 4.75 per cent effective from
felt that this approach takes a longer time and a compressed the fortnight beginning November 16, 2002. (With this
time-frame is desirable to expedite development of financial reduction, CRR has been reduced by as much as 3.75 percentage
w.p m

markets, it is possible to contemplate a package of measures in points over the past two years).
this regard. The package could mean the reduction of CRR to At present, banks are required to maintain a minimum of 50
the statutory minimum level of 3.0 per cent accompanied by per cent of the required reserves in the first week and a
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several changes such as in the present way of maintenance of minimum of 65 per cent in the second week of the reporting
cash balances by banks with RBI. With the lagged reserve fortnight. Despite this flexibility given to banks on the daily
maintenance system now put in place, banks can exactly know maintenance, the actual daily CRR maintenance of majority of
their reserve requirements. With the information technology banks in relation to the prescribed level is now quite high. While
available with banks and with the operationalisation of Clearing moving towards a low CRR, it is necessary that the demand for

Corporation of India Ltd. (CCIL) shortly and with the bank reserves in the inter-bank market is modulated and the
development of repo market, it would be appropriate if CRR is volatility in CRR maintenance is minimised. In this direction:
maintained on a daily basis. However, till banks adjust to such Banks will be required to maintain a minimum of 80 per cent
changes in the maintenance of CRR, a minimum balance of 95 of required CRR amount on a daily basis during a fortnight

per cent of the required reserves on a daily basis may have to be with effect from the fortnight beginning November 16, 2002.
maintained when CRR is reduced to 3.0 per cent. The other The minimum level of 80 per cent would be applicable for all
elements of package have to be worked out carefully. Access the days in a reporting fortnight.
Flexibility in the Treatment of CRR Interest on Cash Balances Maintained with RBI
Normally, banks maintain minimum cash in their own vaults
since it is an idle asset, without the benefit of earning any under CRR
interest. In the context of date change at the turn of the century, At present, all scheduled commercial banks are paid interest at
in order to meet any additional demand for bank notes as a the Bank Rate on eligible cash balances maintained with RBI
contingency, banks may have to keep larger vault cash for under CRR requirement, without detailed scrutiny by RBI, on
meeting their business transactions. At present, such cash in the basis of quarterly interest claim statement submitted by
hand with the bank though an eligible asset for SLR, is not banks. Such interest payment is made to all banks within one
counted for CRR requirements. To facilitate banks to tide over month after the end of the quarter. Based on the
the contingency during the millennium change, it has been recommendations of the Regulations Review Authority, it has
decided to treat cash in hand maintained by the banks for been decided to:
compliance of CRR for a limited period of two months

© Copy Right: Rai University

11.621.6 77
Pay interest on eligible CRR balances on a monthly basis with have expressed difficulty in premature withdrawal of deposits

effect from April 2003. In order to facilitate this, banks are urged reckoned for SLR purposes. Accordingly, it has been decided
to put in place proper technology including adoption of the that:
software package which will help transmission of Form A data SLR holdings of RRBs in the form of deposits with sponsor
by banks directly to RBI. banks maturing beyond March 31, 2003 may be allowed to be
Statutory Liquidity Requirement (Slr) retained till maturity. These deposits may be converted into
SLR = statutory liquidity ratio. Banks in India are required to government securities, on maturity, in case the concerned RRBs
maintain 25 per cent of their demand and time liabilities in have not achieved the 25 per cent minimum level of SLR in
government securities and certain approved securites. These are government securities by that time.
collectively known as SLR securities Although deposits with sponsor banks contracted before April
The RBI has announced a “Special Liquidity Support” measure 30, 2002 would be reckoned for SLR purpose till maturity,
under which banks will be eligible to avail of liquidity to the RRBs are advised to achieve the target of maintaining 25 per
extent of their holdings of dated Government of India cent SLR in government securities out of the maturity proceeds

Securities/Treasury Bills over the SLR required to be of such deposits with sponsor banks as well as from their
maintained. The rate of interest on this facility would be 2.5 per incremental public deposits at the earliest
cent over the bank rate. This means that liquidity will be The RBI has announced a very strong support system for

available to the banking system at a cost of 10.50 per cent anticipated enhanced liquidity needs during the century date

com Tr
(present bank rate is 8 per cent). The banking system is period. All the following measures announced by the RBI
estimated to hold securities in excess of the SLR requirements would be valid for the period December 1, 1999 to January 31,
to the extent of around Rs 600 billion. Thus, theoretically, this 2000
amount of liquidity will be available to the banking system
Questions to Discuss:

rd. F
during this period. The RBI has also asked those who do not
hold any significant amount of excess SLR, to get into standby 1. What do you understand by statutory reserve requirement?
arrangement with banks who hold excess SLR securities. 2. Explain cash reserve ratio (CRR).

iza D
During this period, the cash held by banks will be counted
towards the maintenance of CRR. Currently, banks’ holding of
3. Explain statutory liquidity requirement (SLR).
dfw P
cash in their vaults is reckoned for SLR purposes. It was feared
that during this period, banks may have to hold cash in hand
much in excess of their normal holdings. This would cause a
reduction in the bank’s balances in their current accounts with
w.p m

the RBI. The reduced current account balances, which are

reckoned towards maintenance of CRR, could have caused an
additional demand for liquidity. By equating, for CRR
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maintenance purposes, the current account balances with the

cash in hand, the RBI has not only dealt with this anticipated
liquidity problem but ensured an additional liquidity of around
Rs 50 billion, which is the current holding of cash with banks.
The RBI has also allowed overseas banks to freely access

liquidity from their respective head offices overseas during this

Statutory Liquidity Ratio of Regional Rural Banks

Regional Rural Banks (RRBs) were required to maintain SLR at

25 per cent of their NDTL in cash or gold or in unencumbered
government and other approved securities. In this regard,
balances maintained in call or fixed deposits by RRBs with their
sponsor banks were treated as “cash” and hence, reckoned
towards their maintenance of SLR. As a prudential measure, it
was considered desirable on the part of all RRBs to maintain
their entire SLR portfolio in government and other approved
securities. Accordingly, in the annual policy Statement of April
2002, it was decided that all RRBs should maintain their entire
SLR holdings in government and other approved securities by
converting their existing deposits with sponsor banks into
government securities by March 31, 2003. While a number of
RRBs have already achieved the minimum level of SLR in
government securities, some RRBs and their sponsor banks

© Copy Right: Rai University

78 11.621.6

Learning Objectives need for possessing healthy capital adequacy requirement is

After reading this lesson, you will understand essential for boosting the confidence of the savers.
• Capital adequacy of banks If the saver gives money to the bank in the form of a deposit
and if it is insured, it would be the insurer who should be
• Ratio of the paid-up capital to reserve
concerned in the level of equity in the bank.
• BIS Standards
The following criteria should be used in determining the capital
• Capital adequacy norms

adequacy of the bank:
• Capital funds
Ratio of the Paid-up Capital to Reserve
• Risk adjusted assets and off-balance sheet items The size of the reserve of banks in relation to their paid-up

• Foreign exchange and interest rate related contracts capital is an important index of their financial position and

com Tr
A financial intermediary needs capital to commence its strength. It is also a pointer to the management policy regarding
operations and to continue its existence as a running business. the retention of earnings. However, since the banks carry on
More so, a financial intermediary needs more capital to act as a their business mainly with the depositors’ funds, an increase in
buffer, since the losses if and when they arise, may be the paid-up capital may not keep pace with that in the reserve.

rd. F
substantial. Capital provides a cushion to absorb possible Equity Ratio
losses so that entities dealing with them are protected all the Equity Ratio is the ratio of its equity capital over its loans and
time. This will help sustain the existence of the intermediary,

iza D
which is very vital for proper functioning of the economic
system. The capital will provide a margin of safety that
investments, where loans and investments means all earning
assets, including loans and government securities.
Capital-Deposit Ratio
dfw P
preferably would allow the intermediary to continue operations
The capital-deposit ratio was used in past in the USA and in the
without loss of momentum and at the least, would buy time
UK to measure capital adequacy. The banking authorities in
in which it may re-establish its operational momentum.
India have considered the adequacy of capital in relation to
The significance for capital varies depending on the activity of
w.p m

deposit liabilities. A high capital-deposit ratio is indicative of

financial intermediary. A bank needs capital for servicing its the fact that the depositors will face low risks. It has been
depositors, for maintaining net worth requirements, for recognised by authorities that, with every decline in the ratio of
acquiring assets and establishing branch network as per the capital to deposits, the risks of depositors tend to increase
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requirements, etc. Comparatively for NBFCs is needed for sharply. In the US, in early 20th Century – banks were asked to
entering into fund based activities apart form servicing its maintain a capital fund equal to 10 percent of its deposit
depositors and acquisition of assets. liabilities as a margin of safety. It should be noted that the
Apart from specifying an entry capital for the intermediaries, deposits by themselves contain no risks until they are used to
regulatory authorities (warranted by legislations) fixed a

make loans and investments; and the extent of the risk varies
proportion of capital and reserve to assets, on the basis of the with the character of the assets into which deposits are
type of intermediary. converted.
These requirements termed as Capital Adequacy Requirements By following the above said thumb-rules, one may have an idea

are specified for banks and for NBFCs in particular, this chapter on the extent of coverage of assets on the liabilities. Here it is
will dwell on the Capital Adequacy Requirements as applicable necessary to caution ourselves that it is practically impossible to
to Commercial Banks. determine the capital adequacy of a particular bank or even of
Capital Adequacy of Banks the commercial banking system, since it is not possible to know
In the Indian context, the capital adequacy of banks is all the the future demand that will be made out of capital. Adequate
more important in view of existence of nationalized banks and capital is desirable and necessary, but capital alone cannot ensure
the social status of bank management. An adequate capital fund the safety of a bank and due consideration has to be given to
is needed to bring about solidarity, scope, operation and the the quality and character of its assets, the caliber of its
ultimate strength to a bank. As important players, involved in management and its modus operandi.
helping of the capital formation in this era of intensive Capital to Risk-Weighted Assets Ratio
infrastructural investment, banks need to possess adequate To assess the adequacy of capital based on the quality of assets,
capital funds to discharge this responsibility. the Capital to Risk-Weighted Assets Ratio (CRAR) or the
At the same time, a saver who is depositing his money in a Capital Adequacy Ratio (CAR) is now being focused upon.
bank assumes that the risks associated with the investment of Introduced in 1988 by the Basle Capital Adequacy Accord, this
the funds will be borne by this intermediary. Therefore, the

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11.621.6 79
ratio has become the keyword to comment on the stability of a Tier I Capital

bank. Tier I Capital in the case of Indian banks consists of

BIS Standards • Paid-up capital
As banking began to spread across nations and competition • Statutory reserves
began to heat up among banks from varied countries, it became • Disclosed free reserves
an unfair game for banks from the country imposing stricter
• Capital reserves representing surplus arising out of sale
capital standards as they will be at a competitive disadvantage.
proceeds of assets
Therefore, a need for uniform capital standards for banks was
felt. As a result, regulators from 13 countries including the US i. Equity investment in subsidiaries, intangible assets, and
came together to formulate uniform standards that would losses in the current period and those brought forward from
apply to all their banks. These standards, established under the previous periods, will be deducted from Tier I capital.
auspices of the Bank for International Settlements (BIS), an ii. Elements of Tier I capital in case of foreign banks:
international clearing bank for central banks, were adopted in iii. Interest-free funds from head office kept in a separate

November 1988. The committee has adopted weighted risk account in the Indian books specifically for the purposes of
assets approach, which assigns weights to both on off-balance meeting the capital adequacy norms.
sheet exposures of a bank according to the perceived risk. While

iv. Statutory reserves kept in Indian books.
the framework is being applied by the banking supervisory

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authorities in the G-10 countries, the committee has suggested v. Remittable surplus retained in Indian books which is not
that the banking supervisory authorities of the non- G-10 repatriable so long as the banks function in India.
countries could also try to adopt the framework, particularly, in vi. Cap9ital reserve representing surplus arising out of sale of
respect of banks conducting significant international business in assets in India held in a separate account and which is not
their jurisdictions. eligible for repatriation so long as the banks function in

rd. F
Indian Standards: Narasimham Committee India.
vii. Interest-free funds remitted form abroad for the purposes

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Narasimham committee constituted by the Government of
India, to examine all aspects of banking procedures submitted
its reports in the early 90s. The committee observed that the
of acquisition of property and held in a separate account in
Indian books.
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capital ratios of Indian banks are generally low and some banks The net credit balance, if any, in the inter-office account with
are seriously undercapitalized. The banks in India should Head office / overseas branch will not be reckoned as capital
conform to the standards laid in the Basle Committee on funds. However, any debit balance in Head Office account will
Banking Regulations and Supervisory Practices appointed by the have to be set-off against the capital.
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BIS in a phased manner. Previously, various groups of banks

Tier II Capital
were subject to different minimum capital requirements as
Tier II capital for both Indian and foreign banks consists of the
prescribed in the statutes under which they were set up and
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operate. In addition, it has been prescribed that the foreign

banks operating in India should have foreign funds deployed in Undisclosed reserves and cumulative perpetual preference
Indian business equivalent to 3.5 percent of their deposits as at shares often have characteristics similar to equity and disclosed
the end of each year. The framework of risk weighted assets reserves. These element have the capacity to absorb expected
ratio approach to capital adequacy measurement is more losses and can be included in capital, if they present

equitable as it requires those institutions with a higher risk accumulations of post-tax profits and not encumbered by any
profile to maintain a higher level of capital funds. known liability and should not be routinely used for absorbing
normal loan or operating losses. Cumulative perpetual
Capital Adequacy Norms preference shares should be fully paid-up and should not
As mentioned earlier the Capital Adequacy Ratio is the ratio of

contain clauses, which permit redemption by the holder.

the banks capital to its risk weighted assets. To assess the capital
Revaluation reserves often serve as a cushion against
adequacy of banks based on this ration it is essential to
unexpected losses, but they are less permanent in nature and
understand three aspects:
cannot be considered as ‘core capital’. Revaluation reserves arise
1. Composition of capital from revaluation of assets that are undervalued in the books,
2. Composition of Risk Weighted Assets typically premises, and marketable securities. The extent to
3. Assigning risk weights which the revaluation reserves can be relied upon as a cushion
for unexpected losses depends mainly upon the level of
Capital Funds
certainty that can be placed on estimates of the market values of
The Basle Committee has defined capital in two tiers: Tier I and
the relevant assets, the subsequent deterioration in values under
Tier II. While Tier I capital is the core capital, which provides the
difficult market conditions, or in a forced sale, potential for
most permanent and readily available support against
actual liquidation at those values, tax consequences of
unexpected losses. Tier II capital will consist of element that are
revaluation, etc. Therefore, it would be prudent to consider
not permanent in nature or are not readily available.
revaluation reserves at a discount while determining their value
for inclusion in Tier II capital. The revaluation reserves need to

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80 11.621.6
be discounted by a minimum of 55 percent when determining In February 1999, RBI has given all scheduled commercial


their value for inclusion in Tier II capital. Such reserves will have banks, including the foreign banks operating in India, the
to be reflected on the Balance Sheet as revaluation reserve. autonomy to raise rupee subordinated debt as Tier II capital,
General provisions and loss reserves (GPLR) are not subject to certain terms and conditions. The instruments that
attributable to the actual diminution in value or identifiable can be issued should be plain ‘Vanilla’ type with no special
potential loss in any specific asset and are available to meet features like options, etc. Further, all nationalised banks have to
unexpected losses; they can be included in Tier II capital. obtain permission from the Government for issuing the
Adequate care must be taken to see that sufficient provisions instruments. Permission from RBI is also essential to issue
have been made to meet known losses and foreseeable potential instruments to NRIs/OCBs/FII. RBI’s approval is also
losses before considering general provisions and loss reserves to necessary for the issue of subordinated debt instruments in
be part of Tier II capital. General provisions/ loss reserves will foreign currency or borrowings from head office, to include in
be admitted up to a maximum of 1.25 percent of weighted risk Tier II capital. It is to be noted that investment by banks in the
assets. subordinated debts of the other banks shall be subject to the

ceiling of 5 percent applicable to investments in shares of
In the category of Hybrid debt capital instruments fall in a
corporate bodies and they would be assigned 100 percent of
number of capital instruments, which combine certain
total of Tier I elements for the purpose of compliance with the
characteristics of equity and certain characteristics of debt. Each

has a particular feature which can be considered t affect its quality

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as capital. Where these instruments have close similarities to Risk Adjusted Assets and off-Balance Sheet Items
equity, in particular when they are able to support losses on an Risk adjusted assets would mean weighted aggregate of funded
on-going basis without triggering liquidation, they may be and non-funded items as detailed below. Degrees of credit risk
included in Tier II capital. expressed as percentage weightings have been assigned to
balance sheet assets and conversion factors to of-balance sheet

rd. F
For Subordinated Debt to be eligible for inclusion in Tier II
capital, the instrument should be fully paid-up, unsecured, items. The value of each asset/item shall be multiplied by the
subordinated to the claims of other creditors, free of restrictive relevant weights to produce risk-adjusted values of assets and

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clauses and should not be redeemable at the initiative of the
holder or without the consent of the banks’ supervisory
of off-balance sheets. The aggregate will be taken into account
for reckoning the minimum capital ratio. The weights allotted
to each of the items of assets and off-balance sheet items are
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authorities. These instruments often carry a fixed maturity and.
As they approach maturity, they should be subjected to furnished below
progressive discount for inclusion in Tier II capital. The Risk Weights on Different Items of Assets and off-
subordinated debt instruments should have a minimum
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Balance Sheet Items

maturity of 5 years and if the instruments are issued in the last
quarter of the year, i.e. form January to March; they should have I. Domestic Operations
a minimum tenure of 63 months. Instruments with initial A. Funded Risk Assets
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maturity of less than 5 years or with a remaining maturity of

one year should not be included as part of Tier II capital. The
interest rate should not be more than 200 bp above the yield on
the Central Government securities of equal residual maturity at
the time of issuing bonds. Subordinated debt instruments will

be limited to 50 percent of Tier I capital. The progressive

amount for various maturities to be included into Tier II capital
is given in the table below:

Remaining term to maturity Discount rate

1. Where the date of maturity is beyond 5 0 percent
2. Where the date of ma turity is 20 percent
beyond 4 years but does not exceed 5
3. Where the date of maturity is beyond 3 40 percent
years but does not exceed 4 years

4. Where the date of maturity is beyond 2 60 percent

years but does not exceed 3 years

5. Where the date of maturity is beyond 1 80 percent

years but does not exceed 2 years

6. Where the date of maturity does not 100 percent

exceed one year

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11.621.6 81
c. Interest due on Government securities;

d. Accrued interest on CRR balances and claims on the

Assets Percentage weight
1. Cash and balance with Reserve Bank of India 0 Reserve Bank on account of Government transactions (net
2. Balances in current account with other banks 20
Claims on banks and Public Financial Institutions
Investments in government securities, other Approved
of claims of Government / Reserve Bank on banks on
Securities guaranteed by Central/State government, other
securities where payment of interest and repayment of account of such transactions).
principal are guaranteed by Central/State Government
In case of a default in interest/principal by State Government, banks
should assign 100 percent risk weight on investments in securities of
7. The investments in subordinated debt instruments and
the concerned State Government
5. Investments in other approved securities where payment of 20 bonds issued by other banks or Public Financial Institutions
interest and repayment of principal are not guarante ed by
Central/ State Government for their Tier II capital would carry 100 percent risk weight.
6. Investments in Government Guaranteed Securities of 20
Government undertakings which do not form part of the
approved market borrowing program 7A. Foreign exchange open position limit should carry 100
7. Investments in bonds issued by other banks / PFIs 20
8. Investments in securities which are guaranteed by banks or 20 percent risk weight with effect from 31-3-1999. Open position
PFIs as to payment of interest and repayment of principal
9. Investments in subordinated debt in the form of Tier II
Capital Bonds issued by other banks/PFIs
100 limit in gold should also carry 100 percent risk weight with effect
10. All other investments
11. Loans and advances including bills purchased and discounted
100 from 31-3-1999. Risk weights both in respect of foreign
and other credit facilities
exchange and gold open position limits should be added to the

12. Loans guaranteed by Government of India/State Government
13. In cases where guarantees have been invoked and the 0
concerned state Government has remained in default as on other risk weighted assets for calculation of CRAR.
31-03-2000, a risk weight of 20 percent on such advances
should be assigned. If State Governments continue to be in
default in respect of such invoked guarantees even after 31-03- B. Off-Balance Sheet Items

2001, a risk weight of 100 percent should be assigned
14. Loans granted to public sector undertakings of Government The credit risk exposure attached to off-balance sheet items has

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of India / State Government
15. Others
to be first calculated by multiplying the face amount of each of
the off-balance sheet items by the ‘credit conversion factor’ as
indicated in the table below. This will have to be again
multiplied by the weights attributable to the relevant
counterparty as specified above.

rd. F
16. Premises, furniture and fixtures 100
17. Other assets 100

Notes iza D Instruments

1. Direct credit substitutes, e.g. general
guarantees of indebtedness (including
standby letters of credit serving as
Credit conversion factor
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financial guarantees for loans and
1. Netting may be done only for advances collateralized by cash securities) and acceptances (including
endorsements with the character of
margins or deposits credit balances in current or other acceptances)
2. Certain transaction -related contingent 50
accounts which are not earmarked for any specific purpose items (e.g. performance bonds, bid
bonds, warranties and standby letters
and free from any lien in respect of assets where provisions
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of credit related to particular

for depreciation or for bad and doubtful debts have been 3. Short-term self -liquidating trade -related 20
contingencies such as documentary
made. credits collaterised by the underlying
1A for the purpose of computing risk adjusted values of
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4. Sale and repurchase agreement and 100

asset sales with recourse, where the
assets, banks may “net off” against the total outstanding credit risk remains with the bank
5. Forward asset purchases, forward - 100
exposure of the borrower, the following items also: deposits and parity paid shares and
securities, which represent
i. Claims received from DICGC/ECGC and dept in a commitments with certain draw down
6. Note issuance facilities and revolving 50
separate account pending adjustment underwriting facilities
7. Other commitments with an original 50

ii. Subsidies received against IRDP advances and kept in a maturity of over one year (e.g. formal
standby facilities and credit lines)
separate account. 8. Similar commitments with an original 0
maturity up to one year, or which can
be unconditionally canceled at any
2. Equity investments in subsidiaries, intangible assets and time.
losses deducted from Tier I capital should be assigned zero 9. Aggregate outst anding foreign

exchange contracts of original maturity.

weight. Of less than one year
For each additional year or part thereof
3. Advances covered by the guarantee of DICGC / ECGC may
be assigned the risk weight of 50 percent. The risk weight of
50 percent should be limited to amount guaranteed and not
the entire outstanding balance in the accounts. Notes
4. Advances against term deposits, life insurance policies, life 1. Cash margins/deposits shall be deducted before applying
insurance policies, National Saving Certificates, Indira Vikas the conversion factor.
Patras and Kisan Vikas Patras where adequate margin is 2. After applying the conversion factor as indicated above, t he
available, would carry zero risk weight. adjusted off-balance sheet value shall again be multiplied by
5. Loans to staff of banks would also carry zero risk weight. the weight attributable to the relevant counterpart as
6. The under noted accounting heads should be assigned zero specified above.
risk weight under ‘other assets’: 3. In regard to off-balance sheet items, the following
a. Income tax deducted at source (net of provision) transactions with non-bank counterparties would be treated
b. Advance tax paid (net of provision); as claims on banks and carry a risk weight of 20 percent.

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82 11.621.6
a. Guarantees issued by banks against the counter (net of claims of Government/Reserve Bank on banks on


guarantees of other banks; account of such transactions).
b. Rediscounting of documentary bills accepted by banks. B. Non-funded Assets
Bills discounted by banks, which had been accepted, by
another bank would be treated as a funded claim on a Instruments Credit conversion factor (percent)
bank. 1. Direct
credit substitutes and 100

2. Certain transaction -related contingent 50

4. Foreign exchange contracts with an original maturity of 14 items
calendar days or less, irrespective of the counterparty, may be 3. Short-term self -liquidating trade -related

assigned ‘zero’ risk weight as per international practice. 4. Sale and repurchase agreement and
asset sales with recourse, where the

credit risk remain with the bank

II Overseas operations (applicable only to Indian banks 5. Forward asset repurchase, forward 100
repurchases, forward deposits and
having branches abroad) partly paid shares and securities which
represent commitments with certain
A. Funded Risk Asset drawdown
6. Note issuance facilities and revolving 50

underwriting facilities
7. Other commitments with original 50
maturity of over one year
Assets Percentage Weight
8. Similar commitments with an original 0
1. Cash 0 maturity up to one year, or which can
2. Balance with monetary authority 0 be unconditionally canceled at any time

3. Investments in government securities 0
4. Balances in current account with other 20

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5. All other claims on banks including but 20
not limited to funds loaned in money
markets, deposit placements,
investments in CDs, FRNs, etc
6. Investment in non- bank sectors
7. Loans and advances, bills purchased
100 Cash margins/deposits shall be deducted before applying the
and discounted and other credit
conversion factor. After applying the conversion factor as

rd. F
a. Claims gua ranteed by GOI 0 indicated above, the adjusted off-balance sheet value shall again
b. Claims guaranteed by State Governments 0
c. Claims on public sector undertakings of GOI 100 be multiplied by the weight attributable to the relevant
d. Claims on public sector undertakings of State 100
counterparty as specified in funded risk assets above.
e. Others

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8. All other banking and infrastructural
Foreign Exchange and Interest Rate Related
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Foreign exchange contracts include the following:
i. Cross-currency interest rate swaps
1. Netting may be done only for advances collateralized by cash
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margins or deposits and in respect of assets where ii. Forward foreign exchange contracts
provisions for depreciation or for bad and doubtful debts iii. Currency futures
have been made. iv. Currency options purchased
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2. Equity investments in subsidiaries, intangible assets and v. Other contract of a similar nature
losses deducted from Tier I capital should be assigned zero As in the case of other off-balance sheet items, a two-stage
weight. calculation prescribed below shall be applied.
3. The investments in subordinated debt instruments and
Step 1
bonds issued by other banks or Public Financial Institutions

The notional principal amount of each instrument is multiplied

for their Tier II capital would carry 100 Percent risk weight.
by the conversion factor given below:
4. Advances covered by the guarantee of DICGC/ECGC may
be assigned the risk weight of 50 percent. The risk weight of
Original Maturity Conversion Factor

50 percent should be limited to amount guaranteed and not Less than one year 2
Between one and two years 5
the entire outstanding balance in the accounts. For each additional year 3

5. Advances against term deposits, life insurance policies,

National Saving Certificates, Indira Vikas Patras and Kisan STE
Vikas Patras where adequate margin is available would carry Setp 2
zero risk weight. The adjusted value thus obtained shall be multiplied by the risk
6. Loans to staff of banks would also carry zero risk weight. weightage allotted to the relevant counterparty as given in
7. The under noted accounting heads should be assigned zero funded risks above.
risk weight under ‘Other Assets’ Interest rate contracts
a. Income tax deducted at source (net of provision); Interest rate contracts include the following:
b. Advance tax paid (net of provision); i. Single currency interest rate swaps
c. Interest due on Government securities; ii. Basis swaps
d. Accrued interest on CRR balances and claims on the iii. Forward rate agreements
Reserve Bank on account of Government transactions iv. Interest rate futures

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11.621.6 83
v. Interest rate option purchased

vi. Other contracts of similar nature

Step 1
The notional principal amount of each instrument should be
multiplied by the percentage given below:
Original Maturity Conversion Factor
Less than one year 0.5
Between one and two years 1.0
For each additional year 1.0

Step 2
The adjusted value thus obtained shall be multiplied by the risk
weightage allotted to the relevant counterparty as given in II A

Maintenance of CRAR
After assessing the capital funds and the risk weighted assets,

the bank will have to compute the ratio of the capital to risk

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weighted assets. The minimum CRAR was initially set at 8
percent. However, to meet the international standards, this is
being raised to 9 percent with effect from March 31, 2000.
Banks should furnish an annual return commencing form the

rd. F
year ended March 30, 1992, indicating:
a. Capital funds

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b. Conversion of off-balance sheet/non-funded exposures
c. Calculation of risk weighted assets and
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d. Calculation of capital funds ratio.
The format for the returns is given as a break-up and aggregate
in respect of domestic and overseas operation will have to be
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furnished. The returns should be signed by two official who are

authorized to sign the statutory returns submitted to the RBI.
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The minimum capital adequacy requirement is given statutorily

by RBI. This minimum level is aimed to bring global standards
into the Indian markets. And as the global operations of the
Indian banks increase, it is essential for banks to meet these
standards. Apart from this advantage, banks will also have a

proper banking of their capital for the risks they face while
operating in the ever changing market environment.
Questions to Discuss

1. Discuss Capital Adequacy Norms.

2. What are foreign exchange and interest rate related contracts?
3. What do you understand by risk adjusted assets and off-
balance sheet items?

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84 11.621.6


i al
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rd. F
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11.621.6 85

Learning objectives Reserve Bank Of India and commercial banks. The apex banks
After reading this lesson, you will understand or state cooperative banks obtain their funds from share capital,
deposits, loans from commercial banks, the Reserve Bank of
• Introduction
India and the Government.
• Central Cooperative banks
Characteristics of Co-operative Banks
• State or provincial cooperative banks or apex banks

Some distinguishing characteristics of the nature of co-
• Agricultural credit-intensive development scheme operative banks are as follows:
• The agricultural refinance and development corporation 1. They are organised and managed on the principles of co-

• Nabard operation, self-help, and mutual help. They function with the

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Cooperative banks, another component of the Indian banking rule of “one member one vote”.
organisation, originated in India with the enactment of the 2. They function on “no profit no loss” basis. For commercial
cooperative credit societies act of 1904, a number of cooperative banks also, profitability is no longer the main objective, but
active credit societies. Under the act of 1904, a number of in their case this change has been brought about as a result

rd. F
cooperative credit societies were started. Owing to the increasing of social or public policy, while co-operative banks, by their
demand of cooperative credit, a new act was passed in 1912, very nature, do not pursue the goal of profit maximisation.
which provided for the establishment of cooperative central

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banks by a union of primary credit societies or by a union of
primary credit societies or by a union of primary credit societies
3. Co-operative banks perform all the main banking functions
of deposit mobilisation, supply of credit and provision of
remittance facilities. However, it is said that the range of
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and individuals. services offered is narrower and the degree of product
The chief functions of these banks were: (1) attracting deposits differentiation in each main type of service is much less in
from non-agricul-turists, (2) using excess funds of some the case of co-operative banks, compared to commercial
societies temporarily to make up for shortage in other arid (3) to banks. In other words, co-operative banks are characterised
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supervise and guide the affiliated societ-ies. In 1914, the Mac by functional specialization. It should be added that this is
lagan Committee was appointed to examine the cooperative true, with much less force now, because many changes have
movement and to make recommendations regarding the taken place in the co-operative banking system since the
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improvement of the movement. It recommended the Banking Commission arrived at the above-mentioned
establishment of a State Cooperative Apex Bank. On this conclusion. For example, co-operative banks now provide
recommendation a Central Coop-erative Bank was established housing loans also. The UCBs provide working capital loans
in Bombay. Other provinces also took ac-tion on similar lines. and term loans as well. The State Co-operative Banks (SCBs),
Although these may be considered as the early beginnings in the Central Co-operative Banks (CCBs) and Urban Co-operative

direction of establishing cooperative banks to meet the financial Banks (UCBs) can normally extend housing loans upto Rs
needs of agriculturists, the movement received momentum lakh to an individual. The scheduled UCBs, however, can
only after the Second World War. lend upto Rs 3 lakh for housing purposes. The UCBs can
Cooperative banking India is federal in its structure. At the provide advances against shares and debentures also.

lower rung, there are primary credit societies, then there are the 4. As said earlier, co-operative banks do banking business
central unions or central cooperative banks and at the top there mainly in the agricultural and rural sector. However, certain
are the Provincial Cooperative Banks or State Cooperative types of banks viz., UCBs, SCBs and CCBs operate in semi-
Banks, otherwise known as “Apex” banks. The primary urban, urban, and metropolitan areas also. The urban and
societies may be compared with joint banks. Their main non-agricultural business of these banks has grown over the
function is that of lending money to villagers on easier terms. years. The co-operative banks demonstrate a shift from rural
Much of their work is done by members themselves on an to urban, while the commercial banks, from urban to rural.
honorary basis. They have their own funds supplemented by 5. Co-operative banks are perhaps the ‘first government-
funds drawn from the Central Cooperative Banks through the sponsored, government-supported, and government-
banking unions where such unions exist. The Banking unions subsidised financial agency in India. They get financial and
are federations of primary societies and they act as either other help from the RBI, NABARD, central government and
‘coordinating unions’ or ‘supervisory unions’ between primary state governments. They constitute the “most favoured”
societies and central cooperative banks. The central cooperative banking sector with no risk of nationalisation. For
banks obtain the funds from share capital, deposits, loans from commercial banks, the RBI is a lender of last resort, but for
the apex banks, and where apex banks do not exist, from the’ co-operative banks, it is the lender of first resort, which

© Copy Right: Rai University

86 11.621.6
provides financial resources in the form of contribution to with Demand and Time Liabilities over Rs 50 crore each are


the initial capital (through state governments), working included in the Second Schedule of the RBI Act.
capital, and refinance. The promotional role Of the RBI can 10. As said earlier, co-operative banks accept current, saving, and
be seen in respect of co-operative banks, and this role fixed or time deposits from individuals and institutions
supersedes its regulatory role, in respect of these banks. including banks. Some DCBs numbering about 40 in 1989
A corollary of government’s help to co-operative banks is that are allowed to open and maintain NRI accounts in rupees
there is much government intervention in their working. Co- but not in foreign currency. Deposits mobilized by them in a
operative banks are subject primarily to the control, audit, given area are used for financing activities in that locality.
supervision and periodic inspection of the co-operative Some co-operative banks, namely, Land Development Banks
department of the state government under the Co-operative (LDBs), issue debentures to raise resources for their
Societies Act, but less rigorously, by the RBI under the Banking operations. These debentures are secured by mortgaging
Regulation Act. The RBI and the state government lay down lands belonging to borrowers from LDBs and are often
rules for investment of surplus resources, reserves, and the loan guaranteed by the state government are regarded as trustee

policy of co-operative banks. Consequently, compared to securities and are treated on par with government securities
commercial banks, they have less freedom and flexibility in for making advance. There are three types of such
conducting their operations. debentures: ordinary, rural, and special. These debentures are

6. Cooperative banks belong to the money market as well as to almost entirely subscribed by such institutional investors as

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the capital market. Primary agricultural credit societies provide banks, LIC, and the government.
short-term and medium-term loans. Land Development Types, Structure and Growth of Co-Operative Banks
Banks (LDBs) provide long-term loans, UCBs meet working The following figure present the structure and progress of co-
capital as well as fixed capital requirements, and SCBs and operative banking in India.

rd. F
CCBs also provide both short-term and term loans.
Similarly, they accept short-term and long-term deposits, and
some of them mobilise resources through the issue of
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7. Co-operative banks are financial intermediaries only partially.
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The sources of their funds (resources) are: (a) central and
state governments, (b) the RBI and NABARD, (c) other co-
operative institutions, (d) ownership funds, and (e) deposits
or debenture issues. It is interesting to note that intra-
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sectoral flows of funds are much greater in co-operative

banking than in commercial banking. Inter-bank deposits,
borrowings, and credit form a significant part of assets and
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liabilities of co-operative banks. This means that intra-

sectoral competition is absent and intra-sectoral integration is
high for co-operative banks.
As said earlier, the co-operative banking structure is federal in
However, co-operative banks face stiff competition from
character, with three-tier linkages between state, district and
commercial banks and other financial intermediaries. Till their

village level institutions. At the state level, we have State Co-

nationalisation, commercial banks did not pose any
operative Banks (SCBs) and the State Land Development Banks
competition to co-operative banks. In fact, till then, certain areas
(SLDBs); at the district level, the Central Co-operative Banks
of operations were deliberately left to co-operative banks. But
(CCBs) or the District Central Co-operative Banks (DCCBs) and
recently, the competition from LIC, UTI, and small-savings

the Central Land Development Banks (CLDBs); then at the

organisation has become quite tough, and co-operative banks
village level, the Primary Agricultural Credit Societies (PACSs),
are in a disadvantageous position in this area of inter-sectoral
the Primary Land Development Bank (PLDBs), and the
branches of SLDBs. The lower tiers are members and
8. Co-operative banks have a federal structure of three-tier shareholders of the immediate higher tier. Besides, there are the
linkages.Further,theiroperationismixed of banking type. Urban Co-operative Banks (UCBs) or the Primary Cooperative
Primary credit societies are unit banks; many DCBs also are Banks (PCBs), which are outside this federal structure. Though
unit banks. But SCBs, DCBs (CCBs), and SLDBs, PLDBs federal in its organisational structure, the system is integrated
and many DCBs have a number of branches. Subject to this, vertically on the basis of functional responsibilities of various
it can be said that each co-operative institution in each tier is a components of the system. The SCBs, CCBs and PACSs form
separate entity with definite jurisdiction and has an the short-term and medium-term credit structure and it is the
independent board of management. same in all the states. The land development banks at various
9. Some co-operative banks are scheduled banks, while others levels make the long-term credit structure, which is not uniform
are non-scheduled banks. For instance, SCBs and some in all the states.
DCBs are scheduled banks but other co-operative banks are
non-scheduled banks. At present, 28 SCBs and 11 DCBs

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11.621.6 87
The state level co-operative banks are said to be the apex • Co-operative banks are not doing well in all the states; only a

institutions in this federal structure” However, the apex few account for a major part of their business.
institutions from the point of view of promotion, supply of • These banks still rely very heavily on referencing facilities
resources, supervision and control, are the government, RBI, from the government, the RBI, and NABARD. They have
NABARD, and National Co-operative Bank of India (NCBI). yet not been able to become self-reliant in respect of
The SCBs and SLDBs are in an intermediate position between resources through deposit mobilisation.
the institutions just mentioned on the one hand, and the co-
• They suffer from dangerously low or weak quality of loan
operative banks on the other.
assets, and from highly unsatisfactory recovery of loans.
The SCBs co-ordinate and regulate the working of CCBs. They
• They suffer from infrastructural weaknesses and structural
act as custodians of surplus funds of the CCBs and
flaws. They do not look like banks and do not inspire
supplement them by attracting deposits and by obtaining loans
confidence in the potential members, depositors and
from the RBI. The CCBs mobilise resources in districts to
finance their members, and they also charnel’s funds from the
• They suffer from too much officialisation and politicisation.

SCBs to primary credit societies. The PACSs at the village1evel
form the base of the co-operative_ banking. Although they are Undue governmental interventions have prevented them
expected to be multi-purpose societies, they mostly deal in from developing steadily as a self-reliant and resilient credit

credit. system.

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Problems and Policy Central Cooperative Banks
As in the case of commercial banks, the quantitative growth of The Central Cooperative Banks are independent units inasmuch
co-operative banks has not been accompanied by a qualitative as the provincial cooperative banks have no powers to control
growth. There have always been a number of weaknesses in or supervise the affairs of central banks. They are of two kinds
viz pure’ and ‘mixed’. Those banks; the membership of which

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their performance. Many of these weaknesses were identified by
the All India Rural Credit Survey Committee (AIRCSC) in the is confined to cooperative organisations, only are Included in
early 1950s. By that time, co-operative banks had been in the the ‘pure’ type, while those banks, the membership of which is

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business for 45 years and the AIRCSC had concluded that co-
operatives had failed, but that they must succeed. As a result,
open to cooperative organisations as well as to individuals, ate
included in the ‘mixed’ type. The Pure type of central banks can
be seen in Kerala, Bombay, Orissa, etc, while the mixed type can
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special measures were introduced by the government and the
RBI to revive and strengthen co-operative banks. Even after a be seen in the case of Andhra, Assam, Chennai, Mysore, etc.
span of 50 years, an assessment of the co-operative banks The pure type of banks is based on strict cooperative principles,
shows that many of the weaknesses of the co-operative credit while the mixed type does not adhere to any such strict
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system identified by the Rural Credit Survey Committee principles. However, the latter has an advantage over the former
continue to persist. in so far as they can draw their funds from the non-agricultural
section, too. But by allowing individuals to hold shares, loan
The Khusro Committee asserts: “No credit system has been
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facilities are necessarily extended to them; and in case some of

subjected to as much experimentation at the dictates of those
them happen to be middlemen, who’ may utilise the proceed
outside the system as the co-operative credit system has
of the loan to carry on their trading operations, then it would
been…The history of co-operative credit system has been the
be a hard blow on the very basic principles of cooperation,
history of alternating periods of growth, stagnation and
which strive for the elimination of middle-men.
reorganization and yet quantitatively the achievements of the

co-operative systems have by no means been insignificant… As mentioned earlier, the central cooperative banks draw their
Thus looking to the stake of the movement even in the limited funds from share capital, deposits, loan from the State
sphere of credit, the classic assertion of the Rural Credit Survey Cooperative Banks and where the State Banks do not exist,
made 35 years ago still seems valid that Co-operation has failed from the Reserve Bank and other commercial banks: The main

but Co-operation must succeed…” function of the central banks is to finance the primary credit
societies. In addition to this, they ‘carry on commercial banking
The main weaknesses of co-operative banks are as follows:
activities like acceptance of deposits, the giving of loans and
• The vital link in the co-operative credit system namely, the advances on the sculpt of first-class gilt-edged securities, fixed
PACSs, remain very weak. They are too small in size to be deposit receipts, gold, bullion, goods and documents of title to
economical and viable; besides too many of them are goods, the col-lecting of bills, cheques, handles, the receiving of
dormant, existing only on paper. valuables for safe cus-tody and the performance of services as
• With the expanding credit needs of the rural sector, the an agent to the customer to purchase and sell securities etc. They
commercial banks have come in actively to meet the credit also act, as ‘balancing centres’ making available temporary excess
requirements of this sector, and this has aggravated the funds of one primary to another, which is in need of them.
difficulties of co-operative banks. The theory that co- Defects of the working of the cooperative banks are not likely
operative banks would be buoyed up by the competition to pass uncensored. The linking of commercial banking
from other financial institutions does not appear to have activities with the central banks is often pointed out as against
worked. the principles of coopera-tion. But it should be remembered
that the volume of work is not enough to keep these

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88 11.621.6
institutions fully occupied. The inadequacy of share capital has outstanding, but this is mainly owing to a substantial increase


been characterised as the Achilles’ heel of the central banks. It is in fresh advances resulting in a Outspending in-crease in
also said that these banks do not maintain expert staff of outstanding.
examine the credit-worthiness of the primary societies, thereby
State or Provincial Cooperative Banks or Apex Banks
leading to accumulated overdues. Another criticism raised by the
State Cooperative Bank means the principal society in a state
Royal Commission on Agricul-ture was that the central banks
which is registered or deemed to be registered under the
combined both the financing and supervi-sory work. They
Government Societies Act, 1912, or any other law of the time
recommended that the financing and supervisory work should
being in force in India relating to cooperative societies and the
be separated, contending that the supervisory work of central
primary object of which is the financing of the other societies in
banks had been a failure. But against this, it may be argued that
the state which are registered or deemed to be registered. In
since the central banks are to finance the primary societies the
addition to such a principal society in a state or where there is no
supervisory work should be entrusted to them inasmuch as it is
such principal society in a state, the State Government may
their concern to see that primary credit societies are working in
declare anyone or more cooperative societies carrying on

business in that State to be a state cooperative bank (or banks).
Further it has been found that certain cooperative central banks
As in the case of central banks the state cooperative banks may
are utilising the reserves funds as working capital. This is
be pare in which case, it will be a federation of central

definitely against fundamental principles, which will affect
cooperative banks only, or ‘mixed’ in which case it will be a

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adversely the working of these banks in the final end. It is
federation of both central cooperative banks as well as
highly necessary that adequate reserves should be built up and
individual members. The state banks re-ceive current and fixed
kept apart from working capital so that it may be used only in
deposits from its constituent banks as well as savings deposits
times of emergencies.
and fixed deposits from the general public and from local

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The case against ‘mixed’ societies has already been discussed in boards, municipalities, etc. Further they receive loans at call and
detail. But at present, the mixed type of societies is inevitable, short notice from the commercial banks at current rates of
since to raise enough capital from the agricultural masses itself interest and seasonal loans from the Reserve Bank of India to

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is not possible, because of their poor resources. So the aim
should be to convert the mixed societies into pure societies step
by step as the income of the agricultural masses increases so
finance seasonal agricultural operations. The State Governments
contribute a certain portion of their working capital.
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The principal function of the state banks is to assist the central
that after a certain stage we can dispense with the mixed
banks and to balance excess and deficiencies in the resources of
central banks.
Further, the lending rates of these banks arc said to be very
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This function of the Apex bank to act as a ‘balancing centre’ is

high. The high administrative costs of small and uneconomic
important since direct lending is prohibited among the central
units of central cooperative banks, the difficulty experienced in
banks. The connec-tion between the state banks and the
raising the necessary funds from the Money Market at low rates
primary cooperative societies is not direct. The central banks are
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of interest and the problem of raising enough local funds have

acting as intermediaries between the Apex banks and primary
forced the central banks to charge high rates of interest. But in
societies. Of course, in the absence of a central bank. The state
order to make cooperative finance popular among agriculturists
cooperative bank may act as a central bank and in that case its
and to make the movement a crowning success, the rates of
connection with the primary societies will be direct.
lending should necessarily be brought down. To reduce the

rates of inter-est, the Reserve Bank of India has suggested The working of state banks is not free from complaints. Most
certain measures such as strengthening the cooperative of the companies leveled against the central cooperative banks
movement and improving its efficiency, the mobilising of rural are also valid against the state cooperative banks. Among them,
savings and amalgamating of small uneconomic units into the important are the undesirability of linking commercial

viable units. The state governments can also add their banking activities with cooperative banking, inadequacy of share
contribution in this direction by giving subsidies to the central capital, utilisation of reserve funds i as working capital and the
banks during the initial stages so that the loss arising from policy in allowing individuals to become share-holders of the
charging low rates of interest may be compensated. banks, which is against cooperative principles.
Recent trends in the working of central cooperative banks Agricultural Credit-Intensive Development Scheme
indicate that there is a decline in their number, as a result of The ACID scheme was conceived with a view to concentrating
amalgamation and reorganization of central banks with the efforts on a selective basis to strengthen the co-operative
object of having one song central banks for each district. The structure and link the credit programme with production
owned funds, apart from the bor-rowed funds, of these banks programmes. The scheme was ap-proved by the Reserve bank’s
show an overall increase during recent years. However, it is Agricultural Credit Board in December 1976 and received the
deplorable that many of them were not able to reach the support of the State Governments, All India Fed-eration of
standard of Rs. 3 lakhs per bank prescribed by the Standing State Co-operative Banks, the Planning Commission and the
Advisory Committee on Agricultural Credit as a ‘desirable Union Ministry of Agriculture, and other concerned agencies.
minimum limit” of owned capital. In the matter of overdues, Under the first phase of the scheme, 41 districts (including
there is a decline in the propor-tion of overdues to loans SFDA and DP AP dis-tricts) in 16 States have been selected for

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11.621.6 89
intensive credit development in various sectors of the rural the concerned State Governments As decided by the sub-

economy. Some of the important criteria followed in the committee in its second meeting held in April 1978, top priority
selecting the 41 districts were: (a) the districts which have scope under the Action Programme is being given to (1) reduction of
for development and a reasonable strong co-operative credit overdues, (2) full coverage of small farn1ers and (3) increase in
structure; (b) the central co-operative banks of the district borrow-ing members.
should not have heavy overdues (i.e. ordinarily these should be Since the introduction of the Scheme, there have been certain
less than 40 per cent (c) existence of SFDA and DPAP schemes; developments requiring a review of the Scheme, The lead banks
and (d) the districts where regional rural banks were not have been advised to tern1inate the existing plans by December
functioning (though in a few districts, some parts of the 1979 and formulate fresh District Credit Plans for their lead
districts were covered by regional rural banks). districts from January 19S0 and Annual Action Plan by
In particular, the central co-operative banks in these districts will December each year. The District Credit Plans would be a
have the following main objectives viz., (I) to improve their comprehensive credit plan for the District and would indicate
organisational and operational effectiveness; (2) to create an total credit outlays (sector-wise, scheme-wise and institution-

awareness for grow III and need for diversification; (3) to build wise) for technically feasible and economically viable schemes for
up own resources and manpower so as to ensure gradual financing pro-duction and investments by the bank. Co-
independence from outside help; (4) to progressively operatives, among other finan-cial institutions, are also

professionalism their managements and (5) to bring about participating agencies in the formulation and implementation

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orientation of policies towards benefiting the common of the plans. In the context of these developments it has been
interests of the rural population, especially the weaker ones. decided to integrate the ACID Programme with District Credit
The selection of the districts for the scheme was done in Plans from 1980 onwards.
consultation will the State Governments at a 2-day meeting in The Agricultural Refinance and Development

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Bombay in January 1977, Subsequently, four zonal meetings Of
senior officers of the State Governments, the Chairman and the
In the sphere of long-term agricultural credit, an important
Chief Executive Officers of the state Co-operative Banks and

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land development banks were held at Bombay, Madras, Calcutta
and New Delhi during February and March I 977 for explaining
the objectives of the scheme. As envisaged under the scheme,
development during the Third Five Year Plan had been the
establishment of the Agri-cultural Refinance Corporation. The
Plan elaborated the functions of the Corporation in the
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following terms.
quick surveys of the selected districts in 16 States were
conducted to collect basic data for preparation of district credit “The Corporation will purchase debentures floated by central
plans for the districts. land mortgage banks in the normal course and will also provide
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funds for schemes for increasing agricultural production which

Action programmes to be implemented during kharif 1977
are remunerative in character, but involve considerable invest-
were also prepared for the selected districts. Preliminary
ment or long periods of waiting, such as rubber, coffee, cashew
guidelines were prepared for the formulation of district credit
nut and areca nut plantations, irrigation, contour-bonding and
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plans and arrangements made to prepare such plans in one

soil conservation, and development of orchards and fruit
district of each of the four zones in the country in the first
gardens. The loans advanced by the corporation will be chal-
instance. Steps were also initiated to ensure full co-ordination
lenged through the Central Land Mortgage Banks.”
with commercial banks so that at the district level, where these
banks work as lead banks, duplication of efforts may be The functions of the Corporation have since been transferred to

avoided. the National Bank for Agriculture and Rural Development.

A sub-committee was set up by the Agricultural Credit Board in National Bank for Agricultural and Rural
its meeting held on IS July 1977 with Prof. M.L. Dantwala as
Development (Nabard)
chainman to guide the Reserve Bank in matters of policy and

NABARD started its operations in November 1982 by taking

implementation. The main activity during 1977 -7S, under the
over the developmental and refinancing functions of the
scheme pertained to the prepara-tion of Credit and Action
Agricultural Refinance and Development Corporation on the
Programmes for the selected districts. In the programmes an
one hand and the Reserve Bank of India on the other. The
effort is made to: (1) identify the on-going bankable schemes
National Bank was organised with the basic objective of
financed by various agencies and also that might be fom1ulated
establishing an apex institution in the field of agricultural and
in the near future, (2) assess their credit requirements in a
rural development finance in such a way as to integrate the
realistic man-ner, (3) suitably adjust the credit programmes of
financing of various institutions involved the development of
the concerned financial institutions operating in the district, and
rural areas.
(4) specify the action that is necessary to implement the
programme, The Bank has all authorised capital of Rs. 500 crores and a paid
up capital of Rs. 100 crores. Its paid up capital is shared equally
Such programmes have already been prepared in respect of
by the Government of India and the Reserve bank of India. It
various districts. In pursuance of the scheme’s objective to
can augment its resources by drawing funds from the Central
strengthen the banks organizationally, staffing pattern studies
Government, the State Governments. The Reserve Bank,
of state co-operative banks and the central co-operative banks
international agencies including the World Bank Group and by
have also been undertaken in various States in consultation with

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90 11.621.6
raising funds from the market through bonds and debentures. programmes-to suit the requirements or different areas of


In addition the resources of the National Agricultural (Long rural development; and
Term Operations) and the National Agricultural (Stabilisation) (viii) inspection of cooperative banks and RRBs.
Funds of the Reserve Bank stand transferred to the National
During the short period of its existence, the Banks has played
Rural Credit (Long Term Operations) and the National Rural
its dual role as an apex institution and as a refinancing agency
Credit (Stabilisation) Funds of the NABARD. It can also
creditably by participating actively in the development policy
borrow from the Reserve Bank for financing its short term
formulation, planning, coordination, monitoring, research,
lending operations. In short, the Bank is well equipped with
training and consultancy as well as refinancing areas relating to
adequate financial resources to meet its commitment in the field
agricultural and rural development. It may be noted in this
of agricultural and rural development.
connection the Bank is a single integrated agency cater-ing to the
The management or the Board is vested in a Board of Directors credit needs of all types of agricultural and rural development.
consisting of the following members. It is gratifying to note that the Research Cell of the National
a. A Deputy Governor of the Reserve Bank as Chairman. Bank is paying particular attention to ensure that weaker

b. Three nominees of the Reserve Bank. sections of the rural population benefit more by schemes of
refinance by the Bank, that there is simplification of the
c. Three nominees of the Central Government.
procedures so that quick disposal of applications is possible

d. Three members, two Wit1l experience in cooperative banking and that the Government’s programmes for poverty eradica-

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and one in commercial banking. tion are supported in a meaningful way.
e. Two nominees of the State Governments.
Assistance for Agriculture
f. Two experts in rural economics and rural development. As an apex refinancing agency in the field of rural credit, the
g. A managing director. National Bank provides refinance assistance to the eligible

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h. One or more whole time directors. cooperatives and commercial banks for different purposes and
durations. It provides short term credit for periods not

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NABARD performs all the functions performed by the
erstwhile Agricultural Refinance and Development Corporation
exceeding 18 months to State Coopera-tive Banks/Regional
Rural Banks for seasonal agricultural operations (crop loans)
marketing of crops, purchase and distribution of fertilizers and
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as well as those performed by the Agricultural Credit working capital requirements of cooperative sugar factories. It
Department of the Reserve Bank in the field of agricultural and also provides medium term credit (I8 months to 7 years) to
rural credit. These include: State Cooperative Banks/Regional Rural Banks for approved
(i) provision of short term, medium term and long tem1 agricultural purposes, pur-chase of shares of processing
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financial assistance of Land Development Banks, State societies and conversion of short term crop loans into medium
Cooperative Banks, RRBs, and commercial banks for term loans in areas affected by natural calamities. Long term
promoting agricultural and rural development: credit for a period of 25 years is provided to State Coopera-tive
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(ii) provision of long term loans to State Governments for a Banks/land development banks/Regional Rural Banks/
peri0d Upl.0 20 years for contribution to the share capital of Commercial banks for investment in agriculture under
cooperative credit institutions; schematic lending. Lending term loans (for periods not
(iii) provision of long term loans to any institutions approved exceeding 20 years) are provided to State Governments to
enable them to contribute to the share capital of the cooperative

by the Central Government:

credit institutions.
(iv) contribution to the share capital or ordinary rural
debentures issued by any institution involved in agricultural Refinance Assistance
and rural development: The aggregate credit limits sanctioned by NABARD for co-

operative and State Governments stood at Rs. 4,133.2 crore

(v) provision of necessary resources by way of refinance to the
during 1993-94. Drawals against these limits stood at Rs. 5358.7
primary lenders including State Cooperative Banks,
crores, NABARD has revised the rates of interest on its
commercial banks and RRBs for facilitating integrated rural
refinance with effect from March I, 1994 which would be
applicable to all fresh lending/disbursements. The Bank
These cover all kinds of production and investment credit continues to pursue the policy of development and promotion
agriculture, small scale, cottage and village industries, handi- of agricultural investments in less developed and/or under
crafts, rural artisans and other allied economic activities in banked States.
rural area.
Co-operative Development Fund
(vi) coordination of the activities of central and State
An important development in the area of institutional
Governments the Planning Commission and other all-India
development during 1992-93 was the setting up of a Co-
and State-level institutions entrusted with the development
operative Development Fund by NABARD with an initial
of economic activities in rural areas;
corpus of Rs. 10 crore contributed by it out of its profits for
(vii) promotion of research in agricultural and rural 1992-93 to provide financial assistance by way of grants loans to
development: (viii) formulation of projects and co-operative banks for human resources development with suit-

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11.621.6 91
able training input and to build up better management

information sys-tems and infrastructural facilities for primary

agricultural societies for mobilising deposits. Upto March 1994,
a total assistance of Rs. 6.32 crore has been sanctioned to 10
State Co-operative banks and 3 State Land Development Banks
which include Rs. 3.62 crore in grants ado the balance of Rs.
2.70 crore in interest free loans.
Institutional Strengthening Programme
NABARD has prepared components and guidelines for
institutional strengthening programme aimed at making ‘non
solvent’ and ‘near non solvent’ banks ‘solvent’ and ‘viable’ as
per the recommendations of the Agricultural Review
Committee. The basic components of institutional

strengthening programme would comprise identification of
overdues and bad debts and to make provisions there against,
reduction in cost of management, rationalisation of loan

policies and procedures, expansion and diversification of loans

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portfolio, mobilisation of resources both manpower and
financial and their development, etc.
Questions to Discuss:
1. Discuss Central Cooperative banks.

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2. What do you understand by State or provincial cooperative
banks or apex banks?

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3. Discuss Agricultural credit-intensive development scheme.
4. Discuss the agricultural refinance and development
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5. Explain the features of NABARD.
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92 11.621.6

Learning objectives Notes

After reading this lesson, you will understand 1. * the erstwhile Industrial Reconstruction Bank of India
• Role of DFls in the financial system (IRBI), established in 1985 under the lDBI Act, 1984, was
renamed as Industrial! Investment Bank of India Ltd.
• Operations of major Fls in India – IFCI
(IIHO with effect from March 27, 1997.
• Operations of major Fls in India –IDBI
# IVCF-IFCI Venture Capital Funds Ltd.
We will discuss the nature and operations of the present

2. Figures in brackets under respective institutions indicate the
financial institutions operating in India in today’s class. Today
year of establishment year of incorporation.
we shall focus on IFCI and IDBI.
3. Figures in the brackets under SFCs/SIDCs indicated the

Introduction number of institutions in that category.

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Financial Institutions play an important role in the Indian
financial system. In fact, most of the financial intermediation Industrial Finance Corporation of India
taking place outside banks can be attributed to the operations At the time of Indian independence, there were lacunae in its
of the financial institutions. Financial Institutions (Fls) provide financial system. One among them was the lack of adequate
project finance to the needy corporates and government industrial financing, especially to meet the medium to long-

rd. F
institutions, thereby performing an important role in the term requirements of the industries. In such a set up, it became
infrastructural development in the country. necessary to develop an institutional structure for meeting the

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There are various kinds of financial institutions performing
their role in financial intermediation and infrastructural
development, differing on the basis of their inception and
large fund requirements of the industry. The first step in this
direction was the incorporation of the Institute of Finance
Corporation under the Institute of Finance Corporation Act,
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1948 (IFC Act). Subsequently the IFC Act, 1948 was repealed
operations. Broadly, the existing financial institutions may be
and in its place, the Industrial Finance Corporation (Transfer of
classified as (a) All India institutions like Industrial
Undertaking and Repeal) Act, 1992 (lFCI (Repeal) Act), was
Development Bank of India (lDBI) etc., or (b) Regional/State
formulated which came into force on July 1, 1993. lFCI was
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level institutions like the Gujarat State Financial Corporation etc

converted into a public limited company and was registered
or (c) Other Institu1ions like DICGC etc.
under the Companies Act in July, 1993. In December, 1993, it
It is to be noted that our definition of financial institutions also made its maiden public issue.
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does not encompass Non-Banking Financial Companies. This

The erstwhile IFCI was set up under an Act of Parliament in
is because of the fact that the characteristic of a typical financial
1948, with the share capital subscribed by Government of India
institution, which we are discussing here, and the characteristics
(GOl), RBI, Scheduled Commercial Banks, Insurance
of a NBFC differ in many ways.
Companies, Investment Trusts and Cooperative Banks. With
Organisational Structure of Financial Institution the establishment of the IDBI in 1964, the shareholding of

GOI and RBI was transected to IDBI. IDBI holds 30% of IFls
All Financial Institution
The management of IFCI is vested in its BODs, comprising

professionals drawn from diverse fields like banking, finance,

All India Financial Institution State Level Institutions Other Institutions
economics, insurance, etc.
IFCI is headquartered in New Delhi and has 17 regional offices.
All India
Development Banks
Specialised Financial
Besides Delhi, regional offices are also located at Mumbai, Pune,
IDBI (1964)
ICICI (1955)
EXIM Bank (1982)
IVCF (formerly
UTI (1964)
LIC (1956)
(1982) Kolkata, Hyderabad, Lucknow, Chennai, Ahmedabad,
SIDBI (1990) RCTC) (1988)# GIC &
Bangalore, Bhopal, Jaipur, Kochi, Punjab, Chandigarh,
NHB (1980)
IIBI (1997)* ICICI Venture subsidiaries
IFCI (1948) (formerly TDICI) (1972)
TFCI (1989)
Guwahati, Bhubaneswar and Patna.
IDFC (1997)

SFC SIDC Product Profile

The main functions of IFCI are to provide various kinds of
(18) (28)

financial services to the industries. Primarily, its services focus
(1957) (1962) on project finance as it provides assistance to all viable industrial
projects above Rs.50m. IFCI provides assistance to industrial
concerns for their new projects, expansion, diversification and
modernization schemes. Loans are generally extended for a
period of 5-7 years with a moratorium of 2-3 years. Loans are

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11.621.6 93
extended both in rupee and foreign currency. The latter is • Tourism Advisory & Financial Services Corporation of India

normally for import of capital equipment. Loans are provided (TAFSIL)

after a detailed project appraisal. Typically, the loans are secured • Institute of Labour Development (LTD.)
by the assets of the borrowers, in some cases along with
Other organizations in which the ‘IFCI acts as a co-promoter
corporate/personal guarantee, as additional collateral. After
performing the appraisal, depending on the borrower, the
interest rates are fixed. Apart from extending loans. IFCI also • Stock Holding Corporation of India.
underwrites/directly subscribes to equity/debentures of the • Entrepreneurship Development institute of India
companies. offers financial assistance in the form of equipment • OTC Exchange of India
leasing, equipment credit, suppliers’ and buyers’ credit,
• National Stock Exchange of India
equipment procurement and installment credit. Besides IFCI
provides guarantees for deferred payment and offers • Securities Trading Corporation of India
promotional services like support for technical consultancy, • Biotech Consortium India.

housing development, management development, • AB Home Finance
entrepreneurial development etc. IFCI has introduced capital
• LIC Housing Finance
subsidy scheme for converting palaces/castles/forts, etc. of any
• GIC Grih Vitta

size into heritage hotels. Disbursals during the year have

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registered a growth of 13%. In terms of new sanctions major Financial Resources
sectors are power generation, textiles and iron and steel together Equity, rupee and foreign currency loans and bonds form the
accounting for over 40% of sanctions in FY 1999. IFCI’s loan different types of finance resources for the IFCI. The resource
portfolio is well diversified across industries and geographic management function at IFCI is handled by a separate division
locations. from the headquarters at New Delhi. The requirements for

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IFCI has diversified from its traditional role in pJrojec1 finance funds are communicated by the accounts departments of
to provide finance for leasing and hire purchase concerns, various divisions in the form of monthly cash flow statements

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corporate loans and short-term loans. It also offers a wide range
of financial services including issue management, corporate
advisor and trusteeship. Wholly owned subsidiaries were set up
(current and projected) to the resources Department at New
Delhi. The targets are set in conformity with the projections for
sanctions and disbursements in various activities. Rs.42.6bn
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to enable this diversification of its product portfolio. rupee borrowings were raised- during 1998-99 (67.1%- long-
term; l1.4%-medium-term; and 21.5%- short-term funds). The
These include:
average cost of the aforesaid borrowings Was about 13.5%.
• IFCI Financial Services Ltd. - Merchant Banking Stock IFCI has also issued preference share capital of Rs.3.4bn. The
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Broking and Allied Activities average maturity and average coupon rate of the preference share
• IFCI Investor Services Ltd. - Registrar and Transfer Services capital raised during the year was about 4.5 years and 10.6%
• IFCI Custodial Services Ltd. - Custodial Services respectively.
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• Risk Capital & Technology Finance Corporation Ltd. Performance

The IFCI Financial Services Ltd. undertakes merchant banking, Amongst the 4 AIFIs, lFCI ranks 3rd in terms of asset -base.
underwriting, issue management etc. IFC’I is a Category-I The lower ranking of IFCI amongst its power group can be
Merchant Banker and Debenture Trustee IFCI set up MBASD attributed to its bad asset quality. The outstanding have been

(Merchant Banking and Allied Services Division) in July, 1986. mostly from (exiles, iron& steel; metal products, chemicals,
IFCI also provides underwriting and guarantees. synthetic fibers & resins, and food products industries. The
factors that have led to such a high level of NPAs included the
To face the challenges offered by the increasing competition a
slowdown in industrial growth, slack demand conditions,
need was felt to spruce up the activities of the Corporation.

excess capacity in a number of industries, technological

Moving in this direction in 1998, IFCI has decided to merge the
obsolescence and the loss of competitiveness in some
wholly owned subsidiaries, IFCI Custodial Services Ltd. and
IFCI-Investor Services Ltd., with IFCI Financial Services Ltd.
In an effort to control the rising NPAs, IFCI is now playing a
Further, its wholly Owned subsidiary, Risk Capital &
playing a proactive role in the restructuring of borrower
Technology Finance Corporation Ltd., was renamed as IFCI
concerns for which it has set up the Corporate Restructuring
Venture Capital Funds Ltd., and its operations would
Division. The reduction of NPAs are made through the timely
henceforth be concentrated on managing venture capital funds
grant of relief’s and concessions, encouraging mergers and
in some select industries.
amalgamations with healthy companies, one-time settlement of
Apart from the above mentioned wholly owned subsidiaries. dues, etc. To take proactive measures and prevent any further
IFCI has also promoted various specialised institutions such as rise in the NPAs, the Corporate Monitoring Department has
• Management Development Institute (MDI) been set up at the corporate office to oversee and monitor cases
• Tourism Finance Corporation of India Ltd. (TFCI) with large exposure as well as likely problem loans.
• Rashtriya Gramin Vikas Nidhi (RGVN)
• Investment information & credit rating agency (ICRA)

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94 11.621.6
In addition, an Industry Research Division has been set up for Operations


the purpose of carrying out industry, studies to facilitate the IDBI initially provided long-term assistance to industries such
work of the Credit Department Regional Offices. This research as textiles, fertilizers, chemicals products and machinery. The
studies provided by this division on various industries would assistance was mainly in the form of long-term loans and to a
enable the IFCI to take more informed lending decisions. With small extent, in the form of project lending. In 1964, IDBI also
all these measures, the IFCI is trying to upgrade its asset quality. began a role in assisting the State Finance Corporations (SFCs)
Apart from these new divisions, IFCI has reconstituted its of various states, taking over from Refinance Corporation of
internal management committees. The management India. This assistance was in the form of providing refinancing
committees at the corporate office include the Business Review the term loans granted by the institutions. By 1965, IDBI
Committee, the Credit and Investment Committee. Head entered into rediscounting of -machinery bills to promote the
Office Loan Committee, the Asset Liability Committee, the sale of indigenous machinery on deferred payment basis.
Disinvestment Committee and the Official Language Subsequently, IDBI entered into finanancing exports on a
Implementation Committee. The setting up of the ALM different payment basis, till the time Export- Import (Exim)

Committee was mainly to enable it to conform .to the RBI Bank of India was formed in 1982.
guidelines on ALM for financial institutions. In 1986, IDBI created a Small Industries Development Fund
In an effort to manage its interest rate risk, IFCI has been (SIDF) to provide a special focus to the needs of the small scale

following a policy of linking its interest rate to the prevailing sector. This fund is intended to provide financial as well as non-

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prime lending rate (PLR) at the time of disbursement. In the financial inputs catered to the specific needs of the small scale
case of Foreign currency loans the pricing is one at LIBOR + sector. In 1990, the operations of the fund were hived off in to
spread. Further to tackle the foreign exchange risk management, a wholly owned subsidiary, the small industries development
the repayment for the funds that are borrowed in a foreign bank of India (SIDBI), in order to provide greater focus to the

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currency is ‘made’ in the same currency resulting in no exchange
rate risk on the part of the Corporation. Through the late ’80s and the early ’90s IDBI played a
significant role in the development of financial markets. While
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To face the competition, there is a need to reorient its strategies.
For this purpose, it is envisaged that in the due course of time
it played a major role in setting up of the Stock Holding
Corporation of India Limited (SHCIL), for providing impetus
to the depository services to the financial institutions in 1987, it
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IFCI may operate as a universal bank that has a major focus on
was also the nodal agency for establishing the National Stock
corporate banking. And in order to tap on the other financial
Exchange (NSE) in 1992. Other institutions promoted by
services that offer greater scope for the corporation, IFCI is
IDBI by direct contribution of capita] include: Credit Analysis
diversifying into bill discounting, trade bills important financing
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and Research Limited (CARE) and Investor Services of India

and working capital financing. Most important move in this
Limited (ISIL). Both established in the early nineties, CARE
direction is the joint venture it is entering into with a foreign
offers credit rating, information and equity research services to
partner to diversify into the insurance sector.
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Indian Industry and institutions, ISIL provides registrar

Industrial Development Bank of India transfer and custodial services. IDBI joined other All India
Industrial Development Bank of India (IDBI) is the largest Financial Institutions (AIFls) to promote: Over The Counter
financial institution in India, with assets at the end of 1999 Exchange of India (OTCEI). Shipping credit and Investment
approximating to Rs.600 bn. This apex financial institution in Corporation of India (SCICI)- now merged with ICICI,

India, is also the 10th largest development bank in the world. Tourism Finance Corporation of India (TFCI) and Biotech
Industrial Development Bank of India (IDBI) owes its birth to Consortium of India Limited (which provides aid for
Industrial Development Bank Act (IDBI Act), 1964. As per its commercialization of indigenously developed processes and
charter IDBI is required to play a significant role in (a) planning, products in the field of biotechnology.

promoting and developing industries to fill the gaps in the

Over the years IDBI evolved from being a government arm for
industrial sector (b) co-coordinating the working of institutions
doling developmental credit to various slate finance institutions
engaged in such activities and assisting in their development (c)
and bodies to being a complete one stop shop for long-term
providing technical and administrative assistance for
lending. By the mid-90s, when the first stage liberalization has
promotion, management or expansion of industry (d)
taken its full effect the strength of IDBI of being big came into
undertaking market and investment research and techno-
force. Core sector projects especially in Iron and Steel have been
economic studies to contribute to the development of industry.
major borrowers from IDBI. Approvals and disbursals during
Initially, IDBI was established as a wholly-owned subsidiary of the years) have grown at an average of 99f- and 8% per annum
the Reserve Bank of India (RBI). In 1976, the ownership of respectively.
IDBI was transferred to the Government of India. The IDBI
Act was amended in October 1994 enabling IDBI to raise equity Financial Performance -
from the public, subject to the holding of the Government or The Bank’s working during the year 2001 yielded a Profit Before
India not falling below 51 % of the issued capital. Tax of Rs.734 crore (Rs.1027 crore for the previous year). After
making a net provisioI1 of Rs.43 crore towards taxation for the
year, Profit After Tax was Rs.691 crore (Rs.947 crore). After
apparitions to reserves and reserve funds, the Board of

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11.621.6 95
directors have proposed a dividend of 45% on the equity profits. IDBI has been receiving loans from this fund on

capital. concessional terms. In recognition of its development role,

Total assets of the Bank as on March 31, 2001, increased by IDBI was initially exempted from income tax, which was
15.3% to Rs.71,783crore.(Rs.72,285crore). IDBI’s net worth as subsequently placed in the tax bracket of 30 percent. This tax
on that date also recorded a rise of 8.6% to Rs. 9,126 crore bracket is applicable uniformly to all the AIFls.
(Rs9,025 crore). Apart from the NIC[LTO] a separate Development Assistance
The Bank’s performance can be seen from various indicators. Fund (DAF) was created as per the requirement of the IDBI
The margin, measured by the difference between the average Act. Funds from DAF were source to finance large infrastructure
return on assets and financial cost of liabilities was 2.6% in projects, which, probably, would not have qualified for
1998-99 as against 3.9 % in 1997-98. The return on average assistance on commercial considerations.
assets was 2lk as compared to 2.7%. Return on average net In the pre-reform era, IDBI has been relying on the
worth for the year declined to 15.1 % (19.9%). Earnings per Government of India for funding. ‘IDBI was initially granted
Share and Book Value per Share at the year-end stood at Rs.9.37 an interest free loan amounting to Rs.10 crore at the time of its

and Rs.139.S0 respectively. setting up. Government of India has also been providing
The Bank continued to maintain sound capital adequacy various loans on a concessional basis, while providing
requirement, as represented by the capital adequacy ratio (CAR), budgetary support to IDBI until 1970. Even after 1970, IDBI

which at end-March, 2001 stood at 15.8% as against 8(1() last enjoyed budgetary support towards the funds that were

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year. The Debt equity ratio (including contingent liabilities) disbursed through IDA line of credit from the World Bank. It
stood at 6.53:1 (6.08:1). has to be noted that these loans met the foreign currency
requirement of the industry and in such borrowings. FIs
In 2000 -01, IDBI sanctioned and disbursed Rs.287.1 bn and
normally do not bear any direct exchange risk. which is borne
Rs.174.9 bn respectively. Of it direct finance constituted 95.4%

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either by the borrower or the GOI. Government of India, in
of total sanctions and 92.6% of total disbursements. Protect
order to further help IDBI augment its resources, introduced
Non-Project loans given for eligible industrial.
Companies Deposits (Surcharge on Income Tax) Scheme. As

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These types of loans are disbursed by IDBI either for a
particular project of as a-general Joan, either in foreign currency
or Indian Rupees. Normally, these loans are provided for a
per this scheme companies were exempted from paying then
existing surcharge on income tax provided they deposit an
equivalent amount, repayable after five years, with IDBI. This-
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period of 5-7 years with a moratorium of 2-3 years. Also, the scheme was discontinued in April, 1978. In 1981, in response to
loans will be secured by a fixed charge on fixed assets. As in the the shortage of resources faced by the IDBI the Government
case of banks, the rate of interest that is charged will be a of India extended a budgetary support of Rs.50 crore.
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markup to the Prime Lending Rate (PLR). IDBI also provides

Subsequent to the new thinking imbibed through the
direct assistance through underwriting of securities of corporate
liberalization measures in early 90s, concessional funding by the
enterprises. Such underwriting, though a small part of the
Government of India and RBI began dwindling. Statutory
financing also provides an alternative avenue for investments in
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Liquidity Ratio (SLR) status for bonds issued by FIs was

withdrawn in 1993. These bonds, eligible for investments by
In 1987, IDBI began providing venture capital essentially to the banks under the mandatory SLR category, were a major source
technology oriented start up ventures, which was subsequently of funds for IDBI They carried a lower interest rates (10-11 %)
broadened to provide assistance to wide spectrum of projects and had 15 year maturity period. IDBI then began relying

which are not necessarily technology driven. The venture capital increasingly on the market borrowings sourcing money through
assistance was provided to finance cost of fixed assets, certificate of deposits, floating rate bonds, term money bonds
operating and market development expenditure, among other and other commercial borrowings in both rupees and foreign
venture capital related activities. - currencies.

IDBI provides indirect assistance through refinancing state level In 1994, IDBI act was amended through an ordinance, allowing
institutions for small loans disbursed by them. For approved IDBI to raise equity capital form the market as long as the GOI
loans IDBI makes a fixed spread with government providing a holding did not fall below 51 percent. Also, IDBI’s status was
guarantee for such refinance. changed from a government Undertaking to a. company
The share of different industries in total sanctions during FY registered under the Companies Act, 1956. Subsequent to the
1998 were power 6.2% core (iron & steel, oil, cement, fertilizer) amendment in the Act; IDBl made Rs.21.8bn IPO In July 1992
24.7% chemicals 11.2%m textiles 12.2%, paper 5.48%, other through public offerings of 168m equity shares of Rs. 10 each
industries 30.44% and pharmaceutical 4.11%. at a premium of Rs.120. The issue was over subscribed
approximately 1.4 times. The share was quoted at
approximately Rs.25 on 28.6.2001.
With its wide-ranging lending requirements with concentration
on long-term finance, IDBI needed huge money at a cheap rate. Current Position
In the 70s, to enable IDBI perform various developmental The valuation of IDBI’s stock, relative to HDFC and ICICl,
activities and also to finance small scale industries, at itself shows that IDBI is not viewed favorably by the market.
concessional rates, RBI created a separate National Industrial Due to IDBI’s relatively high exposure to iron and steel
Credit [Long-Term Operations]-(NIC[LTO]), fund out of its projects, which are languishing due to over capacity and global

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96 11.621.6
recession, IDBI had to reconcile with high NPAs. NPAs have


been appropriately provisioned as per the regulations applicable
to banks. Sub-standard and doubtful. Assets constituted 7.7%
(7.0%) and 4.3% (3.1%)respectively of the assets. Loss assets
were fully written off. IDBI made full provisions/ write-offs in
respect of its non-performing assets as per RBI norms.
Questions to Discuss:
1. Discuss the role of DFls in the financial system.
2. What are the operations of major Fls in India namely IFCI?
3. What are the operations of major Fls in India namely IDBI?

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11.621.6 97


Learning objectives resources added on to the list. Broadly, the financial resources of
After reading this lesson, you will understand ICICI are as follows:
• Operations of major Fls in India –ICICI Share Capital
• Regulatory framework for Fls. ICICI is a public limited company and its six lakh shareholders
include Indian promoters (_9.1 %), Indian institutes/Mutual
We will discuss the nature and operations of the present
funds (7%), FIIs (34.8%), Public/ Free float (29.1%). These
financial institutions operating in India in today’s class. Today
figures are pre-IPO issue of 1999, when ICICI came out with a

we will focus on ICICI.
issue priced at Rs.85. In middle of 1999, ICICI became the first
Industrial Credit and Investment Corporation of Indian company to have an ADR listing on the New, York

India Ltd. Stock Exchange (NYSE). American Depository Receipts

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ICICI is India’s second largest Financial Institution with assets (ADRs) were issued in the ratio of 2:1 to the domestic equity
totaling Rs.424.5 bn in 1999. Initially, playing a role of a typical shares of ICICI traded on the Bombay Stock Exchange.
development financial institution-of giving long-term loans, it Reserves
has gradually evolved into a one-stop shop for most retail Reserves which are the internal resources- contribute
finance instruments. The corporation has its presence in significantly towards the fund requirements of the ICICI.

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investment and commercial banking, venture capital funding, Generally, internal generations of ICICI meet 50-60% of its
custodial services, InfoTech, brokerage, consultancy and funds requirement.

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advisory services. Compared to IDBI, which is seen as
conservative, ICICI is of late being more aggressive. ICICI has
increased its market share to 42 percent in sanctions and 43
The borrowings of ICICI fall into the following three types:
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percent of disbursements: • Rupee Borrowings

ICICI was initially established as Industrial-Credit and • Foreign Currency Borrowings

Investment Corporation of India in 1955. It was promoted by • Commercial Borrowings
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the Government, the World Bank and a steering committee of Borrowing storm the Government of India, institutional
5 prominent businessmen and others. The objective of ICICI borrowings, bonds guaranteed by Government and. other
was to assist the private sector. Later on, its services were public issue of bonds feature under the rupee borrowings
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extended even to the public sector, joint sector and the co- category of ICICl. The borrowings from GOI/RBI were mainly
operative sector. Primarily, assistance was provided for the to support developmental objectives of industrial growth. The
following purposes: bonds issued by the FIs, including the ICICI were guaranteed
• Creation expansion and modernisation of companies in the by the Government and qualified as SLR investments for
private sector. commercial banks. They carried lower interest rates (10-11 %)

• Encouraging and promoting industrial investment and the and had a 15-year maturity period. In addition to these low cost
expansion of investment markets. Government borrowings, SLR bonds also were a major source
of funds for most of the FIs till 1993. However, in order to
For these purposes, the ICICI provides long and medium term
ensure a level planning ground, access to such low cost funds is

loans or equity finance, sponsors and underwrites securities

slowly being cut off. Presently, about 10 percent of the FIs
issues, guarantees loans, providing managerial, technical and
balance sheet reflect these resources which are repayable by 2004.
administrative consultancy.
The foreign currency borrowings of the ICICI comprises of the
Headquartered in Mumbai, ICICI also has zonal offices at
multilateral/ bilateral borrowings. ICICI has been playing a
Bangalore, Baroda, Calcutta, Chennai, Coiambatore, Hyderabad,
crucial role in canalizing the foreign currency borrowings it has
New Delhi and Pune.
obtained from the Government, World Bank, KFW, IFC and
Apart form providing assistance to the companies, ICICI has other international agencies to meet the foreign currency
also promoted a number of specialised financial institutions for requirements of the industry. While extending lines of credit,
various other purposes. These include HDFC, CRISIL, TDICI the ICICI will not have to bear the exchange risk as it will be
etc. borne either by the borrower or the Gar.
Financial Resources The other commercial borrowings of ICICI have been coming
Initially, the financial resources of ICICI included share capital, from the international market, where it has been borrowing
interest free loan from Gal and foreign currency advances from funds in various currencies. These borrowings have enabled it
the World Bank. Subsequently, other rupee and foreign currency to reduce its interest costs and also diversify its currency risk.

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98 11.621.6
Deposits ITC Classic Finance and Anagram finance has resulted in


Due to limited access to government borrowings which has widening its retail network in the western and northern parts of
been a chief source of finance, ICICI is now looking at various the country. In addition to this, the merger of ITC Classic
market borrowings as another source of finance. ICICI issues Finance has resulted in a tax shield of Rs.l billion as ITC Classic
certificate of deposits (CDs) in the wholesale market was a loss-making unit.
an4.borrows in the retail market through fixed deposits (FDs)
ICICI has been accepting the changes in the market and as also
Deployment of Resources in acting fast to keep pace with these changes. And to continue
Long-term lending, investment and commercial banking, this trend the FI now aims to move on to become a global
venture capital financing and consultancy and advisory services, player. The strategic acquisitions and diversification activities
debenture trusteeship and customer services are all the major have played a great role in moving ICICI from the role played
financial service offered by ICICI and where most of its funds by a traditional FI. The focus of ICICI is to become is to
are developed. As the objective of ICICI is to promote and become a universal bank and to offer a comprehensive range of

encourage industrial investment, project finance is the key area financial services.
for fund deployment. Exim Bank
ICICI is into equipment finance also as it supports financing of Export-Import Bank of India (Exim Bank), an apex financial

imported and locally manufactured equipment by deferred

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institution, was established in 1982 under an act of the
credit. Two types of credit facilities are offered (1) credit facility parliament to finance facilitate and promote India’s international
that enables the manufacturer to extend credit to’ the customer trade.
for purchasing the specified equipment, (2) asset credit facility The vision of Exim Bank is to develop commercially viable
that enables the purchaser to get the credit and repay over a fixed relationships with a targeted set of externally oriented

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period of line. Further, as the cost of funds is rising, ICICI is companies by offering them a comprehensive range of products
also entering into more profitable financing options. Having and services aimed at helping Indian companies to globalise.
began leasing Operations in 1983, ICICI has emerged as the

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single largest lessor in India While offering this service, ICICI
buys the equipment, retains the legal title and leases it. The
The bank has five overseas offices at Washington DC.
Singapore, Rome. Budapest and Johannesburg. The overseas
offices are strategically located to enhance institutional linkages
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average lease period is 5 years and the lease rentals are
determined as per the market rate. As the thrust on the with multilateral agencies viz., World Bank, International
infrastructure sector is growing, big ticket leasing in Monetary Fund, European Bank of Reconstruction and
infrastructure is gaining interest due to the large size of Development. Asian Development Bank, African Development
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operations. Taking advantage of this, ICICI has enhanced its Bank and regional banks like the PTA in Africa and also
operations in big ticket leasing. interacting with various Export Credit Agencies.

The fee based services offered by ICICI include merchant The overseas offices also assist Indian companies in identifying
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banking corporate advisory services, underwriting, corporate partners of business or joint ventures. Exim Bank has forged
finance, etc. In extending these services, ICICI has been alliances with banks, trade and investment promotion agencies
leveraging on in-house skill base, large client network and the in 31 countries through 53- co-operation agreements and
relationship with their clients. With the scope of these fee based Memoranda of Understanding (MoU).
services rising. ICICI has spun off most of these activities into Exim Bank finances exports of Indian machinery, manufacture

subsidiary companies. goods, consultancy and technology services on deferred

payment terms. It also seeks to co-finance projects with global
Subsidiaries and Acquisitions
and regional development agencies to assist Indian exporters in
In 1993, ICICI has floated a new company, the ICICI Securities
their effort to participate in such overseas projects: Companies

and Finance Company Ltd. (I-Sec) in joint venture with a

can avail of facilities such as forfeiting, underwriting of issues,
subsidiary of J.P.Morgan, with ICICI holding 60 percent of the