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Indian Banking System

Bank is an institution that accepts deposits of money from the public.

Anybody who has account in the bank can withdraw money. Bank also lends money.

Types of banks

Indigenous Banking:

The exact date of existence of indigenous bank is not known. But, it is certain that the old
banking system has been functioning for centuries. Some people trace the presence of
indigenous banks to the Vedic times of 2000-1400 BC. It has admirably fulfilled the needs of
the country in the past.

However, with the coming of the British, its decline started. Despite the fast growth of
modern commercial banks, however, the indigenous banks continue to hold a prominent
position in the Indian money market even in the present times. It includes shroffs, seths,
mahajans, chettis, etc. The indigenous bankers lend money; act as money changers and
finance internal trade of India by means of hundis or internal bills of exchange.

Indigenous bankers are private firms or individuals who operate as banks and as such both
receive deposits and give loans. Like banks, they are also financial intermediaries. They
should be distinguished h professional moneylenders whose primary business is not banking
but money lending.

Before establishment of commercial banks, private money lenders and country bankers
played an important role as important sources of finance. These establishments were known
as Indigenous Bankers. They used to charge a high rate of interest and exploited the people
who took financial assistance. These banks have lost their monopoly with the development of
commercial banks in India. Now-a-days even though a large number of commercial banks act
in the banking system, the indigenous bankers have played a significant role becuase some
people depend on indigenous bankers for financial assistance.


The main defects of indigenous banking are:

(i) They are unorganised and do not have any contact with other sections of the banking

(ii) They combine banking with trading and commission business and thus have introduced
trade risks into their banking business.

(iii) They do not distinguish between short term and long term finance and also between the
purpose of finance.

(iv) They follow vernacular methods of keeping accounts. They do not give receipts in most
cases and interest which they charge is out of proportion to the rate of interest charged by
other banking institutions in the country.
Suggestions for Improvements:

(i) The banking practices need to be upgraded.

(ii) Encouraging them to avail of certain facilities from the banking system, including the

(iii) These banks should be linked with commercial banks on the basis of certain
understanding in the respect of interest charged from the borrowers, the verification of the
same by the commercial banks and the passing of the concessions to the priority sectors etc.

(iv) These banks should be encouraged to become corporate bodies rather than continuing as
family based enterprises.

Industrial Banks:

Industrial units cannot function with the help of short-term financial assistance. They need
long-term loans. It necessitates the growth of industrial banks in India whose primary
objective is to extend long-term loans to industrial sectors. In addition to providing of long-
term financial assistance, they guide industrial units on technical and managerial problems.
The Industrial Development Bank of India (idbi) and the Industrial Finance Corporation of
India (ifci)are the pioneers in the industrial banking system of the country.

Agricultural Banks:

Agricultural banks are a type of banks which provide short-term as well as long-term finance
to the agricultural sector. co-operative banks are a type of agricultural banks which provide
short-term financial assistance to the people engaged in agriculture. Long-term agricultural
loans are given by the Land Mortgage Banks. The National Bank for agriculture and Rural
Development (NABARD) was established in 1982 to promote integrated rural development
and to provide all sorts of credit to agriculture.

Exchange Banks:

Exchange banks denote a type of commercial banks which finance foreign trade in the
country. besides financing foreign trade, they provide the following services for the
development of foreign trade: (a) They facilitate foreign remittances. (b) They discount
foreign bills of exchanges. (c) They help in buying and selling of gold and silver.

Post Office Savings Bank:

Post offices extend banking facilities by post office savings bank. Post offices accept deposits
from the people but do not grant loans like other commercial banks. They usually accept
deposits in the form of savings deposit. They usually pay a high rate of interest as compared
to other commercial banks.
Regional Rural Banks:

Regional Rural Banks are a type of bank who provide credit and other facilities to small
farmers, agricultural labourers, small entrepreneurs and artisans of the rural areas. These
banks accept deposits and give loans. They pay 1/2 percent more interest on fixed deposits as
compared to commercial banks. These banks are established with an authorized capital of Rs.
1 Crore and issued capital of Rs. 2 Lakhs.


The country had no central bank prior to the establishment of the RBI. The RBI is the
supreme monetary and banking authority in the country and controls the banking system in
India. It is called the Reserve Bank as it keeps the reserves of all commercial banks.

The Reserve Bank of India (RBI) is the central bank of India, which was established on April
1, 1935, under the Reserve Bank of India Act. The Reserve Bank of India uses monetary
policy to create financial stability in India, and it is charged with regulating the country's
currency and credit systems.

Main Role and Functions of RBI

Monetary Authority: Formulates, implements and monitors the monetary policy for
A) maintaining price stability, keeping inflation in check ; B) ensuring adequate flow
of credit to productive sectors.
Regulator and supervisor of the financial system: lays out parameters of banking
operations within which the countrys banking and financial system functions for-
A) maintaining public confidence in the system, B) protecting depositors interest ; C)
providing cost-effective banking services to the general public.
Regulator and supervisor of the payment systems: A) Authorises setting up of
payment systems; B) Lays down standards for working of the payment system; C)lays
down policies for encouraging the movement from paper-based payment systems to
electronic modes of payments. D) Setting up of the regulatory framework of newer
payment methods. E) Enhancement of customer convenience in payment systems. F)
Improving security and efficiency in modes of payment.
Manager of Foreign Exchange: RBI manages forex under the FEMA- Foreign
Exchange Management Act, 1999. in order to A) facilitate external trade and
payment B) promote development of foreign exchange market in India.
Issuer of currency: RBI issues and exchanges currency as well as destroys currency &
coins not fit for circulation to ensure that the public has adequate quantity of supplies
of currency notes and in good quality.
Developmental role : RBI performs a wide range of promotional functions to support
national objectives. Under this it setup institutions like NABARD, IDBI, SIDBI,
NHB, etc.
Banker to the Government: performs merchant banking function for the central and
the state governments; also acts as their banker.
Banker to banks: An important role and function of RBI is to maintain the banking
accounts of all scheduled banks and acts as banker of last resort.
Agent of Government of India in the IMF.
Structure of Organised Indian Banking System:

The organised banking system in India can be classified as given below:

Scheduled and Non-Scheduled Banks:

The scheduled banks are those which are enshrined in the second schedule of the RBI Act,
1934. These banks have a paid-up capital and reserves of an aggregate value of not less than
Rs. 5 lakhs, hey have to satisfy the RBI that their affairs are carried out in the interest of their

All commercial banks (Indian and foreign), regional rural banks, and state cooperative banks
are scheduled banks. Non- scheduled banks are those which are not included in the second
schedule of the RBI Act, 1934. At present these are only three such banks in the country.

Branch Banking

Branch banking is engaging in banking activities such as accepting deposits or making loans
at facilities away from a bank's home office. Branch banking has gone through significant
changes since the 1980s in response to a more competitive nationwide financial services
market. Financial innovation such as internet banking will greatly influence the future of
branch banking by potentially reducing the need to maintain extensive branch networks to
service consumers.
Unit Banking

In contrast to branch banking is unit banking which includes any bank that operates without
any associated branches. The bank may exist as a single unit by choice, such as certain small,
independent community banks, or may not be permitted to open branches per certain
government restrictions.

Not all unit banks are completely independent, even if they do not share a name with a larger
banking entity. Some are owned by larger holding companies with associations with other

Commercial banking

A commercial bank is a type of financial institution that provides services such as accepting
deposits, making business loans, and offering basic investment products. Commercial bank
can also refer to a bank, or a division of a large bank, which more specifically deals with
deposit and loan services provided to corporations or large/middle-sized business - as
opposed to individual members of the public/small business - retail banking, or merchant

Role and Importance of Commercial Banks:

1. Accelerating the Rate of Capital Formation:

Commercial banks encourage the habit of thrift and mobilise the savings of people. These
savings are effectively allocated among the ultimate users of funds, i.e., investors for
productive investment. So, savings of people result in capital formation which forms the basis
of economic development.

2. Provision of Finance and Credit:

Commercial banks are a very important source of finance and credit for trade and industry.
The activities of commercial banks are not only confined to domestic trade and commerce,
but extend to foreign trade also.

3. Developing Entrepreneurship:

Banks promote entrepreneurship by underwriting the shares of new and existing companies
and granting assistance in promoting new ventures or financing promotional activities. Banks
finance sick (loss-making) industries for making them viable units.

4. Promoting Balanced Regional Development:

Commercial banks provide credit facilities to rural people by opening branches in the
backward areas. The funds collected in developed regions may be channelised for
investments in the under developed regions of the country. In this way, they bring about more
balanced regional development.

5. Help to Consumers:
Commercial banks advance credit for purchase of durable consumer items like Vehicles,
T.V., refrigerator etc., which are out of reach for some consumers due to their limited paying
capacity. In this way, banks help in creating demand for such consumer goods.

Structure of Commercial Banks in India:

The commercial banks can be broadly classified under two heads:

In India, scheduled commercial banks are of three types:

(i) Public Sector Banks: These banks are owned and controlled by the government. The main
objective of these banks is to provide service to the society, not to make profits. State Bank of
India, Bank of India, Punjab National Bank, Canada Bank and Corporation Bank are some
examples of public sector banks.

Public sector banks are of two types:

(a) SBI and its subsidiaries;

(b) Other nationalized banks.

(ii) Private Sector Banks:

These banks are owned and controlled by private businessmen. Their main objective is to
earn profits. ICICI Bank, HDFC Bank, IDBI Bank is some examples of private sector banks.

(iii) Foreign Banks:

These banks are owned and controlled by foreign promoters. Their number has grown rapidly
since 1991, when the process of economic liberalization had started in India. Bank of
America, American Express Bank, Standard Chartered Bank are examples of foreign banks.

2. Non-Scheduled Banks:

Non-Scheduled banks refer to those banks which are not included in the Second Schedule of
Reserve Bank of India Act, 1934.
7 Main Functions of a Commercial Bank

The main functions of commercial banks are accepting deposits from the public and
advancing them loans.

However, besides these functions there are many other functions which these banks perform.
All these functions can be divided under the following heads:

1. Accepting deposits

2. Giving loans

3. Overdraft

4. Discounting of Bills of Exchange

5. Investment of Funds

6. Agency Functions

7. Miscellaneous Functions

1. Accepting Deposits:

The most important function of commercial banks is to accept deposits from the public.
Various sections of society, according to their needs and economic condition, deposit their
savings with the banks.

For example, fixed and low income group people deposit their savings in small amounts from
the points of view of security, income and saving promotion. On the other hand, traders and
businessmen deposit their savings in the banks for the convenience of payment.

Therefore, keeping the needs and interests of various sections of society, banks formulate
various deposit schemes. Generally, there ire three types of deposits which are as follows:

(i) Current Deposits:

The depositors of such deposits can withdraw and deposit money whenever they desire. Since
banks have to keep the deposited amount of such accounts in cash always, they carry either
no interest or very low rate of interest. These deposits are called as Demand Deposits because
these can be demanded or withdrawn by the depositors at any time they want.

Such deposit accounts are highly useful for traders and big business firms because they have
to make payments and accept payments many times in a day.

(ii) Fixed Deposits:

These are the deposits which are deposited for a definite period of time. This period is
generally not less than one year and, therefore, these are called as long term deposits. These
deposits cannot be withdrawn before the expiry of the stipulated time and, therefore, these are
also called as time deposits.

These deposits generally carry a higher rate of interest because banks can use these deposits
for a definite time without having the fear of being withdrawn.

(iii) Saving Deposits:

In such deposits, money upto a certain limit can be deposited and withdrawn once or twice in
a week. On such deposits, the rate of interest is very less. As is evident from the name of such
deposits their main objective is to mobilise small savings in the form of deposits. These
deposits are generally done by salaried people and the people who have fixed and less

2. Giving Loans:

The second important function of commercial banks is to advance loans to its customers.
Banks charge interest from the borrowers and this is the main source of their income.

Banks advance loans not only on the basis of the deposits of the public rather they also
advance loans on the basis of depositing the money in the accounts of borrowers. In other
words, they create loans out of deposits and deposits out of loans. This is called as credit
creation by commercial banks.

Modern banks give mostly secured loans for productive purposes. In other words, at the time
of advancing loans, they demand proper security or collateral. Generally, the value of security
or collateral is equal to the amount of loan. This is done mainly with a view to recover the
loan money by selling the security in the event of non-refund of the loan.

At limes, banks give loan on the basis of personal security also. Therefore, such loans are
called as unsecured loan. Banks generally give following types of loans and advances:

(i) Cash Credit:

In this type of credit scheme, banks advance loans to its customers on the basis of bonds,
inventories and other approved securities. Under this scheme, banks enter into an agreement
with its customers to which money can be withdrawn many times during a year. Under this
set up banks open accounts of their customers and deposit the loan money. With this type of
loan, credit is created.

(iii) Demand loans:

These are such loans that can be recalled on demand by the banks. The entire loan amount is
paid in lump sum by crediting it to the loan account of the borrower, and thus entire loan
becomes chargeable to interest with immediate effect.

(iv) Short-term loan:

These loans may be given as personal loans, loans to finance working capital or as priority
sector advances. These are made against some security and entire loan amount is transferred
to the loan account of the borrower.

3. Over-Draft:

Banks advance loans to its customers upto a certain amount through over-drafts, if there are
no deposits in the current account. For this banks demand a security from the customers and
charge very high rate of interest.

4. Discounting of Bills of Exchange:

This is the most prevalent and important method of advancing loans to the traders for short-
term purposes. Under this system, banks advance loans to the traders and business firms by
discounting their bills. In this way, businessmen get loans on the basis of their bills of
exchange before the time of their maturity.

5. Investment of Funds:

The banks invest their surplus funds in three types of securitiesGovernment securities,
other approved securities and other securities. Government securities include both, central
and state governments, such as treasury bills, national savings certificate etc.

Other securities include securities of state associated bodies like electricity boards, housing
boards, debentures of Land Development Banks units of UTI, shares of Regional Rural banks

6. Agency Functions:

Banks function in the form of agents and representatives of their customers. Customers give
their consent for performing such functions. The important functions of these types are as

(i) Banks collect cheques, drafts, bills of exchange and dividends of the shares for their

(ii) Banks make payment for their clients and at times accept the bills of exchange: of their
customers for which payment is made at the fixed time.

(iii) Banks pay insurance premium of their customers. Besides this, they also deposit loan
installments, income-tax, interest etc. as per directions.

(iv) Banks purchase and sell securities, shares and debentures on behalf of their customers.

(v) Banks arrange to send money from one place to another for the convenience of their

7. Miscellaneous Functions:
Besides the functions mentioned above, banks perform many other functions of general
utility which are as follows:

(i) Banks make arrangement of lockers for the safe custody of valuable assets of their
customers such as gold, silver, legal documents etc.

(ii) Banks give reference for their customers.

(iii) Banks collect necessary and useful statistics relating to trade and industry.

(iv) For facilitating foreign trade, banks undertake to sell and purchase foreign exchange.

(v) Banks advise their clients relating to investment decisions as specialist

(vi) Bank does the under-writing of shares and debentures also.

(vii) Banks issue letters of credit.

(viii) During natural calamities, banks are highly useful in mobilizing funds and donations.

(ix) Banks provide loans for consumer durables like Car, Air-conditioner, and Fridge etc.

Creation of credit by commercial bank:

Money supplied by commercial banks is called credit money. Commercial banks create credit
by advancing loans and purchasing securities. They lend money to individuals and businesses
out of deposits accepted from the public. However, commercial banks cannot use the entire
amount of public deposits for lending purposes. They are required to keep a certain amount as
reserve with the central bank for serving the cash requirements of depositors. After keeping
the required amount of reserves, commercial banks can lend the remaining portion of public

Methods of credit control

The two categories are: I. Quantitative or General Methods II. Qualitative or Selective

1. Bank Rate Policy:

The bank rate is the rate at which the Central Bank of a country is prepared to re-discount the
first class securities.

It means the bank is prepared to advance loans on approved securities to its member banks.

As the Central Bank is only the lender of the last resort the bank rate is normally higher than
the market rate.
2. Open Market Operations:

This method of credit control is used in two senses:

(i) In the narrow sense, and

(ii) In broad sense.

In narrow sensethe Central Bank starts the purchase and sale of Government securities in
the money market. But in the Broad Sensethe Central Bank purchases and sale not only
Government securities but also of other proper and eligible securities like bills and securities
of private concerns.

3. Variable Cash Reserve Ratio:

Under this system the Central Bank controls credit by changing the Cash Reserves Ratio.

Category # II. Qualitative or Selective Method of Credit Control:

1. Rationing of Credit:

Under this method the credit is rationed by limiting the amount available to each applicant.
The Central Bank puts restrictions on demands for accommodations made upon it during
times of monetary stringency

2. Direct Action:

Under this method if the Commercial Banks do not follow the policy of the Central Bank,
then the Central Bank has the only recourse to direct action. This method can be used to
enforce both quantitatively and qualitatively credit controls by the Central Banks. This
method is not used in isolation;

3. Moral Persuasion:

Under this method Central Bank gives advice, then request and persuasion to the Commercial
Banks to co-operate with the Central Bank is implementing its credit policies.

4. Method of Publicity:

In modern times, Central Bank in order to make their policies successful, take the course of
the medium of publicity. A policy can be effectively successful only when an effective public
opinion is created in its favour.

5. Regulation of Consumers Credit:

Under this method consumers are given credit in a little quantity and this period is fixed for
18 months; consequently credit creation expanded within the limit. This method was
originally adopted by the U.S.A. as a protective and defensive measure, there after it has been
used and adopted by various other countries.
6. Changes in the Marginal Requirements on Security Loans:

This system is mostly followed in U.S.A. Under this system, the Board of Governors of the
Federal Reserve System has been given the power to prescribe margin requirements for the
purpose of preventing an excessive use of credit for stock exchange speculation.