BANKING THEORY & PRACTICE SV DEGREE COLLEGE, ATP

UNIT-1::INTRODUCTION
ORIGIN AND DEVELOPMENT OF BANKING
The banking history is interesting and reflects evolution in trade and commerce. It also throws light
on living style, political and cultural aspects of civilized mankind. The strongest faith of people has
always been religion and God. The seat of religion and place of worship were considered safe place
for money and valuables. The history of banking begins with the first prototype banks of merchants
of the ancient world, which made grain loans to farmers and traders who carried goods between
cities. This began around 2000 BC in Assyria and Babylonia. In olden times people deposited their
money and valuables at temples, as they are the safest place available at that time. The practice
of storing precious metals at safe places and loaning money was prevalent in ancient Rome.

However modern Banking is of recent origin. The development of banking from the traditional
lines to the modern structure passes through Merchant bankers, Goldsmiths, Money lenders and
Private banks. Merchant Bankers were originally traders in goods. Gradually they started to
finance trade and then become bankers. Goldsmiths are considered as the men of honesty, integrity
and reliability. They provided strong iron safe for keeping valuables and money. They issued
deposit receipts (Promissory notes) to people when they deposit money and valuables with them.
The goldsmith paid interest on these deposits. Apart from accepting deposits, Goldsmiths began to
lend a part of money deposited with them. Then they became bankers who perform both the basic
banking functions such as accepting deposit and lending money. Money lenders were gradually
replaced by private banks. Private banks were established in a more organised manner. The
growth of Joint stock commercial banking was started only after the enactment of Banking
Act 1833 in England.

India has a long history of financial intermediation. The first bank in India to be set up on modern
lines was in 1770 by a British Agency House. The earliest but short-lived attempt to establish a
central bank was in 1773. India was also a forerunner in terms of development of financial
markets.

In the beginning of 18th century, British East India Company launched a few commercial banks. Bank
of Hindustan(1770) was the first Indian bank established in India. Later on, the East India
Company started three presidency banks, Bank of Bengal(1806), Bank of Bombay(1840) and
Bank of Madras(1843) These bank were given the right to issue notes in their respective regions.
Allahabad bank was established in 1865 and Alliance Bank in 1875. The first bank of limited liability
managed by Indians was Oudh Commercial Bank founded in 1881. Subsequently, the Punjab
National Bank was established in 1894. In the Beginning of the 20th century, Swadeshi movement
encouraged Indian entrepreneurs to start many new banks in India. Another landmark in the history
of Indian banking was the formation of Imperial bank of India in 1921 by amalgamating 3
presidency banks It is the Imperial Bank which performed some central banking functions in India.
A number of banks failed during the first half of the 20th Century. It affected the people’s belief
and faith in Banks.

By independence, India had a fairly well developed commercial banking system in existence.
In 1951, there were 566 private commercial banks in India with 4,151 branches, the overwhelming
majority of which were confined to larger towns and cities. Savings in the form of bank deposits
accounted for less that 1 per cent of national income, forming around 12 per cent of the estimated
saving of the household sector. The Reserve Bank of India (RBI) was originally established in 1935 by

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an Act promulgated by the Government of India, but as a shareholder institution like the Bank of
England. After India's independence, in the context of the need for close integration between its
policies and those of the Government, the Reserve Bank became a state - owned institution from
January 1, 1949. It was during this year that the Banking Regulation Act was enacted to provide a
framework for regulation and supervision of commercial banking activity.

By independence, India had a fairly well developed commercial banking system in existence.
Reserve bank of India was nationalized in the year 1949. The enactment of the Banking Companies
Act 1949 (Later it was renamed as Banking Regulation Act) was a bold step in the history of banking
in India. In 1955, Imperial Bank of India was nationalized and renamed as State bank of India (SBI).
The SBI started number of branches in urban and rural areas of the country.

In 1967, Govt introduced the concept of social control on banking sector. Nationalization of 14
commercial banks in 1969 was a revolution in the history of banking in India. Six more
commercial banks were nationalized in 1980. Other landmarks in the history of Indian banking
were the establishment of National Bank for Agricultural and Rural Development (1988), merger of
New Bank of India with Punjab National Bank (1993), merger of State Bank of Sourashtra with SBI
(2008) and the merger of State Bank of Indore with SBI (2010). At present, there are 27 Public sector
banks, 20 private sector banks, 30 Foreign banks and 82 Regional Rural Banks in India.

Structure of Banking Sector in India

Reserve Bank of India is the Central Bank of our country. It was established on 1st April 1935 under
the RBI Act of 1934. It holds the apex position in the banking structure. RBI performs various
developmental and promotional functions. As of now 26 public sector banks in India out of which 21
are Nationalised banks and 5 are State Bank of India and its associate banks. There are total 92
commercial banks in India. Public sector banks hold near about 75% of the total bank deposits in
India.

Indian Banks are classified into commercial banks and Co-operative banks. Commercial banks
comprise:
(1) Schedule Commercial Banks (SCBs) and non-scheduled commercial banks. SCBs are further
classified into private, public, foreign banks and Regional Rural Banks (RRBs)
(2) Co-operative banks which include urban and rural Co-operative banks.
The Indian banking industry has its foundations in the 18th century, and has had a varied
evolutionary experience since then. The initial banks in India were primarily traders’ banks engaged
only in financing activities. Banking industry in the pre-independence era developed with the
Presidency Banks, which were transformed into the Imperial Bank of India and subsequently into the
State Bank of India.

The initial days of the industry saw a majority private ownership and a highly volatile work
environment. Major strides towards public ownership and accountability were made
with Nationalisation in 1969 and 1980 which transformed the face of banking in India. The
industry in recent times has recognised the importance of private and foreign players in a competitive
scenario and has moved towards greater liberalisation.

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BANKING THEORY & PRACTICE SV DEGREE COLLEGE, ATP

Structure of Indian Banking System is as Follows:

In the evolution of this strategic industry spanning over two centuries, immense developments have
been made in terms of the regulations governing it, the ownership structure, products and services
offered and the technology deployed. The entire evolution can be classified into four distinct phases.
1. Phase I - Pre-Nationalisation Phase (prior to 1955)
2. Phase II -  Era of Nationalisation and Consolidation (1955-1990)
3. Phase III -  Introduction of Indian Financial & Banking Sector Reforms and Partial Liberalisation
(1990-2004)
4. Phase IV -  Period of Increased Liberalisation (2004 onwards)

Organisational Structure

Reserve Bank of India:

Reserve Bank of India is the Central Bank of our country. It was established on 1 st April 1935
accordance with the provisions of the Reserve Bank of India Act, 1934. It holds the apex position in
the banking structure. RBI performs various developmental and promotional functions.
It has given wide powers to supervise and control the banking structure. It occupies the pivotal
position in the monetary and banking structure of the country. In many countries central bank is known
by different names.
For example, Federal Reserve Bank of U.S.A, Bank of England in U.K. and Reserve Bank of India in
India. Central bank is known as a banker’s bank. They have the authority to formulate and implement
monetary and credit policies. It is owned by the government of a country and has the monopoly power
of issuing notes.

1. Commercial Banks:
Commercial bank is an institution that accepts deposit, makes business loans and offer related services
to various like accepting deposits and lending loans and advances to general customers and business
man.

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BANKING THEORY & PRACTICE SV DEGREE COLLEGE, ATP

These institutions run to make profit. They cater to the financial requirements of industries and various
sectors like agriculture, rural development, etc. it is a profit making institution owned by government
or private of both.
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, they have
to satisfy the RBI that their affairs are carried out in the interest of their depositors.
All commercial banks (Indian and foreign), regional rural banks, and state cooperative banks are
scheduled banks.
Non-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.

Commercial bank includes:

public sector, private sector, foreign banks and regional rural banks

Public Sector Banks:

Currently there are 21 Nationalised banks in India. The public sector accounts for 75 percent of total
banking business in India and State Bank of India is the largest commercial bank in terms of volume of
all commercial banks.
Now from April 1, 2017 all the 5 associate banks of SBI and Bhartiya Mahila Bank are merged with
State Bank of India. After this merger now SBI is counted among the top 50 largest banks of the
world.
Few Nationalised Banks in India are

1. Allahabad Bank 11. Indian Overseas Bank

2. Andhra Bank 12. Oriental Bank of Commerce
3. Bank of India 13. Punjab & Sindh Bank
4. Bank of Baroda 14. Punjab National Bank
5. Bank of Maharashtra 15. State Bank of India
6. Canara Bank 16. Syndicate Bank
7. Central Bank of India 17. UCO Bank
8. Corporation Bank 18. Union Bank of India
9. Dena Bank 19. United Bank of India
10. Indian Bank 20. Vijaya Bank

Private Sector Banks:  

The private-sector banks in India represent part of the Indian banking sector that is made up of
both private and public sector banks. The "private-sector banks" are banks where greater parts of
stake or equity are held by the private shareholders and not by government.

Few Private Sector Banks is:

ICICI Bank KOTAK MAHINDRA Bank YES Bank

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BANKING THEORY & PRACTICE SV DEGREE COLLEGE, ATP

Foreign Banks:
A foreign bank with the obligation of following the regulations of both its home and its host countries.
Loan limits for these banks are based on the capital of the parent bank, thus allowing foreign banks to
provide more loans than other subsidiary banks.
Foreign banks are those banks, which have their head offices abroad. CITI bank, HSBC, Standard
Chartered etc. are the examples of foreign bank in India. Currently India has 36 foreign banks.
Regional Rural Bank (RRB):
The government of India set up Regional Rural Banks (RRBs) on October 2, 1975. The banks provide
credit to the weaker sections of the rural areas, particularly the small and marginal farmers, agricultural
labourers, and small entrepreneurs. There are 82 RRBs in the country. NABARD holds the apex
position in the agricultural and rural development. List of some RRBs is given below:

2. Co-operative Bank:
Co-operative bank was set up by passing a co-operative act in 1904. They are organised and managed
on the principal of co-operation and mutual help. The main objective of co-operative bank is to
provide rural credit.
The cooperative banks in India play an important role even today in rural co-operative financing. The
enactment of Co-operative Credit Societies Act, 1904, however, gave the real impetus to the
movement. The Cooperative Credit Societies Act, 1904 was amended in 1912, with a view to broad
basing it to enable organisation of non-credit societies.
Name of some co-operative banks India are:
1. Andhra Pradesh State Co-operative Bank Ltd
2. The Bihar State Co- operative Bank Ltd.
3. Chhatisgarh Rajya Sahakari Bank Maryadit
4. The Gujarat State Co-operative Bank Ltd.
5. Haryana Rajya Sahakari Bank Ltd.

Three tier structures exist in the cooperative banking:

i. State cooperative bank at the apex level.
ii. Central cooperative banks at the district level.
iii. Primary cooperative banks and the base or local level.

Functions of Commercial Banks

An institution that provides services like accepting the deposits, providing business loans, and offering
basic investment products is known as the commercial banks. It is largely a division of a large bank which
deals with loan and deposit services provided to large and small size businesses. Thus, there are many
functions of commercial banks in India. Mainly there are two functions, primary and secondary. 

1) Primary Functions:

The commercial banks carry out different functions, the essential ones others as follows:
(a) Accepting Deposits:
The banks receive deposits from its customers by initiating them to open current accounts, savings
accounts, fixed accounts, etc.
(b) Providing Loans and Advances:

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They also offer long-term loans, demand loans, short-term loans and many others to fulfil the
customer’s financial needs.
(c) Credit Creation:
Investing the collected sum in the profitable ventures, equities, advancing loans to the business entities,
etc. leads to a generation of profits for the banks.

2) Secondary Functions:
Refer to crucial functions of commercial banks. The secondary functions can be classified under three
heads, namely, agency functions, general utility functions, and other functions.

These functions are explained as follows:

(a) Agency Functions:
Implies that commercial banks act as agents of customers by performing various functions, which are
as follows:
(i) Collecting Cheques:
Refer to one of the important functions of commercial banks. The banks collect Cheques and bills of
exchange on the behalf of their customers through clearing house facilities provided by the central
bank.
(ii) Collecting Income:
Constitute another major function of commercial banks. Commercial banks collect dividends, pension,
salaries, rents, and interests on investments on behalf of their customers. A credit voucher is sent to
customers for information when any income is collected by the bank.
(iii) Paying Expenses:
Implies that commercial banks make the payments of various obligations of customers, such as
telephone bills, insurance premium, school fees, and rents. Similar to credit voucher, a debit voucher is
sent to customers for information when expenses are paid by the bank.

(b) General Utility Functions:

(i) Providing Locker Facilities:

Implies that commercial banks provide locker facilities to its customers for safe keeping of jewellery,
shares, debentures, and other valuable items. This minimizes the risk of loss due to theft at homes.
(ii) Issuing Traveler’s Cheques:
Implies that banks issue traveler’s Cheques to individuals for traveling outside the country. Traveler’s
Cheques are the safe and easy way to protect money while traveling.
(iii) Dealing in Foreign Exchange:
Implies that commercial banks help in providing foreign exchange to businessmen dealing in exports
and imports. However, commercial banks need to take the permission of the central bank for dealing in
foreign exchange.
(iv) Transferring Funds:

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BANKING THEORY & PRACTICE SV DEGREE COLLEGE, ATP

Refers to transferring of funds from one bank to another. Funds are transferred by means of draft,
telephonic transfer, and electronic transfer.
(v) Electronic Banking:
Include services, such as debit cards, credit cards, and Internet banking.

Important Role of Commercial Banks

Besides performing the usual commercial banking functions, banks in developing countries play an
effective role in their economic development. The majority of people in such countries are poor,
unemployed and engaged in traditional agriculture. The commercial banks helps in overcoming the
obstacles and promoting economic development. The role of a commercial bank in a developing
country is as under:

1. Mobilising Saving for Capital Formation:

The commercial banks help in mobilising savings through network of branch banking. People in
developing countries have low incomes but the banks induce them to save by introducing variety of
deposit schemes to suit the needs of individual depositors. They also mobilise idle savings of the few
rich. By mobilising savings, the banks channelise them into productive investments. Thus they help in
the capital formation of a developing country.

2. Financing Industry:
The commercial banks finance the industrial sector in a number of ways. They provide short-term,
medium-term and long-term loans to industry. In India they provide short-term loans. Income of the
Latin American countries like Guatemala, they advance medium-term loans for one to three years. But
in Korea, the commercial banks also advance long-term loans to industry.
In India, the commercial banks undertake short-term and medium-term financing of small scale
industries, and also provide hire- purchase finance. Besides, they underwrite the shares and debentures
of large scale industries. Thus they not only provide finance for industry but also help in developing
the capital market which is undeveloped in such countries.
3. Financing Trade:
The commercial banks help in financing both internal and external trade. The banks provide loans to
retailers and wholesalers to stock goods in which they deal. They also help in the movement of goods
from one place to another by providing all types of facilities such as discounting and accepting bills of
exchange, providing overdraft facilities, issuing drafts, etc. Moreover, they finance both exports and
imports of developing countries by providing foreign exchange facilities to importers and exporters of
goods.
4. Financing Agriculture:
The commercial banks help the large agricultural sector in developing countries in a number of ways.
They provide loans to traders in agricultural commodities. They open a network of branches in rural
areas to provide agricultural credit. They provide finance directly to agriculturists for the marketing of
their produce, for the modernisation and mechanisation of their farms, for providing irrigation
facilities, for developing land, etc.

They also provide financial assistance for animal husbandry, dairy farming, sheep breeding, poultry
farming, pisciculture and horticulture. The small and marginal farmers and landless agricultural
workers, artisans and petty shopkeepers in rural areas are provided financial assistance through the
regional rural banks in India. These regional rural banks operate under a commercial bank. Thus the
commercial banks meet the credit requirements of all types of rural people.

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5. Financing Consumer Activities:

People in underdeveloped countries being poor and having low incomes do not possess sufficient
financial resources to buy durable consumer goods. The commercial banks advance loans to
consumers for the purchase of such items as houses, scooters, fans, refrigerators, etc. In this way, they
also help in raising the standard of living of the people in developing countries by providing loans for
consumptive activities.

6. Financing Employment Generating Activities:

The commercial banks finance employment generating activities in developing countries. They
provide loans for the education of young person’s studying in engineering, medical and other
vocational institutes of higher learning. They advance loans to young entrepreneurs, medical and
engineering graduates, and other technically trained persons in establishing their own business. Such
loan facilities are being provided by a number of commercial banks in India. Thus the banks not only
help inhuman capital formation but also in increasing entrepreneurial activities in developing
countries.

7. Help in Monetary Policy:

The commercial banks help the economic development of a country by faithfully following the
monetary policy of the central bank. In fact, the central bank depends upon the commercial banks for
the success of its policy of monetary management in keeping with requirements of a developing
economy.
Thus the commercial banks contribute much to the growth of a developing economy by granting loans
to agriculture, trade and industry, by helping in physical and human capital formation and by following
the monetary policy of the country.

Reserve Bank of India:

Reserve Bank of India is the Central Bank of our country. It was established on 1 st April 1935
accordance with the provisions of the Reserve Bank of India Act, 1934. It holds the apex position in
the banking structure. RBI performs various developmental and promotional functions.
It has given wide powers to supervise and control the banking structure. It occupies the pivotal
position in the monetary and banking structure of the country.
The central bank is an apex body which aims at controlling and managing the banking system
operations along with regulating the money supply for the economic stability of a country.
Features of Central Bank
To clearly understand what a central bank is, let us go through its characteristics, given below:

 Monopoly: The central bank is only one in every country, enjoying the monopolistic rights and
authorities.
 Apex Body: It is the supreme body of the country’s banking system regulating the other banks
and supporting the whole banking structure of the nation.
 Government-Owned: The central bank is strictly owned by the government and thus belong to
the public sector.
 Legal Entity: It is a legal entity established under the provisions of a particular act of the
government, holding a special significance and rights.

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 Banker of Other Banks and Government: The central bank provides the banking services
such as deposits and withdrawals to the various commercial banks and government.
 Monetary Authority: It keeps complete control over the flow of money within a country
through the formulation of various monetary policies, rules and regulations.
 Note Printing Authority: The central bank is the only bank of the country which has the
authority of printing new notes except coins and Re. 1 note.
 Nation’s Gold and Foreign Exchange Reserve: This bank is also considered to be the
custodian of the country’s foreign exchange as well as gold reserve keeping these assets under its
supervision.
 The backbone of Banking System: Being an apex body, the central bank acts as the backbone
of a country’s banking system, performing all the crucial financial functions. Such as framing the
banking rules and regulations, circulation of currency in the market and advising the government
on economic issues.
 Clearing House: The central bank can be seen as a clearinghouse since it initiates the
settlement of bills, cheques and other financial instruments among the two or more banks to ensure
smooth functioning of the banking system in a country.

Functions of Central Bank

 Currency: The central bank has the authority of printing the notes of all denominations except for
Re.1 notes and the coins.
 Custodian of Cash Reserve: All the banks have accounts with the central bank where they can
maintain some cash reserve for future needs.
 Custodian of Foreign Exchange Reserve: This bank is responsible for managing, controlling and
exchange of the foreign currency and gold in a country, by maintaining the foreign exchange
reserve to keep the exchange rates stable.
 Clearing House: The central bank acts as a mediator between the two or more The central bank
holds many responsibilities and authorities which defines its services. These are as follows:
 The controller of Money Supply and Credit: The primary function of the central bank is to
control the supply of money and the flow of credit in the market. It is facilitated through
quantitative instruments (bank rates, cash reserve ratio, statutory liquidity ratio and open market
operations) and qualitative instruments, i.e. fluctuating the rate of interest for loans.
 Printing commercial banks to settle their accounts at the time loss and manage the transactions
between the commercial banks.
 Lender of the Last Resort: One of the essential functions of the central bank is to provide loans
to commercial banks at the time of emergency, loss and insolvency.
 Banking Services to Banks and Government: This bank provides all the general banking
services like accepting deposits and sanctioning loans to the other banks and the government.
 Issuing Government Bonds: The central bank issues various government bonds to generate
funds, encourage public deposits and investments in the country.
 Formulates Banking Rules and Regulations: This bank performs various regulatory functions
like licensing banks, framing banking norms and policies, preparing a judicial mechanism for debt
recovery by banks, monitoring the banking operations, etc. The central bank even practices moral
suasion for making the commercial banks to abide by the policies so framed.
 Financial Agent and Advisor to the Government:  The central bank acts as a financial advisor
to the government by providing an expert opinion at the time economic crisis, fiscal deficit, and
advancing loans to other countries. At the same time, it also acts as an agent by representing the
country and the government in international conferences and meetings, along with issuing the
government bonds and securities on behalf of the government.

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BANKING THEORY & PRACTICE SV DEGREE COLLEGE, ATP

CENTRAL BANKING VS COMMERCIAL BANKING

BASIS FOR CENTRAL BANK COMMERCIAL BANK

COMPARISON
Meaning The bank which looks after the monetary The establishment, which provides
system of the country is known as banking services to the public is
Central Bank. known as Commercial Bank.
What is it? It is a banker to the banks and the It is the banker to the citizens of the
government of the country. nation.
Governing Reserve Bank of India Act, 1934. Banking Regulation Act, 1949.
Statute

Statute
Ownership Public Public and Private
Profit motive It does not exist for making profit for its It exist for making profit for its
owners owners.
Monetary It is the supreme monetary authority No such authority for commercial
Authority with wide powers. banks.
Objective Public welfare and economic Earning Profits
development.
Money supply Ultimate source of money supply in the No such function is performed by it.
economy.
Right to print Yes No
and issue
currency notes
Deals with Banks and Governments General Public

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