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Banks
Hello. Welcome back. Have you imagined a world where there are no banks present? What role do banks play in
today's world? Why are banks so important to the society and to the economy? To answer all these questions, we
will be considering what the importance of banks is, what roles they play and why we need banks in this session.
Imagine you have a business plan, a new idea where you can create a robot which can wash cars. Now, this is an
excellent idea. You come up with amazing new technology, and it's also not very costly to manufacture in terms of
compared to other competitors, but you don't have the funds to start the manufacturing plant on your own. You
don't have the access to funds to get this business plan going.
There is another person let's call him, Ravi, who has excess funds. He has saved all his life and he has now
accumulated enough wealth, which he wants to utilise by investing it wisely. If Ravi did not invest this money into
another business opportunity or another investment opportunity, he would have it in the form of cold, hard cash,
which is not earning any interest or being of no use to him or to others.
This key function of joining people who save of people who have access wealth or access funds at their disposal, to
people who have business ideas and who can use this funds to generate productive return.
This key function is performed by financial intermediaries or financial markets. In the previous sessions, we looked at
the kind of roles that financial markets play and how they connect the people who save with the people who have
business ideas and who can utilise these funds in a productive manner.
In this session, we'll be looking at banks, which are a key form of financial intermediaries.
In the example that we discussed, you have a business idea. The business idea that we were looking at was that you
wanted to manufacture a robot which can clean cars economically. Ravi had access funds. We were considering how
these excess funds from Ravi, who is in a different state, can reach you who is in New Delhi, and we mentioned that
this job of connecting Ravi the person who has access funds with you, the person who can productively use these
excess funds is performed by financial intermediaries.
Banks act as a middleman in this example between you and Ravi, irrespective of which state you are in or which
state Ravi is in. How does this work?
Ravi, who has access funds, deposits them in his bank account. This can be a savings bank account, a current account
or a term deposit account. There are multiple types of accounts that banks allow people who have access funds to
deposit them in. The bank takes this money from Ravi and then lends it to you, a business person who has a
productive idea on how to use this money, but before it lends this money to you, because the bank took this money
from Ravi. It has to ensure that the business plan you are proposing is sound. It does this through a number of
processes.
Ravi deposits money in the bank because the bank provides him with an incentive known as interest for every Rs.100
that Ravi deposits. The bank says it will give him an additional 3 or 4 rupees, whatever the rate of interest the bank
promises, and it also guarantees the safety of the money that Ravi has deposited in the bank. So now Ravi is sure
that the money he saves in the bank he deposits in the bank. He will get back if he wants it and an additional amount
called the interest.
Similarly, when you approach the bank, the bank is telling you that it will give you a loan, if your business plan is
sound, technologically feasible and commercially feasible. Why do you approach the bank and not somebody else?
Because, banks as part of an organised financial institution are required to abide by certain rules and conditions. This
also means that there are certain inbuilt protections for you, the person who's taking the loan, which might not be
available if you go outside the organised financial institutions, so you also have an incentive to approach a bank.
When the bank is giving you a loan, because it is providing you funds and taking a slight risk, the bank charges an
interest from you on the loan.
So, all these costs and a small percentage for the service that they charge are incorporated into the additional
interest amount that they charge from you.
This is why the interest that banks charge on loans is higher than the interest that banks give out on deposits.
Now, we'll look at how the funds flow from the savers to the people who spend the people who have productive
ideas with what to do with the capital.
People, who borrow money again for various needs, business firms might borrow this money to utilise it in business
activities like starting a new project, starting a new product, launching a new company, etc.
Individuals like you and me might spend it on an education loan or maybe some unfortunate incident where a family
member is in hospital and we need expenses for their care or a joyous vacation, like going on a overseas trip.
Remember, I also included foreigners in the list of people who save or who borrow money. Why would foreigners
save money in India? Are they allowed to? The answer to the second question is yes, but why maybe because India is
providing a higher rate of return than the country where they are from, or maybe because the environment in India
is safer than the country where they are from, whatever their reasons they want to save the money in India, which
according to the laws and regulations, subject to certain limitations, it's still allowed.
Similarly, foreigners are also allowed to borrow money, say experts who are working in India, a British citizen who is
working in India, hired by an Indian company or the branch office of a foreign company, who wants to purchase a car
or utilise it for some other purposes. So they can avail of a loan from banks, or they can also go to other
intermediaries.
Now, are banks and financial intermediaries the only way that borrowers are connected to savers? NO. As we
discussed in the previous session, there are two ways that money flows from savers, the lenders to the borrowers.
The first way which we discussed was the direct route where the borrowers are directly connected to the lenders,
through the financial markets. This could be in the form of private equity firms or venture capital firms, or maybe
even funds being raised directly on the stock exchange through an IPO or different other purposes.
The second route by which borrowers are connected to lenders is the indirect route where financial intermediaries
play a large part, financial intermediaries like banks. In this session, we will be focusing on banks in particular.
The last time i visited a bank branch was about 10 days ago to pick up a credit card. The bank had sent the credit
card to the communication address on their records, but since i was not present at home, it could not be delivered. I
then requested the bank to deliver it to the nearest bank branch from where i could pick it up.
Now, along with me, colleague of mine also visited the branch. We both went together. However, she was not there
to pick up a credit card. She was there to update her KYC information in the bank records. KYC stands for know your
customer. She had received a message from the bank that unless she updated her KYC information, her account
would be downgraded to a basic status.
Now this was not a scam message or a spam message. It was genuine and verified with the bank. So the purpose that
my colleague visited the bank was different from the purpose i visited the bank. I visited the bank with the intent of
obtaining my credit card, which is a kind of a loan product. She visited the bank with the intent of updating her KYC
information connected to her savings account, which is a deposit product. So, the two of us visited the bank to fulfil
two different purposes connected to two different services.
As we discussed in the flow of funds from the lenders to the borrowers, banks come under the category of financial
intermediaries, who perform the job of indirectly connecting the lenders, the people who save money with the
borrowers, the people who spend the money. The borrowers visit the branches, the banks or the branches of other
financial intermediaries to obtain loans.
The lenders go to the same branches or maybe different branches, depending on where they are present to deposit
their excess funds. This process of connecting the lenders to the borrowers is called financial intermediation. This is a
very important process in an economy and a very crucial process, and banks are possibly the biggest financial
intermediaries we have.
But why are banks important? What role do they play in the economy? The benefit that banks give the role that they
play in the economy can be categorised into three different categories: they reduce transaction costs, they enable
risk sharing and they reduce asymmetric information.
What are transaction costs? Transaction costs are any cost that are incurred for a transaction to occur. Now, while
this might seem like a simple definition, they play a very big role and are a great source of friction in the economy.
What are the different kinds of transaction costs that are possible?
First and foremost, is what is known as a search cost? Let us go back to the example where you wanted to start a
business of manufacturing a car cleaning robot. You know that you need funds, but how do you identify somebody
who can give you those funds.
To identify the appropriate person who has additional funds that they can spare that they can invest? You will have
to incur several costs. You will have to go out and search. You may have to make numerous phone calls and maybe
follow up on several people who offered you these funds.
All these costs add up and for an individual like you and me, they may turn out to be substantial costs. Not only do
search costs include literally searching for something, they also include the cost of ensuring that the other party who
we are engaging in a business is a legitimate party. How do you ensure that the person who offered you funds has
not obtained those funds illegally? Has the funds they claim that they have or is not going to take you for a ride. All
this comes under search costs.
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The second aspect of search costs is what is known as the cost of transfer of goods or services, so once you've
identified somebody who can give you the excess funds and ensure that they have a legitimate source of funds and
they have access to the funds.
Let’s say both you and this person in our example, Ravi have agreed that Ravi will give you the money to start the
factory, to start the operations. But Ravi himself would be hesitant to do it without a legally binding contract. Now,
the cost of drawing up the contract to transfer the ownership of goods or services that Ravi has, in this case the
money that he has to you, is a cost that will be incurred and shared between both you and Ravi.
Now good lawyers, people who can draw a strong agreement are not going to provide the services for free, so there
will be costs incurred there as well. Additionally, Ravi might ask for some interest on the loan that he is giving you.
You might not be accepting of the interest that Ravi is demanding, so both of you get down to negotiation and in the
time that it takes to negotiate, there will be some lost opportunity or the money could be used more productively.
So there are costs associated with negotiating as well. Finally, once Ravi has given you the loan and you have been
able to agree on a negotiated rate and also signed up an agreement. Ravi has to ensure that you are using the
money for the purposes you claim you are using, so he has to have a way of ensuring your compliance or in another
case say you don't want the entire money up front, you want only 50 percent up front with the balance over two
instalments.
Now as individuals, these costs can add up to a great amount for you and me. But since a bank is providing
standardised services, they can reduce these costs to a great extent. Let us see how?
When it comes to search costs, because the bank has access to the funds, it is able to do a better due diligence when
you approach it for a loan. You don't have to go out and search for the money. Similarly, Ravi doesn't have to go out
and search for an opportunity for investing. He just provides the bank with the money in the form of deposits, and
now, since the bank has access to the deposits, people approach the bank on their own asking for a loan.
So this reduces the search cost for both you, as well as Ravi. With respect to negotiations, because banks offer
standardised contracts with respect to loans and deposits, they are telling up front how much they will charge on a
loan as interest and how much they will give as interest to people who deposit money. This reduces the transaction
cost involving negotiations as well.
Similarly, since these contracts are standardised, the cost of drawing up legal agreements and the legal requirements
around giving loans or accepting deposits can be spread over hundreds, maybe thousands or millions of accounts.
And since a bank has greater capacity, they can ensure compliance, once you have taken the loan from the bank.
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By following up regularly with you, they can show that you are using the loan for the purposes that you claimed you
would use it for and since it's a bigger financial institution, a bigger institution than Ravi individually is, If you want to
take the loan over two or three instalments, a bank is capable of ensuring that commitment as well. And in the worst
case scenario, say you're not fulfilling the loan requirements.
Let’s assume you are not using the loan for the purposes you said you would use the loan for. The bank also has
institutional mechanisms where they can come after you legally, because these are set procedures. The cost of these
procedures also is reduced for banks. In this way, transaction costs are reduced for both the borrower, in our
example, you, and the person who is depositing money in the bank, Ravi in our example. So, banks play a crucial role
in reducing transaction costs in the economy.
A second role that banks play in the economy is that of enabling risk sharing.
What is risk sharing? So let's circle back to our example where you wanted to start a business. And Ravi had the
funds, access funds, which he can invest.
Now, if you were to borrow the money entirely from Ravi, you might also have to face the circumstances where Ravi
might need the money back earlier than when he has said he will read it at the time of entering into the loan
agreement. There is also the possibility, the risk for Ravi that your business is not successful. So he has basically given
There is a risk for Ravi that your company might feed and the risk for you that Ravi might not honour the
commitments he has made in the loan agreement. These are not the only risks which are present for both you and
Ravi, the other forms of risk as well.
Banks reduce these risks to a great extent. How do they do this? Because banks are playing the role of a financial
intermediary and Ravi is depositing the money in the bank. He does not care, or he does not know where the money
is going. All he cares about, all he wants is that in the future, if he wants to withdraw the money, he can do that.
Banks allow him to do that. But at the same time, when Ravi does withdraw his money, it does not affect the loans
that the banks have made because Ravi is not the only customer of the bank who deposited money in the bank.
Banks have access to funds through other depositors as well.
Similarly, in your case, when the bank has lent you money and in the worst case scenario where your business goes
bust, because the technology has not evolved sufficiently enough, or because there is too much competition in the
market, whatever, the reason when the business fails, the lender, the person who lent the money to the bank, Ravi,
is not at risk of losing his entire money.
This is because on behalf of lenders like Ravi, the bank has pulled all the resources together and lent you the money
and as a result, the risk that Ravi takes is reduced to a great extent.
A single bank itself might not be able to give the loan to this company like Jindal steel and power. Forget the bank,
even a millionaire would probably shy away from giving a loan to a company like Jindal steel and power. Despite the
fact, that Jindal steel and power is a reputed company and other successful history of operations. Why? Because the
millionaire is aware of the risk that he is taking, or she is taking by lending so much money to a single company.
Similarly, banks also want to share the risks. In this case, because the banks have the expertise, they are able to bring
on board, other banks or other financial institutions to share that risk. As a result, because of the institutional
mechanisms present within the banks, they are also able to fund to finance large projects, which are required for the
economy. All of us would agree that our new power plant is crucial for our economy to run smoothly and
successfully.
A millionaire might not have the capacity to bring on board other people who have funds. Other millionaires, even if
he knows other millionaires, you might have a difficult job convincing them to come on board and lend money.
Given how big a project this is and given how individually all of them would be very of the risk, but institutions like
banks because of their expertise and because they are able to diversify the risk and spread the risk across multiple
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customers and multiple people, they are able to bring on board other institutions. This is a very important function, a
very important role played by banks.
The third role that banks play, again a very important role is the role of reducing asymmetric information.
What is this symmetric information? As the name suggests, this is a case where one party has more information than
the other party about the transaction that is being undertaken. We will come back to the example of you starting the
business of manufacturing, car cleaning robots and Ravi, the lender or the investor. Now asymmetric information
can work from both sides. You might have information which Ravi does not have access to.
You know that the market is difficult. Ravi not being an expert, might not know this. You know that the technology is
not matured in yet, Ravi, again, by not being an expert, might not know this. Similarly, Ravi might have information,
which you don't have access to. Ravi knows possibly that he might need the money much before the five years he is
committing to in the agreement.
He might know that he needs the money six months from now and needs to withdraw whatever money he has given
you or needs to demand whatever money he has given you. But he is not willing to tell you that. Why? Because, he
does not want to lose out on an opportunity.
Now, asymmetric information can be categorised further into two different types. One is adverse selection and the
other is moral hazard. What is adverse selection? Adverse selection is the risk where one party in this case, you or
Ravi is choosing a wrong counterparty to partner with.
You don't know that Ravi does not have access to the money. He is merely portraying it as if he has access to the
money. And as a result, you are willing to commit to a partnership and borrow money from Ravi. This is an example
of adverse selection from your side. From Ravi's perspective, Ravi does not know that the market is very competitive
and the chances of the business succeeding are moderate at best. So that would be an example of adverse selection
from Ravi's side.
Banks reduce to this to a great extent. How do they do this? Because you are approaching the bank and Ravi is not
the only person who deposited money in the bank. If the bank comments to give you the loan over two or three
instalments, the bank has the capability to honour that commitment. So you do not have the risk of adverse
selection about access to funds.
The second risk of asymmetric information is moral hazard. What is moral hazard? Let us take a different example
his time, when I purchased car insurance; my behaviour has been documented by researchers to change. People
who don't have car insurance have been documented to be driving more carefully on the road. Why? Because if the
car has any accident or any damage is incurred to the car, they are liable to pay for the entire repairs.
On the other hand, people who have purchased car insurance, it has been shown by research that they have a
slightly increased chance of driving more riskily. The reason for this being the person who purchased this car
insurance believes that if the car does end up in an accident, the entire financial responsibility of repairing the car
goes on the insurance company. As long as this person has not driven illegally, they can get back the cost of the
repairs from the car insurance company, the company, which has provided the insurance policy.
As a result by purchasing car insurance, the holder of the insurance policy, the driver or the owner tends to behave
in a slightly more riskier fashion. The company which sold the car insurance policy has no way of ensuring that the
owner of the car who purchased the policy does not behave in a risky fashion.
This is known as the moral hazard problem where the person who has purchased the product or service is engaging
in an activity contrary to what the service is for or the product is for.
Similarly, when a bank loan is taken, there are possibility that the person who took the loan is not going to utilise the
loan for the purposes for which they claimed or is going to invest it, even though it for the purpose, for which the
loan was taken in a slightly reckless fashion, by giving higher salaries than required in the market, or by utilising it for
untested technologies. The banks can ensure that the person who took the loan, the borrower does not engage in
such activity thereby reducing the risk of moral hazard.
Now, although we discussed the several roles that banks play in the economy or word of caution over here. Because
banks provide several services, there is the possibility of a conflict of interest between the different services
provided by the bank. It is possible that banks may use the information that is provided for one service for other
purposes.
There was recently a very big case in the United States in this aspect, where a bank called Wells Fargo utilise the
information of customers and opened accounts or sold them products, which the customers did not want to
purchase. Customers who had savings banks accounts with this bank Wells Fargo, ended up with credit cards or loan
products, which they had not signed up for. It is crucial to keep an eye out for these conflicts of interest.
This is because despite the capabilities of banks, despite the strengths transaction costs and they symmetric
information are not completely eliminated. There are still some transaction costs left in the system. There is still
some asymmetric information between borrowers and banks left. This is very important to remember.
Now, that we've looked at the role of banks in economy, let's get down to the different types of banks. Can I keerthi
Pendyal go into to any bank to open an account? There is a bank, for example, called the Exim bank of India. Can I
walk into this bank to open an account? If not, why can't I do this? Which banks can I go to? What services can I as
an individual obtain?
If I start a company tomorrow, can that company obtain services in any banks present across India? What are the
different kinds of banks? And how are they classified?
In this section, we'll be looking at the different kinds of banks. Why they're classified as they're classified.
The second category is by the stake of ownership who owns the banks. So we have public sector banks or private
sector banks. Then come the corporative banks to the third category of banks.
The fourth category of banks, which we'll be looking at in this section are Regional rural banks. And finally, the
specialised banks.
We will look at each of these types of banks in detail. The first category is scheduled banks versus non-scheduled
banks. What are scheduled banks? Put simply scheduled banks are the banks whose name is included in the second
schedule of the RBI act of 1934.
As we discussed earlier, the mandate of the RBI is given by the RBI act, or this act has several schedules. And the
second schedule lists down a list of banks by name. All the banks, who his name is mentioned in this schedule, are
called a scheduled banks.
These are the three conditions that a bank has to meet to get its name included in the second schedule of the RBI
act.
What advantages would a bank have by getting its name as a scheduled bank? The first and foremost is that banks
can borrow money from the RBI at a rate, what is known as bank rate. This is in case the bank needs access to short-
term funds to overcome a crunch in capital. The banks can then approach the RBI and ask for a short-term loan,
which scheduled banks are allowed to do.
The second benefit is to something called a concept called re-discounting. The Reserve Bank of India is willing to re-
discount the bills of exchange of scheduled banks.
The third benefit and the most important benefit is that because the scheduled bank has to maintain cash reserves
with the RBI on a daily basis. This gives confidence to the public, that the bank is a sound one and the sound financial
institution and their deposits will be safe.
This also means that in case there is a bank run, in case there is a crisis, the bank can access these cash reserves to
get over this crisis.
Second category are Nationalised banks, Canara bank, central bank of India, Indian bank. All these are nationalised
banks, which are included in the second scheduled and hence are scheduled banks.
Then we have other Indian scheduled banks, including the private sector banks like ICICI bank, HDFC bank, Yes bank.
The regional rural banks, which are also listed in the second schedule of the RBI act and finally, we have some
foreign banks, which are also included there.
Now that we've discussed, what are scheduled banks? What are non-scheduled banks? Banks, whose name is not
present in the second schedule of the RBI act of 1934, are categorised as non- scheduled banks.
There is a bank in Punjab called the Capital local Area Bank Ltd. This bank's name is not present in the second
schedule of the RBI act of 1934. Therefore this bank is a non- scheduled bank.
Other examples include Bank of Baroda, Oriental Bank of Commerce, Union Bank of India, Indian bank, etc.
Automatically private sector banks would be banks where the majority shareholding more than 50 percent is held by
private individuals or by companies. Examples include ICICI bank, HDFC bank, Yes bank and Axis bank. There are
several private sector banks present in India.
The third kind of banks that we'll be looking at are co-operative banks. These are banks which are governed both by
the Banking Regulation Act and the Cooperative Societies Act as the name suggests these banks are incorporated as
a co-operative. They give out loans to members and non-members and are owned by members on the principle of
one word, one share. There are different kinds of corporate of banks present in India.
The main classification is urban corporate of banks and rural cooperative banks. Within urban corporate of banks,
they can further categorise them as Scheduled urban co-operative banks and non-scheduled urban co-operative
banks.
District central co-operative banks and State co-operative banks centralise the functions of all these PACS together
so as to minimise risk.
Co-operative banks play a very important role in the economy in that they encourage the habit of saving and
participating in the organised financial sector, among people who are traditionally unbanked, people who are in the
lower socioeconomic conditions of society.
The fourth category of banks are the Regional Rural banks. Now, Regional Rural banks are a specific type of
scheduled banks, which are started by the government to focus on the requirements of the rural population. Their
mandate is to ensure that they lend money to people in villages. People like farmers, small traders, and small
businessmen with the purpose of developing the economy of the villages of India.
The MGNREGS scheme stands for Mahatma Gandhi National Rural Employment Guarantee Scheme. This was an act
passed by the central government in early 2000’s, which ensures that people who do not have jobs have at least a
hundred days of employment in a year. The wages paid through this scheme are disbursed to people in rural India
through RRB’s.
EXIM bank of India is a very specific kind of bank called the specialised bank. What are specialised banks? Why do we
need specialised banks?
As we discussed earlier, specialised banks are banks, which focus on a specific target, specific function. They are
formed for the purpose of fulfilling this function or fulfilling this mission. They provide services focused on this
particular target function of there's only customers who fulfil the criteria laid down by the bank can avail of the
services of these banks.
The EXIM bank of India was formed in 1982 with the explicit purpose of providing financial services to exporters and
importers from India. The bank's purpose is to provide financial assistance, to allow Indian businesses to export their
goods and services overseas, or import goods and services from overseas, which will be used in their businesses.
Why do we need a specialised bank for this? When this bank was formed in 1982, many Indian businesses faced
issues in providing guarantees for payments like letters of credit or in arranging finance to ensure that they were
able to send their goods overseas.
To overcome these difficulties and to allow Indian businesses to flourish and succeed, the government of India had
formed the EXIM bank of India.
The SIDBI provides loans and financial services, financial assistance to entrepreneurs who want to start small
businesses. Again, why is it that we need to have a separate bank for providing this financial assistance? Why can't
entrepreneurs who are starting these companies or businesses approach full service banks, like state bank of India or
bank of Baroda?
Entrepreneurs, who are starting off on their own especially starting small businesses need assistance sometimes
much beyond financial assistance. It could be in the form of advisory for their businesses, consultancy, or maybe
even getting clearances for their businesses. A lot of these services like advisory are provided by SIDBI. Not only does
it provide financial assistance, it also helps entrepreneurs get on their feet once such assistance is obtained.
The third specialised bank we will be looking at is NABARD. NABARD stands for National Bank for Agricultural and
Rural Development. As the name suggests, this is the Apex bank in India, which looks at providing financial assistance
to projects that look at rural development and agricultural loans.
Along with the RBI, NABARD is also responsible for regulating rural cooperative banks and RRB’s.
Now that we've looked at three important specialised banks, the question arises: are these specialised banks
important even today? Do they have a role to play in the economy today? Let’s take the example of NABARD.
NABARD provides assistance to banks in rural India and to state governments to improve the infrastructure of rural
India, as well as to provide agricultural loans to people in villages. In the case of the current pandemic that India and
the rest of the world is going through. In 2020, several of these rural banks, state governments and corporations
owned by state governments had difficulty in obtaining financing for the projects they had undertaken.
NABARD was able to provide a special liquidity facility to these companies, to the state governments and to these
rural banks, so that they were able to overcome this shortfall in liquidity for a limited period. This special liquidity
facility allowed these companies, gave them some more time to arrange for the financing that they needed. This
shows that these specialised banks have a role to play, even in today's world.
Did you know that ICICI and IDBI started their lives as development finance institutions as specialised banks?
ICICI stands for Industrial Credit and Investment Corporation of India. This was started in 1955 as a joint venture
between the World Bank, India's public sector banks and public sector insurance companies, with the purpose of
promoting industrial investment in India.
Both these institutions have moved on to become full-service banks. ICICI obtained a banking license in 1994, under
its subsidiary ICICI bank limited. IDBI became a full-fledged commercial bank in 2004, when its name was included in
the second schedule of the RBI act of 1934.
These two institutions who started their life as development finance institutions, as specialised banks later moved on
to become full service banks where individuals, like you and me, can go and open bank accounts. Specialised banks
are not a feature that is unique to India. Even developed countries have their own specialised banks.
For example, like the EXIM bank of India, the United States has its own EXIM bank. The function of the exam bank in
the USA is similar to the EXIM bank of India that is to provide financial assistance to businesses who export and
import, goods and services. Not just providing financial assistance to US businesses, even overseas businesses,
foreign companies can take assistance from the EXIM bank of USA.
However, there are conditions put on such financial assistance by the EXIM bank of USA, where the goods and
services purchased by the borrower have to be purchased from American companies.