Banking History & Introduction

Dr. S. A. Siddiqui
Assistant Professor- Finance
History of Indian Banking
The word, ‘Bank’ is said to be derived from French word “Bancus” or “Banque”, i.e., a bench. It is
believed that the early bankers, the Jews of Lombardy, transacted their business on benches in the
marketplace. Others believe that it is derived from German word “Back” meaning a Joint Stock Fund.
The modern banking system began with the opening of Bank of England in 1694. Bank of Hindustan
was the first bank to be established in India, in 1770. The earliest institutions that undertook banking
business under the British regime were agency houses which carried on banking business in addition to
their trading activities. Most of these agency houses were closed down during 1929-32.
Three Presidency banks known as Bank of Bengal, Bank of Bombay and Bank of Madras were
opened in 1809, 1840 and 1843 respectively at Calcutta, Bombay and Madras. These were later merged
into the Imperial Bank of India in 1919 following a banking crisis.
The first bank of limited liability managed by Indians was the Oudh Commercial Bank started in 1881.
Earlier between 1865 and 1870, only one bank, the Allahabad Bank Ltd., was established. Subsequently,
the Punjab National Bank began in 1894 with its office in Lahore (now in Pakistan).
The Swadeshi movement, which began in 1906, prompted formation of a number of commercial banks
such as the Peoples Bank of India Ltd., the Central Bank of India, the Indian Bank Ltd. and the Bank of
Baroda Ltd. A series of banking crises between 1913-1917 witnessed the failure of 588 banks.
The Banking Companies (Inspection Ordinance) came in January, 1946 and the Banking Companies
(Restriction of Branches) Act was passed in February, 1946. The Banking Companies Act was passed in
February 1946, which was later amended to be known as the Banking Regulation Act,1949.
Meanwhile, the RBI Act 1934 was passed and the Reserve Bank of India became the first central bank of the
country w.e.f. 01.04.1935, it took over the central banking activities from the Imperial Bank of India. The
RBI was nationalized on 1.1.1949.
The Imperial Bank of India was partially nationalized to form the State Bank of India in 1955. In 1959,
subsidiaries of the SBI namely, State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of
Indore, State Bank of Mysore, State Bank of Patiala, State Bank of Saurashtra and State Bank of Travancore
were established.
On July 19th, 1969, the Government of India took over ownership and control of 14 major banks in the
country with deposits exceeding INR 50 crore each. Again on 15th April, 1980, six more banks with total
time and demand liabilities exceeding INR 200 crores were nationalised. In 1993, one of the nationalised
banks namely, New Bank of India was merged with another nationalised bank, i.e. Punjab National Bank.
 Recent Developments
The Punjab National Bank combines the Oriental Bank of Commerce (OBC) and the United Bank of India
(UBI) (PNB). As a result of this merger, the PNB will now be India’s second-largest public sector bank in
terms of branch network, after the State Bank of India. There will be 11,437 outlets, and the PNB’s overall
business will be Rs. 17.95 lakh crore.
Canara Bank and Syndicate Bank are combined. Canara Bank will become India’s fourth-
largest public sector bank after this merger. With a branch strength of 10,342, Canara’s overall company will
be worth 15.20 lac crore. Thanks to network overlap, this integration would lower operating costs. Since
these two banks have identical work cultures, a seamless integration should be possible.
Union Bank of India merges Andhra Bank and Corporation Bank. Union Bank of India will
become the fifth-largest public sector bank merger in India. This acquisition has the potential to raise the
business of the post-merger bank by 2-4.5 times. Union Bank of India’s gross business will be Rs. 14.59 lac
crore after the merger, with a total of 9,609 branches.
The Indian bank will be combined with Allahabad Bank in the fourth merger. Allahabad Bank will become
India’s seventh-largest public sector bank after the merger. The overall company of Allahabad bank after the
merger will be Rs. 8.08 lac crore, with 6,104 branches. As a result of the integration of the two banks, the
size of their company will double, increasing their global competitiveness.

Vijaya Bank and Dena Bank were merged with Bank of Baroda with effect from April 1, 2019. The
customers of BoB’s will now have access to 8,248 domestic branches and around 10,318 ATMs across India.

State Bank of India (SBI) was merged with Bharatiya Mahila Bank and its associate banks in the year 2017.
Its Combined Domestic Branches now total up to 24,000 approx.

The merger of HDFC into HDFC Bank was announced on 4th April 2022. In terms of market capitalisation,
this merger will lead to making it the third-largest entity in India.
Principles of Banking
Safety and Soundness: Banks must prioritize the safety of their customers' deposits

and investments, as well as maintain the overall financial soundness of the institution.

This involves establishing risk management processes, adequate capital reserves, and

prudent lending practices to minimize the possibility of insolvency or financial

distress.
Liquidity Management: Banks should maintain sufficient liquidity to meet

depositors' withdrawal demands and other financial obligations. Proper liquidity

management involves holding a reasonable portion of liquid assets relative to

liabilities and having access to funding sources during times of stress.

Capital Adequacy: Banks must maintain adequate capital levels to absorb potential

losses and provide a cushion against unexpected economic downturns or market

fluctuations. Regulatory authorities set minimum capital requirements based on the

risks a bank undertakes, such as credit risk, market risk, and operational risk.
Prudent Lending and Credit Evaluation: Banks should engage in responsible

lending practices, ensuring that loans are extended to creditworthy borrowers who

have the capacity to repay. Thorough credit evaluation processes, risk assessments,

and ongoing monitoring of loans are essential to mitigate credit risk.

Customer Confidentiality: Banks are required to maintain strict confidentiality

regarding their customers' financial information and transactions. Client data should

only be disclosed when authorized by the customer or when required by law.

Transparency and Disclosure: Banks should provide clear and comprehensive

information to their customers regarding the terms and conditions of products and

services offered. Transparent communication helps customers make informed

decisions and builds trust in the banking system.

Regulatory Compliance: Banks must comply with applicable laws, regulations, and

industry standards. Adhering to these guidelines helps prevent misconduct, protect

consumers, and maintain financial stability.

Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT):

Banks must implement robust AML and CFT measures to prevent their services from

being used for illicit activities, such as money laundering and terrorist financing.
Diversification of Risk: Banks should diversify their lending and investment

portfolios to avoid excessive exposure to specific industries or sectors. A diversified

approach helps reduce the impact of localized economic downturns.

Social and Environmental Responsibility: Banks are increasingly expected to

consider the social and environmental impact of their activities. Emphasizing

sustainable practices and responsible lending supports the long-term well-being of

society and the environment.

Innovation and Technology: Banks should embrace technological advancements to

enhance efficiency, security, and customer experience. However, they must also

carefully manage the risks associated with digital banking and cybersecurity.

Corporate Governance: Effective corporate governance is essential for ensuring

that banks are managed and controlled responsibly. This includes establishing a clear

organizational structure, defining roles and responsibilities, and fostering a culture of

integrity and accountability.

Basic Concepts & Need for Banking
A bank is known as a financial institution responsible for accepting deposits from the
public and creates a demand deposit while simultaneously providing loans to its
borrowers. Banks can perform these lending activities either directly or through capital
markets.

The purpose of banking systems is to give security and confidence to the economy. A
banking system operates in line with managing the flow of money between people and
businesses.
Deposits: Deposits are the primary source of funds for banks. Customers deposit

their money with the bank, which creates a liability for the bank to repay the

deposited amount on demand or after a specified period. There are different types of

deposits, including savings accounts, current accounts, fixed deposits, and

certificates of deposit.
Lending: Banks lend a substantial portion of the deposited funds to individuals,

businesses, and governments. They earn interest on these loans, which forms a

significant part of their revenue. Lending allows banks to support economic

activities and foster growth by providing funds to borrowers for various purposes,

such as purchasing homes, financing businesses, or funding infrastructure projects.

Interest: Interest is the cost of borrowing money or the return on deposited

funds. When a bank lends money to borrowers, they charge interest on the loan

amount. Conversely, when customers deposit money in their accounts, the bank

pays them interest on their deposits. The difference between the interest paid on

deposits and the interest earned from loans contributes to the bank's profit.
Assets and Liabilities: In banking, assets are the resources that the bank owns,

including cash, loans, investments, and properties. Liabilities, on the other hand,

represent the bank's obligations to its customers and other creditors, such as

deposits and borrowings. The difference between a bank's assets and liabilities is its

net worth or shareholders' equity.

Reserves: Banks are required to maintain a certain percentage of their deposits as

reserves with the central bank. These reserves act as a safeguard to ensure that

banks can meet their customers' withdrawal demands and other financial

obligations. Central banks use reserve requirements as a tool to regulate the

money supply and control inflation.

Credit Creation: One of the unique functions of banks is their ability to create credit.

When a bank receives deposits, it is required to keep only a fraction of those deposits

as reserves. The rest can be lent out to borrowers, thereby creating new money in the

form of loans. This process of credit creation contributes to economic growth and

expansion.
Payment Services: Banks facilitate various payment services, including issuing

checks, providing debit and credit cards, and enabling electronic fund transfers.

These services make transactions more convenient for customers and businesses,

supporting the smooth functioning of the economy.

Credit Risk: Banks face credit risk when borrowers fail to repay their loans or obligations.

To mitigate this risk, banks assess the creditworthiness of borrowers before granting loans

and continuously monitor the credit quality of their loan portfolio.

Risk Management: Banks manage various types of risks, including credit risk (risk of

borrower default), market risk (exposure to fluctuations in interest rates and financial

markets), operational risk (risks associated with internal processes and systems), and

liquidity risk (ability to meet short-term obligations).

Profit and Loss Management: Banks aim to generate profits by earning more interest

on loans and investments than they pay in interest on deposits and other liabilities. At

the same time, they must carefully manage their expenses and risk exposure to maintain

profitability.

Financial Intermediation: Banks act as intermediaries between those who have excess

funds (depositors) and those who need funds (borrowers). They channel funds from

savers to investors, thereby promoting efficient allocation of resources in the economy.

Banking Products and Services: Banks offer a wide range of products and

services to meet the diverse needs of their customers. These may include savings

accounts, checking accounts, loans, mortgages, investment advisory services,

insurance products, and more.

Banking Regulations: Banks operate under strict regulatory frameworks

imposed by government authorities and central banks. Regulations are designed

to ensure financial stability, protect depositors' interests, and maintain the

integrity of the banking system.

 Types of Banks in India

Central Bank
The Reserve Bank of India (RBI) is the central bank of the country.
It acts as the apex body for monitoring and regulating other banks and financial
institutions.
It also acts as a banker to the government.
RBI plays a key role in laying down the statutory liquidity ratio, cash reserve ratio,
reverse repo rate, and repo rate.
Commercial Bank
It performs the functions for the general public with respect to accepting deposits and/
or extending loans.
Such banks use the loans as investments with the aim to earn profits.
Some of the commercial banks in the country are HDFC Bank, State Bank of India,
United Bank of India, etc.
Specialized Bank
These banks are formed with the sole purpose of catering to a particular industry or
sector.
They may focus on import and export or provide financial services to specific
sectors of the country.
The EXIM Bank is the best example of a specialized bank.
Cooperative Bank
These banks are established under the State Cooperative Societies Act.
They provide easy credit to the members of the cooperative banks.
One of the basic activities of the cooperative banks is to provide financial resources
to the underprivileged population.
New India Cooperative Bank Limited, Ahmedabad Mercantile Cooperative Bank, etc.
are the examples of cooperative banks in India.
 Commercial Banks in India
Public Sector Banks
Commercial banks in which the government holds majority of the shares in the bank
(more than 50%) are the public sector banks.
Punjab National Bank, Canara Bank, Bank of Baroda, etc. are the examples of public
sector banks in India.
Private Sector Banks
Commercial banks in which individual shareholders possess higher equity stakes are
called private sector banks.
The functions and activities of these banks are similar to that of public sector banks.
A few aspects like the charges imposed, and duration and description of the services
of a private sector bank is different from that of public sector banks.
Axis Bank, ICICI Bank, HDFC Bank, etc. are the most eminent private sector banks
in India.
A payments bank is like any other bank, but operating on a smaller scale without
involving any credit risk.
In simple words, it can carry out most banking operations but can’t advance loans or
issue credit cards.
It can accept demand deposits (up to Rs 1 lakh), offer remittance services, mobile
payments/transfers/purchases and other banking services like ATM/debit cards, net
banking and third party fund transfers.
India Post, Paytm payment bank etc.
Small Finance Banks

The small finance banks shall primarily undertake the basic banking functions of accepting

deposits and lending to the small business units, micro and small industries, marginal

farmers, and unorganized sector.

Loans and advances less than or equal to INR 25 lakhs, must constitute a minimum of 50%

of the loan portfolio.

These banks must have 25% of its branches set up in unbanked parts of the country.

Janalakshmi Small Finance Bank, Ujjivan Small Finance Bank, Equitas Small Finance

Bank are some of the small finance banks in the country.

Regional Rural Banks

are Indian Scheduled Commercial Banks ( Government Banks) operating at regional level

in different states of India.

These banks have quite specific mandates like providing loans to small farmers and

marginal workers, agricultural labourers, small entrepreneurs, craftsmen, etc.

Limited to agriculture finance, small sector loans, craftsmen, artisans, and other small

sectors.

Some of the Regional Rural Banks in India are Pragathi Krishna Gramin Bank, Kerala

Gramin Bank, and so on.

Need for Banking
Safekeeping of Funds: Banks provide a secure and reliable place for individuals,

businesses, and governments to deposit their funds. Deposits in banks are protected and

insured, reducing the risk of loss due to theft or accidents.

Facilitation of Transactions: Banks act as intermediaries in financial transactions.

They enable the smooth transfer of money between individuals and businesses, making

it convenient to pay for goods and services, settle debts, and conduct business across

distances.
Payment Services: Banks offer a variety of payment services, such as checks, debit

cards, credit cards, and electronic fund transfers, making it easier for people to make

payments and manage their finances.

Credit and Lending: Banks provide loans and credit facilities to individuals and

businesses, supporting investment, entrepreneurship, and economic growth. Access to

credit allows individuals to buy homes, cars, and other essential goods, while businesses

can expand their operations and create job opportunities.

Savings and Investment: Banks encourage savings by offering interest on deposits,

providing individuals with a safe way to store their money while earning a return. They

also offer investment products, allowing people to grow their wealth and plan for the

future.

Financial Intermediation: Banks act as intermediaries between those who have excess

funds (savers) and those who need funds (borrowers). This process, known as financial

intermediation, channels savings into productive investments, stimulating economic

activity and growth.

Risk Management: Banks play a crucial role in managing financial risks. They assess

creditworthiness before providing loans, diversify their portfolios to reduce risk, and

hold reserves to handle unforeseen financial challenges.

Monetary Policy Transmission: Central banks, which regulate the banking sector, use

monetary policy tools to influence the overall economy. By adjusting interest rates and

money supply, they aim to control inflation, encourage investment, and stabilize the

economy.
Foreign Trade and Exchange: Banks facilitate international trade by offering trade

finance services, foreign exchange transactions, and letters of credit. These services are

essential for businesses engaging in cross-border transactions.

Financial Inclusion: Banking promotes financial inclusion by providing access to

financial services to all segments of society, including those who were previously

underserved or excluded. This allows marginalized populations to participate in the

formal economy and improve their financial well-being.

Economic Stability: A well-functioning banking system contributes to overall

economic stability. It helps absorb economic shocks, supports businesses during

downturns, and fosters confidence in the financial system.

Wealth Distribution: Banking services help redistribute wealth by allocating savings to

productive investments, which can create jobs and income opportunities for various

stakeholders in the economy.

Functions of Banks
 The various functions of the commercial banks include:

Accepting Deposits from their customers is one of the chief functions of the
commercial banks. These deposits can be accepted from both individuals as well as
business organizations. Savings deposits, time deposits, and current deposits are the
ways through which funds can be deposited in the commercial banks.
Providing Loans is another activity undertaken by the commercial banks. These are the
same funds that the bank received by way of deposits. Banks earn profits by using the
money deposited by its customers and investing them in loans. However, extending
loans may be of different kinds like cash credit, overdraft, discounting bills, advances,
etc.

Fund Remittance or money transfer is also carried out by commercial banks. The funds
can be transferred through various modes like NEFT, draft pay orders, IMPS, RTGS, etc.
as per the specified commissions.
Cheque Issuance is done by the commercial banks in order to help its customers
withdraw funds. Using a cheque, customers can withdraw the money for their own use
or for the payee. A cheque can be either bearer or crossed. While a bearer cheque can be
encashed over-the-counter, a crossed cheque can be deposited in the payee’s account
only.
General Utilities are also provided by the commercial banks. These include traveler’s
cheque issuance, facility for credit and debit card, locker facility for safe custody, etc.
Services as an Agent include collection of cheques, insurance premium payment,
drafts and bills, trustee or executor or customers’ estate, and so on.
https://sbi.co.in/
Performance Measures
Performance measures of banks are essential metrics used to evaluate their financial

health, operational efficiency, and overall effectiveness. These measures help

stakeholders, including investors, regulators, and customers, assess a bank's

performance and make informed decisions. Below are some key performance

measures commonly used for banks:

Return on Assets (ROA):

1. ROA measures a bank's profitability relative to its total assets.

2. Formula: Net Income / Average Total Assets

3. A higher ROA indicates better efficiency in generating profits from its assets.

Return on Equity (ROE):

1. ROE measures a bank's profitability in relation to shareholders' equity.

2. Formula: Net Income / Average Shareholders' Equity

3. A higher ROE indicates the bank's ability to generate higher returns for its

shareholders.
Net Interest Margin (NIM):

1. NIM measures the difference between interest earned from loans and interest paid on

deposits, relative to interest-earning assets.

2. Formula: (Interest Income - Interest Expense) / Average Interest-Earning Assets

3. A higher NIM indicates better interest rate management and potential earnings from

loans and investments.

Assume Company ABC boasts a return on investment of $1,000,000, an interest

expense of $2,000,000, and average earning assets of $10,000,000. In this scenario,

ABC's net interest margin totals -10%, indicating that it lost more money due to

interest expenses than it earned from its investments. This firm would likely fare

better if it used its investment funds to pay off debts rather than making this

investment.
Efficiency Ratio:

1. The efficiency ratio assesses a bank's cost management by comparing operating

expenses to revenue.

2. Formula: Operating Expenses / Net Revenue

3. A lower efficiency ratio indicates more efficient cost management.

Loan-to-Deposit Ratio:

1. The loan-to-deposit ratio measures the percentage of loans financed by customer

deposits, indicating a bank's lending and liquidity position.

2. Formula: Total Loans / Total Deposits

3. A balanced loan-to-deposit ratio shows a stable funding structure.

Non-Performing Loan (NPL) Ratio:

1. The NPL ratio represents the percentage of loans that are in default or

close to default.

2. Formula: (Non-Performing Loans / Total Loans) * 100

3. A lower NPL ratio indicates better credit risk management.

Capital Adequacy Ratio (CAR):

1. CAR assesses a bank's capital adequacy and ability to absorb losses.

2. Commonly measured by the Basel III capital standards (Tier 1 Capital / Risk-

Weighted Assets). Tier 1 capital refers to a bank's equity capital and disclosed

reserves.

3. A higher CAR indicates a stronger capital position and financial stability.

Net Interest Income (NII):

NII represents the difference between interest income earned on assets and interest

expenses paid on liabilities.

Deposit Growth Rate:

1. The deposit growth rate measures the percentage change in total deposits over a

specific period.

2. It indicates the attractiveness of the bank's deposit products to customers.

Loan Growth Rate:

1. The loan growth rate measures the percentage change in total loans over a specific

period.

2. It reflects the bank's lending activities and the demand for credit in the market.
Net interest rate spread (NIS) is the difference between the average yield that a

financial institution receives from loans—along with other interest-accruing activities—

and the average rate it pays on deposits and borrowings. The net interest rate spread is a

key determinant of a financial institution’s profitability (or lack thereof).

NIS = (Investment Return - Interest Expenses) – expenses incurred on both transactions

Most commercial banks (such as savings and loans) generate their main source of

profits through net interest rates spreads. For instance, they may credit depositors

1.25% on their money while issuing a mortgage to a home buyer charging 4.75%. In

this case the net interest rate spread would be 3.5%, minus any fees or costs incurred

by the bank in effecting both transactions.