BA4003 - BANKING AND FINANCIAL SERVICES

UNIT I
INTRODUCTION TO INDIAN BANKING SYSTEM & PERFORMANCE EVALUATION

Overview of Indian Banking system – Structure – Functions – Key Regulations in Indian Banking
sector – RBI Act, 1934/ 2006 – Banking Regulation Act, 1949 – Negotiable Instruments Act 1881/ 2002 –
Provisions Relating to CRR – Provision for NPA’s - Overview of Financial Statements of banks – Balance
Sheet – Income Statement – CAMEL

1. Overview of Indian Banking system:

The Indian banking system has been an integral part of the country's economic development
since its inception. Over the years, it has evolved to meet the changing needs of the economy and its
people. The banking system has played a pivotal role in mobilizing resources, providing credit facilities,
and promoting financial inclusion. It is one of the most stable and resilient sectors in the Indian
economy.

1.1 Structure of the Indian Banking System

The Indian banking system is a complex and diverse one, comprising a wide range of institutions.
These institutions can be broadly classified into three categories:

Commercial Banks: Commercial banks are the largest and most important segment of the Indian
banking system. They account for over 60% of the total assets of the banking sector. Commercial banks
are engaged in a wide range of activities, including deposit mobilization, lending, and other financial
services.

Cooperative Banks: Cooperative banks are institutions that are owned and controlled by their members.
They are primarily engaged in providing banking services to the rural and agricultural sector.
Cooperative banks account for about 10% of the total assets of the banking sector.

Development Banks: Development banks are specialized institutions that provide financial assistance to
specific sectors of the economy. They play a crucial role in promoting economic development.
Development banks account for about 30% of the total assets of the banking sector.

1.2 Indian Banking System

 The modern banking system in India started with General Bank of India in 1786
 East India Company established the bank of Bengal in 1809, bank of Bombay in 1840, bank of
Madras in 1843.
 These were initially independent unit
 Subsequently, these three banks were amalgamated & become Imperial Bank of India
 After Independence the Imperial bank of India was nationalized under State bank of India act
 1955 and become known as State Bank of India
 1969, Indira Gandhi, PM by nationalizing 14 major banks,

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

 In 1991, Govt. opened banking to private sector banks (ICICI & Bank of America) by dropped
20% Public sector
 State owned banks still controls approximately 80% of the Country banking assets.
1.3 Banking

According to RS Meyers, Banks are institutions whose debts are referred to as bank deposits and
they are commonly accepted in final settlement of other peoples debts.

1.3.1 Traditional Services Offered By Banks

1. Exchange of Currency
2. Commercial Notes and Loans
3. Offering Savings Deposits
4. Safekeeping of Valuables
5. Supporting Government Activities with Credit
6. Checking Accounts
7. Trust Services

1.4 Functions of Bank

"Banking" refers to the activities conducted by financial institutions, known as banks, which are
crucial components of a country's economic infrastructure. The primary functions of banks include:

1. Accepting Deposits:
Banks provide a safe place for individuals and businesses to deposit their money. Common types
of deposits include savings accounts, current accounts, fixed deposits, and recurring deposits.

2. Providing Loans and Advances:

Banks lend money to individuals, businesses, and governments for various purposes, such as
home loans, personal loans, business loans, and agricultural loans.

3. Facilitating Payments:
Banks offer services that enable the transfer of funds between individuals and entities. This
includes electronic funds transfers, checks, and wire transfers.

4. Currency Issuance:
In many countries, banks, in collaboration with the central bank, play a role in the issuance and
withdrawal of currency notes and coins.

5. Investment Banking:
Larger banks often have divisions involved in investment banking, which includes activities like
underwriting, mergers and acquisitions, and securities trading.

6. Wealth Management:
Some banks provide services for wealth management, helping individuals and businesses
manage and grow their financial assets.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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7. Foreign Exchange Services:

Banks facilitate currency exchange for international trade and travel. They also engage in foreign
exchange markets.

8. Electronic Banking:
With the advent of technology, banks offer electronic banking services such as internet banking,
mobile banking, and ATMs for convenient and efficient transactions.

9. Risk Management:
Banks engage in risk management activities to assess and mitigate various types of risks,
including credit risk, market risk, and operational risk.

10. Regulatory Compliance:

Banks are subject to regulatory frameworks that vary by country. Regulatory bodies, such as the
central bank, oversee and regulate banking activities to maintain financial stability.

11. Financial Intermediation:

Banks act as intermediaries between savers and borrowers, channeling funds from those with
surplus to those in need of funds.

12. Community Development:

Banks may participate in community development activities, supporting initiatives that
contribute to the economic and social development of the community.

13. Credit Creation:

Through the process of fractional reserve banking, banks can create credit by lending out a
significant portion of the deposits they receive.

14. Customer Services:

Banks provide a range of customer services, including account management, financial advice,
and assistance with various financial transactions.

15. Credit Cards and Payment Services:

Many banks issue credit cards and provide payment services, allowing customers to make
purchases and payments conveniently.

1.5. Structures of Indian Banking System

Financial system is a system of arranging different types of funds required for the
business. It deals about

(a)Financial Institutions

(b) Financial Markets

(c) Financial Instruments

(d) Financial Services

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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2. Banking Regulation in India

The Banking Regulation Act came into effect on 16 March 1949 and it applies to the whole of
India. The act was amended by Banking Laws Amendment Act, 1983, The Banking Public Finance
Institutions And Negotiable Instrument Laws Amendment Act, 1988 And The Banking Regulation
Amendment Act, 1994.

The purpose of enacting the Banking Regulation Act, 1949 was twofold:

1. To consolidate and amend the law related to banking companies.

2. To check the abuse of powers by managers of banks and also to safeguard the interest of
depositors and the interest of the country in general.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

 BA4003 - BANKING AND FINANCIAL SERVICES

Banking in India is mainly governed by:

1. The Reserve bank of India Act, 1934

2. The Banking Regulation Act, 1949 and
3. The Foreign Exchange Management Act, 1999.

2.1. The Reserve bank of India Act, 1934

The RBI Act was enacted to establish and set out functions of the RBI. It grants the RBI powers to
regulate the monetary policy of India and lays down the constitution, incorporation, capital,
management, business and functions of the RBI.

2.2. The Banking Regulation Act, 1949

The BR Act provides a framework for supervision and regulation of all banks. It also gives the RBI
the power to grant licences to banks and regulate their business operation.

2.3. The Foreign Exchange Management Act, 1999

FEMA is the primary exchange control legislation in India. FEMA and the rules made thereunder
regulate cross-border activities of banks. These are administered by the RBI.

The other key statutes include:

 The Negotiable Instruments Act 1881;

 The Recovery of Debts Due to Banks and Financial Institutions Act 1993;
 The Bankers Books Evidence Act 1891;
 The Payment and Settlement Systems Act 2007;
 The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest
Act 2002
 The Banking Ombudsman Scheme 2006.

3. Negotiable Instruments Act 1881/ 2002

The Negotiable Instruments Act, 1881 is a significant law that governs the use of negotiable
instruments in India. It provides for the regulation of promissory notes, bills of exchange, and cheques.
The Act was enacted to provide a uniform legal framework for the use of negotiable instruments in India

The Negotiable Instruments Act, 1881, is an Indian legislation that governs the law relating to
negotiable instruments. Negotiable instruments are written documents that promise payment of a
specific amount of money either on-demand or at a specific future date.

3.1. Types of Negotiable Instruments:

Promissory Notes: A written promise by one party (the maker) to pay a certain sum of money to
another party (the payee) or to the bearer of the instrument.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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Bill of Exchange: An instrument in writing containing an unconditional order, signed by the maker
(drawer), directing a certain person (drawee) to pay a specified sum of money to a specified person
(payee) or to the bearer.

Cheque: A bill of exchange drawn on a specified banker and not expressed to be payable otherwise than
on demand.

3.2. Features of Negotiable Instruments

1. Writing & Signature

2. Money
3. Freely Transferable
4. Title of Holder free from all defects
5. Notice
6. Special Procedure
7. Popularity
8. Evidence

3.3. Provisions of Negotiable Instruments Act, 1881

 Negotiating Back
 Capacity to incur liability under instrument (Sec 26)
 Liabilities of parties
o Liability of legal representatives (Sec 29)
o Liability of Drawer (Sec 30)
o Liability of Drawee of Cheque (Sec 31)
o Liability of maker of note & acceptor of bill (Sec 32)
o Liability of endorser (Sec 35)
o Liability of Prior parties to a holder (Sec 36)
o Nature of Suretyship

4. Non-Performing Assets

NPA expands to non-performing assets (NPA). Reserve Bank of India defines Non Performing
Assets in India as any advance or loan that is overdue for more than 90 days. “An asset becomes non-
performing when it ceases to generate income for the bank,” said RBI in a circular form 2007.

To be more attuned to international practises, RBI implemented the 90 days overdue norm for
identifying NPAs has been made applicable from the year ended March 31, 2004. Depending on how
long the assets have been an NPA, there are different types of non-performing assets as well.

4.1. Provision for Non-Performing Assets

Provision for Non-Performing Assets means the banks keeps aside a certain amount from their
profits in a particular quarter for NPAs. This is because this asset can turn into losses in the future. Thus,
by this method, banks can maintain a healthy book of accounts by provisioning for bad assets.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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4.2. Types of Non-Performing Assets (NPA)

Different types of non-performing assets depend on how long they remain in the NPA category.

a) Sub-Standard Assets: An asset is classified as a sub-standard asset if it remains as an NPA for a period
less than or equal to 12 months.

b) Doubtful Assets: An asset is classified as a doubtful asset if it remains as an NPA for more than 12
months.

c) Loss Assets: An asset is considered a loss asset when it is “uncollectible” or has such little value that
its continuance as a bankable asset is not suggested. However, some recovery value may be left in it as
the asset has not been written off wholly or in parts.

5. Overview of Financial Statements of banks – Balance Sheet – Income Statement

Banks prepare two sets of financial statements (includes Balance Sheet and Profit and Loss
Account), one containing the performance of the Bank through its Banking operations, both domestic
and international and the other called consolidated Financial Statements containing the performance of
the Bank of its Banking

The financial statements of banks provide a comprehensive view of their financial health,
performance, and position at a specific point in time. The two primary financial statements for banks are
the Balance Sheet and the Income Statement (also known as the Profit and Loss Statement). Let's take a
brief overview of each:

5.1. Balance Sheet:

1. Assets:

Cash and Cash Equivalents: Includes physical cash, deposits held at other financial institutions, and
short-term, highly liquid investments.

Loans and Advances: The amount of money the bank has lent to customers.

Investments: Securities such as government bonds and corporate bonds held by the bank.

Fixed Assets: Physical assets like buildings and equipment

2. Liabilities:

Deposits: Customer funds held in various types of accounts, including savings accounts, current
accounts, and fixed deposits.

Borrowings: Funds borrowed by the bank from other financial institutions or through the issuance of
bonds.

Shareholders' Equity: The portion of the bank's capital contributed by shareholders.

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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3. Net Assets (or Shareholders' Equity):

Calculated as Assets minus Liabilities: Represents the residual interest in the assets of the bank after
deducting liabilities

5.2. Income Statement (Profit and Loss Statement):

1. Net Interest Income (NII):

The difference between interest earned on loans and investments and interest paid on deposits
and borrowings.

2. Non-Interest Income:

 Fee and Commission Income: Income generated from various fees charged for banking services.
 Trading Income: Gains or losses from trading activities, particularly relevant for banks involved
in financial markets.
 Other Operating Income: Miscellaneous income sources not related to interest.

3. Operating Expenses:

 Employee Salaries and Benefits: Costs associated with the workforce.

 Administrative Expenses: Overhead costs for running the bank.
 Depreciation: Reduction in the value of fixed assets over time.

4. Provisions and Contingencies: Amount set aside to cover potential losses, such as bad loans or
investments.

5. Profit Before Tax (PBT): The total income minus total expenses before accounting for taxes.

6. Income Tax Expense: The amount of income tax the bank is liable to pay based on its taxable income.

7. Net Profit (or Net Income): Profit remaining after deducting all expenses, including taxes, from total
income. This is what is available to be distributed to shareholders or retained for future use.

6. CAMELS:

The acronym CAMELS stands for the following factors that examiners use to rate financial
institutions: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity.

The standard CAMEL rating system includes the five components mentioned earlier: Capital
Adequacy, Asset Quality, Management Quality, Earnings, and Liquidity. However, if you're referring to
"CAMELS," with an "S" at the end, it usually stands for the CAMELS rating system used by regulatory
authorities in the United States. The "S" in CAMELS typically stands for "Sensitivity to Market Risk,"
which is an additional dimension considered in the evaluation. The complete breakdown is as follows:

 C - Capital Adequacy
 A - Asset Quality

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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 M - Management Quality
 E - Earnings
 L - Liquidity
 S - Sensitivity to Market Risk

So, the CAMELS rating provides a more comprehensive assessment of a bank's risk profile, including
its ability to manage and withstand market risks. This system is commonly used by regulatory agencies,
such as the Federal Reserve in the United States, to evaluate and supervise financial institutions.

6.1 CAMELS Rating System

It’s a numerical rating system in which the examiner assigns rates to the qualities of bank in
respect of its financial conditions, risk profile and over all performance.

In India, the RBI, Banks supervisory board, and the Industry trackers are using this rating system
to provide a summary that explains the financial condition of each bank at the time of examinations.

Rating Rating Range Rating Analysis Interpretation

1 1.0 – 1.4 Strong Most suitable in all aspect
2 1.5 – 2.4 Satisfactory Favorable but has certain weaknesses
Involves financial, operational or managerial
Less than
3 2.5 – 3.4 weaknesses which require supervisory
satisfactory
concern
Involves financial weakness up to and
4 3.5 – 4.4 Deficient
alarming stage
Involves critical financial weakness which may
5 4.5 – 5.0 Critically deficient
lead to failure of institution

6.2 Key Rations Involved in CAMELS Rating

Capital adequacy

 Capital adequacy ratio

 Debt-Equity Ratio
 Advance to assets ratio
 Govt. Securities to total investments

Assets

 Net NPA to Total Asset

 Net NPA to Net Advance
 Total investment to total assets
 Percentage change in NPA

Management Capability

 Total Advances to total deposit

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul

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 Profit per employee

 Business per employee
 Return on net worth

Earnings

 Operating profit to average working funds

 Percentage growth in net profit
 Net profit to average assets

Liquidity (called asset liability management)

 Liquid assets to demand deposit

 Liquid assets to total deposits
 Liquid assets to total assets
 G-Sec to total asset
 Approved securities to total asset

Sensitivity

 Interest spread ratio

BA4003-NOTES Dr.B.Velmurugan, HoD/MBA NPRCET, Dindigul