Chap 13

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Chapter 13
Banking and Non

Banking Institutions
Indian Financial System, 5e

By: Bharati V. Pathak
Chapter Objectives

To understand:
1. Banking institutions
2. Development of Banking in India
3. Scheduled Commercial Banks
4. Mobilisation, iending and investment of Banks
5. Reforms in the Banking sector
6. Payment and Settlement System
7. Diversification in Banking operations
8. Consolidation in Banking
9. Risk Management in Indian Banks
10. Regional Rural Banks
11. Cooperative banking
12. Non-banking Financial Companies

Banking

Core activities(Functions)
a. Acceptance of deposits: Demand deposits,
Time deposits
b. Lending of funds
c. Credit Creation
d. Ancillary functions

Development of Banking in India

 Origin in Vedic times
 First bank set up in 1683 in Madras
 Principle of limited liability applied in 1860
 Three presidency banks amalgamated into Imperial Bank of India in
1921 – now known as State Bank of India
 Number of banks increased between 1941 and 1945
 Banks under private ownership of Maharajas between 1947 and 1969
 In 1969, Nationalisation of 14 banks
 In 1980, another six nationalised
 Between 1969 and 1992, rapid expansion of branch network
 Nationalisation killed competition and led to deterioration of operating
standards
 First phase of comprehensive reforms in June 1992
 Competition infused in 1993 by allowing setting up of private sector
banks
 Second phase of reforms underway.

Banking Structure in India

Scheduled Commercial Banks

 Scheduled commercial banks are those
included in the second schedule of the
Reserve Bank of India Act,1934.
 In terms of ownership and function,
commercial banks can be classified into
four categories: public sector banks,
private sector banks, foreign banks in
India, and regional rural banks.

The State Bank of India

 Initially known as Imperial Bank
 Came into existence on July 1, 1955
 Objectives: to promote agriculture, to help
RBI in its credit policies, to help government
pursue broad economic policies
 Seven subsidiaries
 Dominates Indian banking structure in
terms of :Reach, Size, Market share,
Business diversity and Position in government
segment.
 GOI transacts its business through SBI
 At present, it has five subsidiaries
Public Sector Banks

 Public sector banks are banks in which
the government has a major holding.
 These can be classified into two groups:
(i) the State Bank of India and its
associates; and (ii) nationalized banks

Nationalized banks

 Nationalization in two phases- in 1969 and in 1980
 To widen the branch network
 At present 27 nationalized banks
 Now allowed access to capital market
 Edge over private sector banks in terms of size,
geographical reach and access to low deposits
 Dominant segment is commercial banking – accounting
for nearly three- fourths of assets and income.
 Responded to the new challenges of competition

Private Sector Banks

 In the pre- reforms period, 21 private sector
banks
 At present, 12 old private sector and 9 new
private sector banks
 Guidelines revised in January 2001
 Norms for issue and pricing of shares revised
in 2001-02
 Level of foreign participation enhanced
 Tapped new markets, offered innovative
products and services
 Reserve bank norms propose dispersing
ownership of private sector banks.
Differentiated Banking

 For deepening financial inclusion in India, the
RBI set up a differentiated banking structure
in the form of small finance banks and
payments banks.

Small Finance Banks

 On 27 November 2014, the Reserve Bank of India
issued the required guidelines that have to be followed
for licensing of small finance banks in the private
sector.
 Objectives: The objectives of setting up the small
finance banks will be to further the financial inclusion
by (a) provision of savings vehicles and (ii) supply of
credit to small business units, small and marginal
farmers, micro and small industries and other
unorganized sector entities, through high technology
but low cost operations.

Payments Banks

 The Reserve Bank of India issued the guidelines for
licensing of payments banks on27 November 2014.
 Objectives: The objectives of setting up of payment

banks will be to process further the financial inclusion by
providing
(i) small savings accounts and
(ii) payments/remittance services to migrant labour
workforce, low income households, small businesses,
other unorganized sector entities and other users.

Foreign Banks in India

 Operating in India since decades
 43 foreign banks with 331 branches
 Set up subsidiaries
 Their presence benefited the financial system:
a. Brought in new technology
b. Enabled Indian companies to access foreign
currency
c. Active players in the money market and foreign
exchange market
 Now permitted to have either branches or subsdiaries
but not both
 Road map laid out by RBI will enable entry and provide
them same treatment as PSBs.
Branches of Indian Banks Abroad

 As on end March 2015, 15 Indian Banks have
branches abroad
 SBI with 52 branches, followed by BOB and
Bank of India
 PSBs foreign operations to be merged as part
of the consolidation process
 As against 331 branches of foreign banks
present in India, Indian banks have only 183
branches overseas

Setting up of Off-shore Banking
Units

 Operate virtually as foreign branches in India
 Cover only non-residents, deal only in foreign
currencies and free from control of interest
rates
 SBI opened up first off shore banking unit at
SEERZ, Mumbai in 2003

Mobilization of Funds

 Deposits: Household sector, corporate sector,
financial institutions, rest of world(NRI and
foreign consulates and embassies) and
government
 Non-Deposits: Public issues; Borrowing in the
call/notice market, repo, and CBLO; private
placement; and ECBs

Lending of Funds

 Agriculture
 Priority sector
 Industry
 Infrastructure
 Household
 Sensitive sectors
 NBFCs
 Factoring Companies

Priority Sector Lending

 A stipulated target of 40% of net bank credit
for both public and private sector banks
 A target of 32% for foreign banks
 Loan to SSI sector, Loan to NBFCs for the
purpose of lending to SSI sector, housing
loans in rural and semi urban areas, and
educational loans reckoned as priority sector
lending

Investments of Banks

 Investment in SLR securities
 Banks holding 28 of their NDTL as SLR
securities compared to the required 23% on
account of
 Slow growth in demand for credit
 Strong capital flows from abroad
 High market borrowings of the govt
 Zero provisioning on government paper
 Risk aversion of banks

Investments in Non-SLR
Securities

 CPs
 Mutual fund units
 Shares and debentures of PSUs and Private
sector corporates

Reforms in Banking Sector

 Narasimhan Committee (1991) recommendations changed the face of
Indian Banking : recommended prudential norms, entry of private
sector banks and gradual reduction of SLR and CRR
 Khan Committee (1997) recommended : universal banking, mergers
and amalgamation and a risk based supervisory framework
 Verma Committee recommended greater use of IT, restructuring of
weak banks and VRS for bank staff.
 The first phrase of reforms is aimed at : Improving the allocative
efficiency of resources through improving policy framework , financial
health and institutional infrastructure.
 The first phase focused on removing financial repression and stepping
up prudential regulation
 The second phase of reforms aims at:
- strengthening the banking sector
- moving towards international banking practices
- increased emphasis on corporate governance

Restructuring of PSBs

 Closing down non- viable branches
 Reducing number of regional and zonal
offices
 Down sizing of staff through VRS

Technology in Banking

 Computerization
 e-banking and e-payments
 ATMS

Payments and Settlement
System Reforms

Introduction of
Electronic Fund Transfer (EFT)
Real Time Gross settlement (RTGS)
Centralized Funds Management System (CFMS)
Negotiated Dealing System (NDS)
Structured Financial Messaging Solution (SFMS)

Diversification in Bank
Operations

Diversified to non-traditional para-banking
activities such as-
 Factoring and Forfaiting
 Primary dealer system
 Venture capital financing
 Retail banking
 Insurance
 Loan syndication and consortium financing

Mergers and Acquisitions in
Banking

 Increased bank mergers
 Narasimhan Committee recommended
formation of 3-4 large banks with international
presence, 8-10 banks with national presence
and local and rural banks
 Mergers to exploit synergies, cost cutting and
acquiring new markets

Equity Capital Raised by Public
Sector Bank

 PSBs allowed to raise funds through equity subject to
maintenance of 51% public ownership
 SBI was the first to tap the equity market
 Both public and private sector banks raised funds
through public issues, private placement and ADRs
/GDRs.
 Government injected funds to strengthen the capital base
and restore banks new worth in three phases
 As at end of March 2005, public holding in six banks
ranged between 40 and 49% ; in 12 banks between 30
and 49%;and in 4 banks, Government holding more than
90%

Prudential Regulations

 To ensure financial safety, soundness and solvency in banks
 Norms on capital adequacy, accounting, income recognition,
provisioning and exposure
 Capital adequacy norms:
CAR – A measure of the amount of bank’s capital
expressed
as a percentage of its risk weighed credit exposures
Tier I capital: can absorb losses without ceasing trading
Tier II capital: can absorb losses in the event of a winding up
 As at March 2005, 86 out of 88 commercial banks maintained
CRAR at or above 9%
 Stipulated CRAR : 9 %

Basel I

 The Basel Committee on Banking Supervision (BCBS) prepared a
framework through a consultative process to secure international
convergence of supervisory regulations governing the capital adequacy of
international banks.
 This framework was finalized in 1988 and is known as the Basel Accord
or Basel I.
 The objectives of Basel I were twofold: (i) serve to strengthen the
soundness and stability of the international banking system, and (ii) to
diminish an existing source of competitive inequality among international
banks.
 The three main components of the Basel I framework were constituents of
capital, the risk weighting system, and the target ratio. The central focus
of this framework was credit risk and especially, country transfer risk.
 Basel I prescribed two tiers of capital for the banks: Tier I capital which
can absorb losses without a bank being required to cease trading and Tier
II capital which can absorb losses in the event of a winding-up.

Criticism of Basel I

 Recommended a ‘one size-fits-all’ approach
 Assumed that the aggregate risk of a bank was equal to the sum of its
individual risks
 These baseline capital adequacy norms were found to be inadequate as
they almost entirely addressed credit risk
 Many large banks in advanced countries developed advanced risk
measurement approaches to estimate the amount of capital required to
support risks. Thus, the Basel I framework was found to be redundant
in its approach.

Basel II

 Some common rules to provide a level playing field for banks
framed by Basel committee
 Objectives of the new accord:
 Promotion of safety and soundness of the financial system.
 Enhancement of competitive equality
 Constitution of a more comprehensive approach to
addressing risks
 Three pillars
 Minimum capital requirement
 Supervisory review process
 Market discipline
 All banks implemented Basel II with effect from March 2007

 Banks to initially adopt standardized approach for credit risk
and basic indicator approach for operational risk
Basel II Failed to Address Certain Issues
Which Emerged During the Financial Crisis
of 2007–08

 Basel II was pro-cyclical; in times, when banks were doing well, it did not
impose additional capital requirement on banks. On the other hand, in stressed
times, when banks required additional capital, Basel II required banks to bring
capital. The failure to bring in additional capital forced major international banks
into a vicious cycle of deleveraging, thereby leading global financial markets
and economies around the world into recession.
 Most of the assets of the banks were trading book exposures such as securitized
bonds, derivative products, and other toxic assets which could not be liquidated
in the times of crisis.
 Banks were highly levered and there was no regulation for limiting leverage.
 Basel II failed to address liquidity risk as part of capital regulation. which
cascaded into solvency risk.
 Basel II focused more on individual financial institutions and ignored the
systemic risk arising from the interconnectedness across institutions and
markets, which led the crisis to spread to several financial markets.

Basel III

 Basel III is a comprehensive set of reform measures to strengthen the
regulation, supervision and risk management of the banking sector.
These measures aim to:
 Improve the banking sector’s ability to absorb shocks arising from
financial and economic stress, whatever the source
 Improve risk management and governance
 Strengthen banks’ transparency and disclosure
 The reforms target at:
 bank-level, or microprudential, regulation, which will help raise the
resilience of individual banking institutions to periods of stress.
 macroprudential, system wide risks that can build up across the
banking sector as well as the procyclical amplification of these risks
over time.
 The Reserve Bank issued Guidelines based on the Basel III reforms on
capital regulation on May 2,2012 which have been implemented from
April 1, 2013 in India in phases and it will be fully implemented as on
March 31, 2018

Composition of Regulatory
Capital

 Banks are required to maintain a minimum
Pillar 1 Capital to Risk-weighted Assets
Ratio (CRAR) of 9 per cent on an on-going
basis (other than capital conservation buffer
and countercyclical capital buffer etc.).
 The Capital Adequacy Framework rests on
three components or three Pillars. Pillar 1 is
the Minimum Capital Ratio while Pillar 2 and
Pillar 3 are the Supervisory Review Process
(SRP) and Market Discipline, respectively.

Overview of Basel III

Timeline of Basel III

Risk Management in Indian
Banks

 Types: Credit risk, Market risk, Technological risk, Liquidity
risk, and Contingent risk
 RBI issued detailed guidelines in Oct 1999 encompassing
credit, market and operational risk
 RBI prescribed regulatory limits on banks exposure to
individual and group borrowers
 Building up risk management capabilities of banks
 Assignment of risk weights of various classes
 Application of marked- to- market principle for investment
portfolio
 Limits of deployment of funds in sensitive activities
 Know Your Customer and Anti- Money Laundering guidelines

Supervisory Measures

 Establishment of the Board for Financial
supervision as the apex supervisory authority
 Introduction of CAMELS supervisory rating
system
 Increased internal control through
strengthening of internal audit

Cooperative Banking

 Came into existence with the enactment of
the Cooperative Credit Societies Act of 1904
 Supplements commercial banks
 Comprises urban cooperative banks and rural
cooperative credit institutions

UCBs

 Mobilize savings from middle and low income urban
groups
 Cater to small borrowers in non agricultural sector and
rural areas
 Mostly engaged in retail banking
 Grew in 70s and 80s
 Supervised by RBI while rural cooperative credit
societies by NABARD
 UCBs with Rs. 50 crore net owned funds or above can
extend their area of operation
 Required to maintain CRR and extend loans to priority
sector
 1555 Non- scheduled UCBs and 51 scheduled UCBs
 Deteriorating financial health

Cooperative Credit Structure

Rural Cooperative Banks

 Form almost 70 % of the rural credit outlets
 Receive refinance facility from NABARD
 State Cooperative Banks (StCBs) form the upper tier, Central
Cooperative Banks (CCBs) the middle tier and the Primary
Agricultural Credit Societies (PACS) the lower tier of the
short- term structure
 StCBs – apex institutions – coordinating CCBs
 CCBs channelize funds from StCBs to PACs
 PACs deal directly with individual farmers
 State Cooperative Agriculture and Rural Development Banks
(SCARDBs) and Primary Cooperative Agriculture and Rural
Development Banks form upper and lower tier of long- term
credit cooperatives
 Deterioration in financial health of rural banks

NBFCs

 Supplement the role of banks
 More flexible structure than banks
 Provide a range of services
 Types:
 Hire purchase finance company
 Investment company
 Mutual Benefit Financial Company (MBFC)
 Equipment Leasing Company
 Miscellaneous Non banking Co. (MNBC)
 Residuary Non-banking company (RNBC)
 Housing Finance Companies
 Insurance companies
 Stock broking companies
 Merchant banking companies
 Primary Dealers

RNBCs, MBFCs, and MNBCs

RNBCs
 Class of NBFCs which cannot be classified as leasing,
hire purchase, loan etc
 Four companies operating as RNBCs
 Account for more than 85% of the public deposits
mobilized by NBFCs
MBFCs – notified under section 620 of Companies Act,
1956
MNBCs– engaged in the chit fund business
Application of prudential norms to NBFCs
Restrictions on bank funding to NBFCs
Converting themselves into Universal Banks


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Chap 13

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"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Banking and Non

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

 Objectives: The objectives of setting up of payment

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

 Strong capital flows from abroad

 High market borrowings of the govt

 Zero provisioning on government paper

 Risk aversion of banks

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Real Time Gross settlement (RTGS)

Centralized Funds Management System (CFMS)

Negotiated Dealing System (NDS)

Structured Financial Messaging Solution (SFMS)

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".

Indian Financial System, 5e

"Copyright © 2018 Pearson India Education Services Pvt. Ltd".