BANKING THEORY LAW AND PRACTICES

UNIT - I
• Origin of banks -Def inition of banking- Classif ic ation of
banks- Banking System: Unit Banking -– Branch Banking
Universal Banking & Banking Markets – Functions of
Modern commercial Banks - Balance Sheet of
commercial Banks – Credit Creation by commercial
Banks
 ORIGIN OF BANKS

• THE EARLY PHASE OF BANKING IN INDIA –

• UP TO 1947: Beginning of Banking in India Laid the
foundations of the Indian banking system.

• The first bank of a joint stock variety was Bank of Bombay,

established in 1720 in Bombay

• Bank of Hindustan in Calcutta, which was established in 1770

by an agency house. Trade was concentrated in Calcutta after
the growth of East India Company’s trading and administration.
• With this grew the requirement for modern banking services,
uniform currency to finance foreign trade and remittances by
British army personnel and civil servants.
• The first ‘Presidency bank’ was the Bank of Bengal established
in Calcutta on June 2, 1806 with a capital of Rs.50 lakh.
• The Bank of Bombay was the second Presidency bank set up in
1840 with a capital of Rs.52 lakh.

• Bank of Madras the third Presidency bank established in July

1843 with a capital of Rs.30lakh.

• They were known as Presidency banks as they were set up in the

three Presidencies that were the units of administrative
jurisdiction in the country for the East India Company.

• The Presidency banks were governed by Royal Charters. The first

Indian owned bank was the Allahabad Bank set up in Allahabad
in 1865, The second, Punjab National Bank was set up in 1895 in
Lahore, and The third, Bank of India was set up in 1906 in
Mumbai. All these banks were founded under private ownership.
 ORIGIN OF BANKS

• The presidency banks were amalgamated into a single bank, the

Imperial Bank of India, in 1921. The Imperial Bank of India also
functioned as a central bank prior to the establishment of the
Reserve Bank in 1935.

• The Reserve Bank of India Act 1934 was enacted paving the way
for the setting up of the Reserve Bank of India. The issue of
bank failures and the need for catering to the requirements of
agriculture were the two prime reasons for the establishment of
the Reserve Bank. The banking sector came under the purview of
the Reserve Bank in 1935.
• BANKING IN THE EARLY YEARS OF INDEPENDENT INDIA - 1947
TO 1967 When the country attained independence, Indian
banking was entirely in the private sector. In addition to the
Imperial Bank, there were five big banks, each holding public
deposits aggregating Rs.100 crore and more,viz.
• Central Bank of India Ltd., Punjab National Bank Ltd., Bank of
India Ltd., Bank of Baroda Ltd. and United Commercial Bank Ltd.
A major development during this period was the enactment of
the Banking Regulation Act and supervise the banking sector.
empowering the Reserve Bank to regulate In 1955, the Imperial
Bank of India was nationalized and was given the name “State
Bank of India”.
• It was established under State Bank of India Act, 1955.
 SOCIAL CONTROL OVER BANKS
• 1967 TO 1991 : The main objectives of social control was
• to achieve a wider spread of bank credit
• prevent its misuse, direct a larger volume of credit flow to
priority sectors and
• make it more effective instrument of economic development.
On July 19, 1969, 14 major banks were nationalized.
• First Phase of Reforms: 1991-92 to 1997-98
• The main issues faced at the beginning of this sub-phase (1991
-92 to 1997-98) were the poor financial performance, low
asset quality, weak capital position of banks and the absence of
adequate competition. Several measures, therefore, were
initiated by the Government, the Reserve Bank and the banks
themselves to improve their profitability, financial health and
capital position. Major measures initiated included introduction
of objective prudential norms, reduction in statutory pre-
emptions and operational flexibility and functional autonomy to
public sector banks.
DEFINITION OF BANKING
• Banking Regulation Act of India, 1949 defines Banking as
“accepting, for the purpose of lending or of investment of
deposits of money from the public, repayable on demand or
otherwise or withdrawal by cheque, draft order or otherwise.”
• The Reserve Bank of India Act, 1934 and the Banking Regulation
Act, 1949, govern the banking operations in India.

Banking Structure in India :

• A well-regulated banking system is a key comfort for local and
foreign stake-holders in any country. Prudent banking regulation is
recognized as one of the reasons why India was less affected by the
global financial crisis.
• Banks can be broadly categorized as Commercial Banks or Co-
operative Banks.
• Banks which meet specific criteria are included in the second
schedule of the RBI Act, 1934. These are called scheduled banks.
They may be commercial banks or co- operative banks. Scheduled
banks are considered to be safer, and are entitled to special
facilities like re-finance from RBI. Inclusion in the schedule also
comes with its responsibilities of reporting to RBI and maintaining a
percentage of its demand and time liabilities as Cash Reserve Ratio
(CRR) with RBI.
CLASSIFICATION OF BANKS :
The types of banks in India can be divided into the following
categories –
1. Central Bank
• The central bank in this country is the Reserve Bank of India
(RBI) which acts as the apex body for regulating and
monitoring all other banks in the country. It also acts as a
banker to the government in certain situations. RBI is
instrumental in laying down the repo rate, reverse repo rate,
cash reserve ratio, and statutory liquidity ratio.

2. Cooperative Bank
• Cooperative banks in India are established under the State
Cooperative Societies Act, providing easy credit to the
members of the cooperative banks. One of the core functions
of cooperative banks is to provide financial resources to the
rural population at large. Examples of cooperative banks in
India are – New India Cooperative Bank Limited, Ahmedabad
Mercantile Co-operative Bank Ltd.

3. Commercial Bank
• Commercial banks perform the function for the public in terms of
accepting profits or extending loans. These loans act as
investments of the commercial banks intending to earn profit.
Examples of commercial banks in India are the State Bank of
India, United Bank of India, ICICI Bank, HDFC Bank, etc.

4. Specialized Bank
• Specialized banks are formed with the specific goals of catering
to a particular industry or sector. It may focus on export and
import or provide financial services to some specific industries.
An example of a specialized bank in India is Export-Import Bank.
•

Types of Bank Accounts
The major types of bank accounts are –
Savings Account
• The facilities of savings account are only for savings purposes, and
a bank is liable to pay interest on the funds which are deposited in
the account. In India, the rate of interest for savings accounts
ranges from anywhere between 4% to 7%.
Current Account
• The current account mainly contains liquid deposits that are utilized
for business purposes and not for savings or investments. No
interest is paid on such an amount, and there are no maturity
periods as well due to the continuous nature of the account.
Fixed Deposit Account
• A particular sum of money is deposited in a fixed deposit
account for a given duration. If a deposit is taken out before the
maturity date, penalties will be imposed. Fixed deposits enjoy
higher interest rates. The interest rate is subjected to variation
from bank to bank and also periodic revisions.
Recurring Deposit Account
• In the case of a recurring deposit account, a deposit will have to
be made by the account holder at regular intervals for a specified
period. The bank will have to pay the relevant rate of interest
when the amount is repaid after the fixed period.
 UNIT BANKING

• Unit Banking :
• A unit banking is a banking system in which one bank, generally
a small independent bank that renders banking services to its
local community.
• Unit banking refers to a bank that is a single, usually small bank
that provides financial services to its local community. A unit
bank is independent and does not have any connecting banks
and branches in other areas.
• It is managed by its own governing body or the Board members.
• It has an independent existence, as it is not under the control of
any other individual, bank, or body corporate.
• The unit bank serves a limited area, and so it possesses an
expert knowledge of the problems and basic needs of the
localities and aims at resolving them.
 BRANCH BANKING
• Branch Banking :
• Branch banking refers to a bank that is connected to one or
more other banks in an area or outside of it; to its customers, this
bank provides all the usual financial services but is backed and
ultimately controlled by a larger financial institution.
• It has a central office called as the head office and other offices
which are set up at different locations to serve the customers are
called as branches. The branches are controlled and coordinated
by the head office, with the help of their regional or zonal offices.
• The bank is under the control of the Board of Directors (BOD)
and it is owned by shareholders. Each bank branch has a
manager who looks after the management of the concerned
branch of which he/she is the in charge, as per the policies and
instructions laid down from time to time by the head office.
• For the purpose of financial reporting at the end of the financial
year, the assets and liabilities of all the branches and the head
office are summed up.
 UNIVERSAL BANKING
• Universal banking is a system in which banks provide a wide
variety of financial services, including commercial and
investment services. It is a place where all financial products are
available under one roof.
• Universal banking is common in some European countries,
including Switzerland. Universal banking combines the services
of a commercial bank and an investment bank, providing all
services from within one entity.
• The services can include deposit accounts, a variety of
investment services and may even provide insurance services.
• Universal banking is done by very large banks. These banks
provide a lot of finance to many companies. So, they take part in
the Corporate Governance (management) of these companies.
• These banks have a large network of branches all over the
country and all over the world. They provide many different
financial services to their clients.
 Advantages of Universal Banking
• 1. Investors' Trust : Universal banks hold stakes (equity shares)
of many companies. These companies can easily get other
investors to invest in their business
• 2. Economics of Scale :Universal banking results in economic
efficiency.
• 3. Resource Utilization: Universal banks use their client's
resources as per the client's ability to take a risk. If the client has
a high risk taking capacity then the universal bank will advise him
to make risky investments and not safe investments.
• 4. Profitable Diversification: Universal banks diversify their
activities. So, they can use the same financial experts to provide
different financial services.
 Advantages of Universal Banking

• .5. Easy Marketing :

• The universal banks can easily market (sell) all their financial
products and services through their many branches. They can
ask their existing clients to buy their other products and services.
This requires less marketing efforts because of their well-
established brand name.
• 6. One-stop Shopping :
• Universal banking offers all financial products and services
under one roof. One-stop shopping saves a lot of time and
transaction costs.
• It also increases the speed or flow of work. So, one-stop
shopping gives benefits to both banks and their clients.
 Disadvantages of Universal Banking
• 1. Different Rules and Regulations :
• Universal banking offers all financial products and services under
one roof. For e.g. Mutual Funds, Insurance, Home Loans, etc.
have to follow different sets of rules and regulations, but they are
provided by the same bank.
• 2. Effect of failure on Banking System :
• Universal banking is done by very large banks. If these huge
banks fail, then it will have a very big and bad effect on the
banking system and the confidence of the public.
• 3. Monopoly :
• Universal banks are very large. So, they can easily get monopoly
power in the market. This will have many harmful effects on the
other banks and the public.
• 4. Conflict of Interest :
• Combining commercial and investment banking can result in
conflict of interest. Some banks may give more importance to
one type of banking and give less importance to the other type of
banking.
 COMMERCIAL BANK
• Commercial bank is an institution which performs the functions
of accepting deposits, granting loans and making investments
with the aim of earning profits. They are also called ‘DEPOSIT
BANKS’ .
• The amount of money earned by a commercial bank is
determined by the SPREAD which is the difference of the interest
it pays on deposits and the interest it earns on loans.
• PRIMARY FUNCTIONS :
1. Acceptance of Deposits
• Commercial banks receive deposits from the people who have
surplus money and willing to deposit with banks for the purpose
of safety and interests etc.
• The main types of deposits are:-
• Current Deposits
• Savings Deposits
• Fixed Deposits
•
2. Advancing Loans :
• The deposits received by banks are not allowed to remain
idle. So, after keeping certain cash reserves, the balance
is given to needy borrowers and interest is charged from
them, which is the main source of income for commercial
banks. Bank advances loans to all types of persons,
businessmen and investors, against personal security,
gold, silver, stock of goods & other assets.
• a) Overdraft Facilities: In this case, the depositor in a
current account is allowed to draw over and above his
account up to a previously agreed limit. The bank allows
the customer to overdraw his account through cheques.
The bank, however, charges interest only on the amount
overdrawn from the account.
• b) Term Loans: Banks give term loans to traders,
industrialists and now to agriculturists also against some
collateral securities. Term loans their maturity period
varies between 1 to 10 years. Sometimes, two or more
banks may jointly provide large term loans to the borrower
against a common security. Such loans are called
participation loans or consortium finance.
• c) Money at Call:
• Bank also grant loans for a very short period, generally not
exceeding 7 days to the borrowers, usually dealers or brokers in
stock exchange markets against collateral securities like stock or
equity shares, debentures, etc., offered by them. Such advances
are repayable immediately at short notice hence, they are
described as money at call or call money.
• d) Consumer Credit:
• Banks also grant credit to households in a limited amount to buy
some durable consumer goods such as television sets,
refrigerators, etc., or to meet some personal needs like payment
of hospital bills etc. Such consumer credit is made in a lump sum
and is repayable in installments in a short time.
3. Credit creation :
• Credit creation is most significant function of commercial banks.
While sanctioning a loan to a customer, they do not provide cash
to the borrower. Instead, they open a deposit account from which
the borrower can withdraw. In other words, while sanctioning a
loan, they automatically create deposits, known as a credit
creation from commercial banks.
4. Clearing of cheques :
• It is the process of moving a cheque from the bank in which it
was deposited to the bank on which it was drawn, and the
movement of the money in the opposite direction. This process
is called the clearing cycle and normally results in a credit to the
account of bank of deposit, and an equivalent debit to the
account at the bank on which it was drawn.
 Secondary Functions


1. Banks act as agents to their customers in different ways:
a) It collect cheques, rent, interest etc & pay insurance premium,
mutual funds, rent, water taxes, electricity bills etc of their
customers.
b) Collection of dividend on shares purchased by customers.
c) Buy and sell shares, securities on behalf of their customers.
d) Purchase & sale of foreign exchange. Agency services
2. Banks act as agents to their customers in different ways: e) Acts
as Correspondent: Sometimes banks act as representative and
correspondents of their customers. They get passports, traveller’s
tickets etc for their customers.
3. Acts as Trustee and Executor: Banks preserve the ‘Wills’ of their
customers and execute them after their death. g) Income-tax
Consultancy: Banks may also employ income tax experts to prepare
income tax returns for their customers and to help them to get
refund of income tax. Agency services
General utility services

1. Commercial banks also provide certain services of general utility

to the society: a) Locker facilities: The customers can keep their
valuables, such as gold and silver ornaments, important documents.
b) Banks issue traveller’s cheque or credit cards to their customers
so that they may be spared from the risk of carrying cash during the
journey. c) Business information & statistics. d) Banks underwrite
the shares and debentures issued by the Government, public or
private companies.
2. Commercial banks also provide certain services of general utility
to the society:
d) Acting Referee: Banks may act as referees with respect to the
financial standing, business reputation and respectability of
customers. e) Merchant Banking: Some commercial banks have
opened merchant banking divisions to provide merchant banking
services. f) Gift Cheques: Some banks issue cheques of various
denominations to be used on auspicious occasions.
 Balance Sheet of commercial Banks
• Introduction of Balance Sheet of Commercial bank
• Balance Sheet is a financial record of all the assets, Liabilities
and Capital.
• Asset are anything of Value that is Owned by Commercial bank.
Assets are anything that can be easily and quickly converted into
cash.
• Liabilities is anything that Commercial bank Owes . To need to
pay or repay.
• Anything which owned Somebody Else.
• The Best Example is Deposits.
• Capital is a section within the liabilities component of the
balance Sheet. Balance Sheet gives an idea about the health of
commercial Bank.
• Capital Shareholder’s Fund Reserves ( Retained Profit )
• The balance sheet of a commercial bank provides a picture of
its functioning.
• It shows its assets and liabilities on a particular date at the end
of one year. The assets are shown on the right- hand side and
the liabilities on the left-hand side of the balance sheet. The
assets and liabilities of a bank must balance.
• The balance sheet which every commercial bank in India is
required to publish once in a year. Assets= Liabilities + Capital
• The Distribution of Assets:
• The assets of a bank are those items from which it receives
income and profit. The first item on the assets side is the cash in
liquid form consisting of coins and currency notes lying in
reserve with it and in its branches.
• • The second item is in the form of balances with the central
bank and other banks. The commercial banks are required to
keep a certain percentage of their time and demand deposits
with the central bank. 5
• The Distribution of Liabilities:
• The liabilities of commercial banks are claims on it. These are the
items which form the sources of its funds. Of the liabilities, the
share capital of the bank is the first item which is contributed by its
shareholders and is a liability to them. • The second item is the
reserve fund. It consists of accumulated resources which are meant
to meet contingencies such as losses in any year.

Importance Of Balance Sheet

• Financial Position.
• Advancing Position.
• Profitability.
 Credit creation of commercial banks

•It is a process through which bank can create credit from the initial
deposits.
•A commercial bank is called a dealer of credit or factories of credit.
•It can create credit i.e. can expand the monetary base of a country.
It does not by issuing new money but by its loan operations.
•They advance much more than what the collect from people on the
basis of the cash deposits.
• The process of credit creation is that the depositors think they
have so much money with banks and borrowers from bank say they
have so much money with them. Summing the two, we find an
amount more than the cash deposit.
•Through the process of credit creation, commercial banks provide
finance to all sectors of the economy thus making them more
developed than before.
•The basis of credit money is the bank deposits. •The bank deposits
are of two kinds
i.e. (i) Primary deposits
(ii) Derivative deposits
•Primary deposits arise or formed when cash or cheque is
deposited by customers. •When a person deposits money or
cheque, the bank will credit his account. •The customer is
free to withdraw the amount whenever he wants by cheques.
•These deposits are called “primary deposits” or “cash
deposits.”
•It is out of these primary deposits that the bank makes
loans and advances to its customers. •The initiative is taken
by the customers themselves. In this case, the role of the
bank is passive. •So these deposits are also called “passive
deposits.”
•Bank deposits also arise when a loan is granted or when a
bank discounts a bill or purchase government securities.
•Deposits which arise on account of granting loan or
purchase of assets by a bank are called “derivative deposits.”
•Since the bank play an active role in the creation of such
deposits, they are also known as “active deposits.”