SUMAN

VISHWAKARMA

SOCIAL CONTROL OVER

BANKING

SEMINAR SUBMITTED TO THE UNIVERSITY OF

MUMBAI FOR L.L.M DEGREE SEM 3RD IN
BUSSINESS.

BY.SUMANVISHWAKARMAUNDERTHEGUIDENCEOFPROF.
MR.SANJAYJADHAVDEPARTMENTOFLAW,UNIVERSITYOF
MUMBAI2012TO2013
04Sep13

The banks are the custodians of savings and powerful institutions to provide credit. They mobilize the
resources from all the sections of the community by way of deposits and channelize them to industries
and others by way of granting loans. In 1955 the Imperial Bank of India was nationalized and SBI was
constituted.

Background
The banks are the custodians of savings and
powerful institutions to provide credit. They mobilise the resources from all the
sections of the community by way of deposits and channelize them to industries
and others by way of granting loans. In 1955 the Imperial Bank of India was
nationalised and SBI was constituted.
It was observed that commercial banks were
directing their advances to the large and medium scale industries and the
priority sectors such as agriculture, small-scale industries and the exports were
neglected.
The chairmen and directors of banks were
mostly industrialists and many of them were interested in sanctioning large
amount of loans and advances to the industries with which they were connected.
To overcome these deficiencies found in the working of the banks, the Banking
Laws (Amendment) Act was passed in December 1968 and came into force on
1-2-1969. It is known as the scheme of 'social control' over the banks. The then
deputy Prime Minister, Mr. Morarji Desai made a statement in the Parliament
on the eve of introducing the bill to amend the banking laws Act.
He explained that the aim of social control was,
"to regulate our social and economic life so as to attain the optimum growth rate
for our economy and to prevent at the same time monopolistic trend,
concentration of economic power and misdirection of resources".
The following are the main provisions of this
amendment, Bigger banks had to be managed by whole time chairman
possessing special knowledge and practical experience of the working of a
banking company or of finance, economics or business administration.
The majority of directors had to be persons with special knowledge or practical
experience in any of the areas such as accountancy, agriculture and rural
economy, banking, co-operative, economics, finance, law, small scale industries
etc.The banks were also prohibited from making any loans or advances, secured
or unsecured to their directors or to any companies in which they have
substantial interest.
The growth of commercial banking during the
first three plan periods has been lopsided. Without demanding proper security
some banks were diverting funds to large and medium industries.

Bank branches were opened only in big cities.

Rural areas were neglected. Banks made discrimination between private sector
and public sector between rural and urban and between agriculture, trade and
industry. The banks were financing those industries which were producing
luxury goods.
The government felt that this type of growth was
not in consonance with planning. The growth appeared to be defiant in many
respects. There was a growing demand for the bank credit for the development
of agriculture, industry and self-employment. So it was essential for the banking
system to attract savings.
Therefore, the government felt that need for social
banking as against capitalist banking. A scheme of social control was
introduced in 1967. The government enacted Banking Laws Amendment Act in
1968.This act has given more power to the government to control banking. The
objectives of this Act was to ensure more equitable distribution of the resources
of the banking system. The priority sectors like agriculture, small-scale
industry, public sector and self-employment were to receive their due share in
obtaining bank finance. Apart from this the banks are required to reconstitute
their board of directors .
The government set up National credit council in
1968. The Finance Minister was the chairman and the Governor of the Reserve
Bank was the vice chairman of the council. The main functions of the National
credit council were:
1. assessing the volume of credit required for the economy as a whole.
2. providing guidelines for the distribution of credit to the priority sector.
3. ensuring equitable distribution of credit in the economy.

Bank regulations are a form of government regulation which subject banks to

certain requirements, restrictions and guidelines. This regulatory structure
creates transparency between banking institutions and the individuals and
corporations with whom they conduct business, among other things. Given the
inter connectedness of the banking industry and the reliance that the national
(and global) economy hold on banks, It is important for regulatory agencies to
maintain control over the standardized practices of these institutions. Supporters
of such regulation often hinge their arguments on the "too big to fail" notion.
This holds that many financial institutions(particularly investment banks with
a commercial arm) hold too much control over the economy to fail without
enormous consequences . This is the premise for government bailouts, in which
government financial assistance is provided to banks or other financial
institutions who appear to be on the brink of collapse. The belief is that without
this aid, the crippled banks would not only become bankrupt, but would create
rippling effects throughout the economy leading to systemic failure. India has a
long history of both public and private banking . Modern banking in India began
in the 18th century, with the founding of the English Agency House in Calcutta
and Bombay. In the first half of the 19th century, three Presidency banks were
founded. After the 1860 introduction of limited liability, private banks began to
appear, and foreign banks entered the market. The beginning of the 20th century
saw the introduction of joint stock banks. In 1935, the presidency banks were
merged together to form the Imperial Bank of India, which was subsequently
renamed the State Bank of India.

The post independence period witnessed

massive growth in the Indian banking system. The first step taken in this
direction was nationalization of the Reserve Bank of India in 1948. It changed
the outlook of the Reserve Bank by giving them the status of monitoring
authority to regulate and control the socio-economic activities laid down by the
government. In order to have sound and balanced growth of banking business
in the country,
The Reserve Bank of India Act, 1949 was passed
to have control of the Reserve bank over the banking industry. In 1955, the
Imperial Bank of India was nationalized under the name of State Bank of India.
The scheme of social control was initiated by the government in the year 1967.
Followed by it, the government nationalized 14 major banks which held a
deposit of around Rs 50 crores on 19th July 1969 and 6 more banks which held
deposit of around Rs 200 crores on 15th April 1980. This process was done to
ensure more equitable and purposeful distribution of the credit. Besides the
above developments, financial institutions were established for meeting the
specialized needs. These include Industrial Development Bank of India (IDBI),
Industrial Credit and Investment Bank of India for meeting the long term
financial needs of the large scale operations. Similarly for meeting the
requirements of the Small Scale Industries (SSIs), State Financial Corporation
(SFC), Small Industries Development (SIDC) and Small Industries
Development Bank of India (SIDBI) have been established. The National Bank
for Agriculture and Rural Development (NABARD), Land Development Bank
(LDB), Regional Rural Bank (RRB) etc. has been established for taking care of
the credit needs in the agriculture sector.

NATIONALIZATION.
Barely four months after the third meeting of the National Credit Council,
on 9 July 1969, Indira Gandhi sent a note to the Congress Working Committee
through Fakhruddin Ali Ahmed, who was the Minister for Industrial
Development, suggesting the nationalization of major banks. This came
as a complete surprise, for the prevalent belief in Congress circles was that
What was most disturbing for the Reserve Bank was the impression that was
created in the media that it was opposed to nationalization. This perhaps had to
do with the personality of Jha himself, and with the fact that the Bank had
striven hard to make a success of the social control experiment. As Vice
Chairman of the National Credit Council, Jha ensured that a large number of
documents were submitted on different aspects of social control.
The Bank had substantial inputs in the work of the groups formed by the
Council. It also helped to provide the secretariat for the Council, and to create in
March 1969 a cell attached to the Banking Commission. These actions by
themselves did not imply that Jha was opposed to nationalization of major
Indian banks. All the oral accounts point out that while Jha did not favour bank
nationalization, he did not openly articulate his personal view on the subject.
The real issue was summed up by I.G. Patel in his book,
Glimpses of Indian Economic Policy: An Insiders View: For me, one
consequence of nationalization was controversy once again about my
jurisdiction and that of my department. A new banking department was created
in the ministry under A. Bakshi from the RBI, an old leftist and acerbic friend
of Haksar who could obviously be more relied upon to run nationalized banks
than L.K. or I.G. (p. 137). As Patels quote shows, Jha was identified with
forces that did not figure in the leftist groups that considered social control as an
apology and a dilatory tactic to prevent the state from gaining the commanding
heights of Indian finances. After the legal tangle over nationalization was
temporarily sorted out, Jha convened a Rural Credit Survey Committee
commercial banks only provided 0.9% of the total volume of advances and
loans to the agricultural sector (Reserve Bank of India 2008a). Rural India
continued to rely mostly on moneylenders that charged them very high interest
rates on their loans.

The government had to make some major changes

to promote equal socio-economic development. The Government of India
nationalized the Imperial Bank of India, with the purpose of, extension of
banking facilities on a large scale, more particularly in the rural and semi-urban
areas, and for diverse other public purposes. The State Bank of India Act
(1955) renamed the Imperial Bank of India as the State Bank of India (SBI).
However to prevent it from being under administrative pressure its ownership
was vested with the RBI. SBI underwent rapid expansion and opened 416
branches in 5 years all over the country (Reserve Bank of India2008a).
The security that the government owned SBI
helped it compete against deposits in safe avenues such as the post offices and
savings at home. Five years later in 1960 eight more banks were nationalized
and they formed the subsidiaries of the State Bank of India. With the
nationalization of these eight banks one third of the banking sector was under
the direct control of the government.
The Indian banking system had made considerable
progress since independence: (1) bank failures had decreased,
(2) bank presence in the country increased,
(3) banking legislation had a stronger foundation,
and
(4) deposits had increased.
However, the benefits had still not flowed in their
entirety to the general public, because credit was not reaching sectors that most
needed it, and the banking industry did not have a national presence, because of
its concentration in metropolitan and urban areas. On December 1967, through
the Banking Laws Amendment Act (Reserve Bank of India 2008), the idea of
social control was introduced. The main objective of social control was to
achieve:
(1) bank credit allocation to the right sectors,
(2) prevent misuse of bank funds, and
(3) use banks to promote and help finance socioeconomic development.
The National Credit Council was established in 1968
to help allocate credit according to the Five Year Plan priorities .In 1969 by
putting into effect the Banking Companies (Acquisition and Transfer of
Undertakings) Ordinance, fourteen banks were nationalized.

Nationalization led to major structural changes in

the banking sector of India. Branch expansion was accompanied by
development of priority sectors of the economy, with credit being directed
towards these sectors contrary to profit motives of the banks. The Credit
Guarantee Corporation of India Ltd. was established for providing guarantees
against the risk of default in payment, which increased the number of loans to
smaller borrowers by the banks. .
The interest rate paid by the banks on deposits.
The nationalization phase was marked by stringent controls on the banking
industry. As of September 22nd, 1990 the Cash Reserve Ratio was 15.00% and
the Statutory Liquidity Ratio was 38.5% (Reserve Bank of India), combined
they amounted to 53.5% of all demands and liabilities being saved in liquid
government securities or as cash with the RBI. The banks were being used by
the government to fund their projects for economic development. This led the
banks to be unprofitable forcing the government to adopt changes and thus,
came about the reforms of 1991 led by the Narasimham Committee.
There are two main approaches to banking
regulation. One endpoint is government. ownership of the banking industry and
the other endpoint is free banking system. Barth, Caprio and Levine (2008)
describe the two main approaches as the Public Interest Approach and the
Private Interest View of Regulation. In India up until 1991 there was an
increased amount of government regulation in the banking industry, and social
control over the banks was mandated successful. Social control in banking
would realize if the banks to manage to allocate resources efficiently while
mobilizing credit in all sectors including the marked out priority sectors.
Barth,Caprio and Levine (2008) define socially efficient as, that the banking
system allocates resources in a way that maximizes output,while minimizing
variance, and is distributionally preferred.
The government of India initially put in process the
policy of social control to help regulate, stabilize and expand the banking
system. The government had good intentions, and it led to a banking system that
spanned across the nation and was undergoing fewer banking failures, and
actually making profits while lending to priority sectors.



THE SECOND ROUND

Nationalization that incorporated six more

banks, and increased government regulation, made the banking system very
inefficient and unprofitable; Joshi and Little (1997) said, By 1991, the country
had erected an unprofitable, inefficient, and financially unsound banking
sector.
There are various ways a government can
interfere with the banking system of an economy, and the Indian government,
participated in all the below mentioned measures. Barth, rate of economic
growth within those states accelerated and quality of bank lending improved.
Caprio and Levine (2008)
outline the main ones as:
(1) restrictions on banks,
(2) entry,
(3) capital requirements,
(4) supervisory powers,
(5) safety net support the,
(6) market monitoring and
(7) government ownership.
(1) Restrictions on Banks: It can be in the form of activity restrictions. It is
critical to impose activity restrictions on banks, and that helps define the term
bank. Regulatory restrictions can decrease efficiency of the banks and reduces
their ability to diversify their income streams and decrease overall risk of
operations. A cross country data study by Barth, Caprio and Levine (2001) finds
that greater regulatory restrictions lead to a higher probability of a country
suffering from a major bank crisis and lower banking sector efficiency. The
Indian banks operated under many regulatory restrictions which limited their
activities in off balance sheet activities.
(2) Entry restriction: Governments have control over the banking system by
regulating the entry of new private and foreign banks. Jayaratne and Strahan
(1998) have performed studies that suggest when US created a more
competitive environment by removing branching restrictions ,The Indian
government had placed restrictions on entry of foreign banks and private banks.
These banks required government licenses to operate in India.

In 1993 the RBI permitted private entry into the

banking sector, but imposed restrictions on branch expansion. Various studies
have shown that entry restrictions are not favorable for the banking industry.
(3) Capital Requirements: In addition to entry restrictions, governments can
enforce regulations on minimum capital requirements. It can affect risk taking
activities and it helps create a pseudo overall economy.with the benefits derived
from imposition of capital requirements by the government.
(4) Supervisory Powers and Market Monitoring: It can be combined into one
category and it refers to official supervision of banking activities in the country.
Developing countries usually have directed credit programs and high reserve
and liquidity requirements, this helps provide a cushion in times of crisis and as
they liberalize these requirements, the banks need to have proper supervision of
their activities. However, the private interest view argues otherwise. However
there are not many studies on this that promote either view.
The private interest view argues that excessive
supervision can lead to corruption by government officials. It also says that
government employees have no motivation to work in the government as the
government pays them lesser than private banks and they would be willing to
take bribes to produce a good report on a bank. India has instituted agencies that
monitor banks performance. RBI also has supervisory powers and it places
them in effect by looking at the financial statements of banks on a regular basis
through the course of the year.
(5) Safety Net Support: It has two main parts, one being the lender of the
last resort and the other an explicit deposit insurance system. Proponents of
the private interest view feel that it is a moral hazard and present several other
ways to protect small depositors.

The objectives of bank regulation, and the emphasis, vary between

jurisdictions. The most common objectives are:
Prudentialto reduce the level of risk to which bank creditors are exposed (i.e.
to protect depositors)
1. Systemic risk reductionto reduce the risk of disruption resulting from
adverse trading conditions for banks causing multiple or major bank failures
1. Avoid misuse of banksto reduce the risk of banks being used for
criminal purposes, e.g. laundering the proceeds of crime.
2. To protect banking confidentiality.
3. Credit allocationto direct credit to favored sectors.
4. It may also include rules about treating customers fairly and
having corporate social responsibility(CSR).

EVALUTION.
PRIVATE OWNERSHIP,
NATIONALIZATION AND
DISINVESTMENT
Effects of these reforms on the private and public banking
system
Credit structure and setting up of institutional framework
for providing longterm finance to agriculture and industry. Banking sector, which
during the preindependence India was catering to the needs of the government,
rich individuals and traders, opened its door wider and set out for the first time to
bring the entire productive sector of the economy large as well as small, in its
fold. During this period number of commercial banks declined remarkably. There
were 566 banks as on December, 1951; of this, number scheduled banks was 92 and
the remaining 474 were non-scheduled banks.
This number went down considerably to the level of
281 at the close of the year 1968. The sharp decline in the number of banks was due
to heavy fall in the number of non-scheduled banks which touched an all time low
level of 210. The banking scenario prevalent in the country up-tothe year 1968
depicted a strong stress on class banking based on security rather than on' purpose.
Before 1968, only RBI and Associate Banks of SBI were mainly controlled by
Government. Some associates were fully owned subsidiaries of SBI and in the rest,
there was a very small shareholding by individuals and the rest by RBI.
EXPANSION PHASE (1968-1984)
The motto of bank nationalization was to make
banking services reach the masses that can be attributed as "first- banking
revolution". Commercial banks acted as vital instruments for this purpose by way
of rapid branch expansion, deposits mobilization and credit creation. Penetrating
into rural areas and agenda for geographical expansion in the form of branch
expansion continued. The second dose of nationalization of 6 more commercial
banks on April 15, 1980 further widened the phase of the public sector banks and
therefore banks were to implement all the government sponsored programmes and
change their attitude in favour of social banking, which was given the highest
priority.

This phase witnessed socialization of banking in

1968. Commercial banks were viewed as agents of change and social control on
banks.
However, inadequacy of social control soon became
apparent because all banks except the SBI and its seven associate banks were in the
private sector and could not be influenced to serve social interests. Therefore, banks
were nationalized (14 banks in 1969 and 6 banks in 1980) in order to control the
heights of the economy in conformity with national policy and objectives.
This period saw the birth and the growth of what is
now termed as directed lending by banks.
It also saw commercial banking spreading to far and
wide areas in the country with great pace during which a number of poverty
alleviation and employment generating schemes were sought to be implemented
through commercial banks. Thus, this period was characterized by the death of
private banking and the dominance of social banking over commercial banking. It
was hardly realized that banks 'were organizations with social responsibilities but
not social organizations.
This period also witnessed the birth of Regional Rural
Bank (RRBS) in 1975 and NABARAD in 1982 which had priority sector as their
focus of activity.
Although number of commercial banks declined from
281 in 1968 to 268 in 1984, number of scheduled banks shot up from 71 to 264
during the corresponding period, number of non-scheduled banks having registered
perceptible decline from 210 to 4 during the period under reference. The rise
in the number of scheduled banks was, as stated above, due to the
emergence of RRBS.
The fifteen years following the banks nationalization in
1969 were dominated by the Banks expansion at a path breaking pace. As many as
50,000 bank branches were set up; three-fourths of these branches were opened in
rural and semi-urban areas. Thus, during this period a distinct transformation of far
reaching significance occurred in the Indian banking system as it assumed a broad
mass base and emerged as an important instrument of socio-economic changes.
Thus, with growth came inefficiency and loss of control over widely spread offices.
Moreover, retail lending to more risk-prone areas at concessional interest rates had
raised costs, affected the quality of assets of banks and put their profitability under
strain.
The competitive efficiency of the banks was at a low ebb.
Customer service became least available commodity. Performance of a bank/banker
began to 61 be measured merely in terms of growth of deposits, advances and other
such targets and quality became a casualty.

The progress of branch expansion is presented in the Table:

BRANCH EXPANSION SINCE 1969 TO 1991
Year Total No. of Branches
1969
8262
1980
32419
1991
60,220

Rural Branches
1833
15105
35206

Semi-urban Branches
3342
8122
11,344

It can be seen from the Table 4.1 that the total number
of bank branches increased eight-fold between 1969 to 1991.
The bulk of the increase was on account of rural
branches which increased from less than 2000 to over 35000 during the period.
The percentage share of the rural and semi-urban branches rose from 22 and 4
respectively in 1969 to 45 percent and 25 percent in 1980 and 58 per cent and 18
percent in 1991.
The impact of this phenomenal growth was to bring
down the population per branch from 60,000 in 1969 to about 14,000. The banking
system thus assumed a broad mass-base and emerged as an important instrument of
social-economic changes. However, this success was neither unqualified nor
without costs.
While the rapid branch expansion, wider geographical
coverage has been achieved, lines of supervision and control had been stretched
beyond the optimum level and had weakened. Moreover, retail lending to more
risk-prone areas at concessional interest rates had raised costs, affected the quality
of assets of banks and put their profitability under strain.

PRIVATE OWNERSHIP
The underprovision of credit to small-scale industry
was one of the key reasons cited for nationalization in 1969: thus, it might in fact be
the case that while the public sector banks provide relatively little credit to SSI
firms, private banks are even worse. In the next sub-section we examine the effect
of bank ownership on bank allocation of credit.
Bank Ownership and Sectoral Allocation of Credit As
mentioned above, an important rationale for the Indian bank nationalizations was to
direct credit towards sectors the government thought were underserved, including
small scale industry, as well as agriculture and backward areas.
Ownership was not the only means of directing credit:
the Reserve Bank of India issued guidelines in 1974, indicating that both public and
private sector banks must provide at least one-third of their aggregate advances to
the priority sector by March 1979. In 1980, it was announced that this quota would
be increased to 40 percent by March 1985. Sub-targets were also specified for
lending to agriculture and weaker sectors within the priority sector. Since public
and private banks faced the same regulation, in this section we focus on how
ownership affected credit allocation.
The comparison of nationalized and private banks is
never easy: banks that fail are often merged with healthy nationalized banks, which
makes the comparison of nationalized banks and non-nationalized banks close to
meaningless.
The Indian nationalization experience of 1980
represents a unique chance to learn about the relationship between bank ownership
and bank lending behavior. The 1980 nationalization took place according to a
strict policy rule: all private banks whose deposits were above a certain cutoff were
nationalized.18 After 1980, the nationalized banks remained corporate entities,
retaining most of their staff, though the board of directors was replaced by
nominees of the Government of India.
Both the banks that got nationalized under this rule and
the banks that missed being nationalized, continued to operate in the same
environment, and face the same regulations and therefore ought to be directly
comparable .Even this comparison between banks just nationalized and just not
nationalized may be invalid, because policy rule means that banks nationalized in
1980 are larger than the banks that. remained private. If size influences bank
behavior, it would be incorrect to attribute all differencesbetween nationalized and
private sector banks to nationalization. In this section, based on Cole, we adopt an
approach in the spirit of regression discontinuity design, and compare banks
that were just above the 1980 cut off to those that were just below the 1980 cutoff,
while control- 18While the 1969 was larger, and also induced a discontinuity,

We do not use it because many of the banks just below the cut-off in 1969 were
nationalized in 1980.
One policy option that is being discussed is
privatization. The evidence from Cole, discussed above, suggests that privatization
would lead to an infusion of dynamism in to the banking sector: private banks
have been growing faster than comparable public banks in terms of credit, deposits
and number of branches, including rural branches, though it should be noted that
in our empirical analysis, the comparison group of private banks were the
relatively small old private banks.48 It is not clear that we can extrapolate from
this to what we could expect when the State Bank of India, which is more than an
order of magnitude greater in size than the largest old private sector banks. The
new private banks are bigger and in some ways would have been a better group
to compare with.
However while this group is also growing very fast,
they have been favored by regulators in some specific ways, which, combined
with their relatively short track record, makes the comparison difficult.
Privatization will also free the loan officers from the fear of the CVC and make
them somewhat more willing to lend aggressively where the prospects are good,
though, as will be discussed. Later, better regulation of public banks may also
achieve similar goals.
Historically, a crucial difference between public and
private sector banks has been their willingness to lend to the priority sector. The
recent broadening of the definition of priority sector has mechanically increased
the share of credit from both public and private sector banks that qualify as
priority sector. The share of priority sector lending from public sector banks was
42.5 percent in 2003, up from 36.6 percent in 1995.
Private sector lending has shown a similar increase
from its 1995 level of 30 percent. In 2003 it may have surpassed for the first time
ever public sector banks, with a share of net bank credit to the priority sector at
44.4 percent to the priority sector.49 Still, there are substantial differences
between the public and private sector banks.
Most notable is the consistent failure of private
sector banks to meet the agricultural lending subtarget, though they also lend
substantially less in rural areas. Our evidence suggests that privatization will make
it harder for the government to get the private banks to comply with what it wants
them to do.

However it is not clear that this reflects the greater

sensitivity of the public banks to this particular social goal. It could also be that
credit to agriculture, being particularly politically salient, is the one place where
the nationalized banks are subject to political pressures to make imprudent loans.
Finally, one potential disadvantage of privatization comes from the risk of bank
failure.
In the past there have been cases where the owner of the
private bank stripped its assets, and declared that it cannot honor its deposit
liabilities.
The government is, understandably, reluctant to let
banks fail, since one of the achievements of the last forty years has been to
persuade people that their money is safe in the banks.
Therefore, it has tended to take over the failed bank,
with the resultant pressure on the fiscal deficit. Of course, this is in part a result of
poor regulationthe regulator should be able to spot a private bank that is stripping
its assets. Better enforced prudential regulations would considerably strengthen
the case for privatization. On the other hand, public banks have also been failing
the problem seems to be part corruption and part inertia/laziness on the part of the
lenders.
As we saw above, the cost of bailing out the public
banks may well be larger (appropriately scaled) than the total losses incurred from
every bank failure since 1969 All numbers are from various issues of Report on
Trends and Progress of banking in India.

PROTECTION OF DEPOSITORS
As stated earlier, financial intermediation by commercial banks has played a
key role in India in supporting the economic growth process. An efficient
financial intermediation process, as is well known, has two components:
effective mobilization of savings and their allocation to the most productive
uses. In this chapter, we will discuss one part of the financial intermediation
by banks: mobilization of savings. When banks mobilize savings, they do it in
the form of deposits, which are the money accepted by banks from customers to
be held under stipulated terms and conditions. Deposits are thus an instrument
of savings.
Since the first episode of bank nationalization
in 1969, banks have been at the core of the financial intermediation process in
India. They have mobilized a sizeable share of savings of the household sector,
the major surplus sector of the economy.
This in turn has raised the financial savings of
the household sector and hence the overall savings rate. Notwithstanding the
liberalization of the financial sector and increased competition from various
other saving instruments, bank deposits continue to be the dominant instrument
of savings in India. provides a description of the most standard instruments of
bank regulation: deposit insurance, capital adequacy requirements and lender of
last resort.
These three policies are linked one with the other.
Deposit insurance protects the smallest depositors from a bank bankruptcy and
prevents bank runs. Capital adequacy requirements are necessary in order to
make sure that bank managers follow a responsible credit policy, in the absence
of an effective control on the part of depositors. Lender of last resort policies
further reduce the risk of banks bankruptcies providing banks with Emergency
Liquidity Assistance facilities that are designed to avoid that temporary
situations

Safety of deposits
At the time of depositing money with the bank, a
depositor would want to be certain that his her money is safe with the bank and
at the same time, wants to earn a reasonable return.The safety of depositors'
funds, therefore, forms a key area of the regulatory framework for banking. In
India, this aspect is taken care of in the Banking Regulation Act, 1949 (BR
Act).
The RBI is empowered to issue directives/advices on
several aspects regarding the conduct of deposit accounts from time to time.
Further, the establishment of the Deposit Insurance Corporation in 1962
(against the backdrop of failure of banks) offered protection to bank depositors,
particularly small-account holders. This aspect has been discussed later in the
Chapter.
Deregulation of interest rates
The process of deregulation of interest rates started in
April 1992. Until then, all interest rates were regulated; that is, they were fixed
by the RBI. In other words, banks had no freedom to fix interest rates on their
deposits. With liberalization in the financial system, nearly all the interest rates
have now been deregulated.
Now, banks have the freedom to fix their own
deposit rates with only a very few exceptions. The RBI prescribes interest rates
only in respect of savings deposits and NRI deposits, leaving others for
individual banks to determine.
Deposit policy
The Board of Directors of a bank, along with its top
management, formulates policies relating
to the types of deposit the bank should have, rates of interest payable on each
type, special deposit schemes to be introduced, types of customers to be targeted
by the bank, etc. Of course, depending on the changing economic environment,
the policy of a bank towards deposit mobilization, undergoes changes.

Types of Deposit Accounts

The bank deposits can also be classified into
(i) demand deposits and
(ii) time deposits.
(i) Demand deposits are defined as deposits payable on demand through cheque
or otherwise. Demand deposits serve as a medium of exchange, for their
ownership can be transferred from one person to another through cheques and
clearing arrangements provided by banks. They have no fixed term to maturity.
(ii) Time deposits are defined as those deposits which are not payable on
demand and on which cheques cannot be drawn. They have a fixed term to
maturity. A certificate of deposit (CD), for example, is a time deposit
Certificate of Deposit
A Certificate of Deposit (CD) is a negotiable money
market instrument and is issued in dematerialized form or as a Usance
Promissory Note, for funds deposited at a bank or other eligible financial
institution for a specified time period. Guidelines for issue of CDs are currently
governed by various directives issued by the RBI, as amended from time to
time. CDs can be issued by
(i) scheduled commercial banks (SCBs) excluding
Regional Rural Banks (RRBs) and Local Area Banks (LABs); and
(ii) select all-India Financial Institutions
that have been permitted by the RBI to raise short-term resources within the
umbrella limit fixed by RBI. Deposit amounts for CDs are a minimum of Rs.1
lakh, and multiples thereof. Demand and time deposits are two broad categories
of deposits. Note that these are only categories of deposits; there are no deposit
accounts available in the banks by the names 'demand deposits' or 'time
deposits'. Different deposit accounts offered by a bank, depending on their
characteristics, fall into one of these two categories.
There are several deposit accounts offered by banks in India; but they can be
classified into three main categories:
1.Current account
2.Savings bank account
3.Term deposit account

Deposit Insurance:
Deposit insurance helps sustain public confidence
in the banking system through the protection of depositors, especially small
depositors, against loss of deposit to a significant extent. In India, bank deposits
are covered under the insurance scheme offered by Deposit Insurance and
Credit Guarantee Corporation of India (DICGC), which was established with
funding from the Reserve Bank of India.
The scheme is subject to certain limits and
conditions. DICGC is a wholly-owned subsidiary of the RBI.
1. Banks insured by the DICGC All commercial banks including branches of
foreign banks functioning in India, local area banks and regional rural banks are
insured by the DICGC.22
Further, all State, Central and Primary cooperative banks
functioning in States/Union Territories which have amended the local
Cooperative Societies Act empowering RBI suitably are insured by the DICGC.
Primary cooperative societies are not insured by the DICGC.
2 Features of the scheme
When is DICGC liable to pay?
In the event of a bank failure, DICGC protects bank deposits that are payable in
India. DICGC is liable to pay if (a) a bank goes into liquidation or (b) if a bank
is amalgamated/ merged with another bank.
Methods of protecting depositors' interest
There are two methods of protecting depositors' interest when
an insured bank fails:
by transferring business of the failed bank to another sound bank23
(i)
(in case of merger or amalgamation) and
(ii) where the DICGC pays insurance proceeds to depositors (insurance
pay-out method).

Types of deposit covered by DICGC

The DICGC insures all deposits such as savings, fixed, current, recurring, etc.

except the following types of deposits:

A). Deposits of foreign Governments;
B). Deposits of Central/State Governments;
C). Inter-bank deposits;
D). Deposits of the State Land Development Banks with the State
co-operative bank;
E). Any amount due on account of any deposit received outside India;
F). Any amount, which has been specifically exempted by the corporation
with the previous approval of RBI.
Maximum deposit amount insured by the DICGC
Each depositor in a bank is insured up to a
maximum of Rs100,000 for both principal and interest amount held by him in
the same capacity and same right.
For example, if an individual had a deposit with principal amount of Rs.90,000
plus accrued interest of Rs.7,000, the total amount insured by the DICGC would
be Rs.97,000. If, however, the principal amount were Rs. 99,000 and accrued
interest of Rs 6,000, the total amount insured by the DICGC would be Rs 1
lakh.
The deposits kept in different branches of a bank are
aggregated for the purpose of insurance cover and a maximum amount up to Rs
1 lakh is paid. Also, all funds held in the same type of ownership at the same
bank are added together before deposit insurance is determined. If the funds are
in different types of ownership (say as individual, partner of firm, director of
company, etc.) or are deposited into separate banks they would then be
separately insured.
Also, note that where a depositor is the sole proprietor
and holds deposits in the name of the proprietary concern as well as in his
individual capacity, the two deposits are to be aggregated and the insurance
cover is available up to rupees one lakh maximum. Cost of deposit insurance
Deposit insurance premium is borne entirely by the insured bank. Banks are
required to pay the insurance premium for the eligible amount to the DICGC on
a semi-annual basis.

The cost of the insurance premium cannot be passed on

to the custom. Withdrawal of insurance cover
The deposit insurance scheme is compulsory and no
bank can withdraw from it. The DICGC, on the other hand, can withdraw the
deposit insurance cover for a bank if it fails to pay the premium for three
consecutive half year periods. In the event of the DICGC withdrawing its
cover from any bank for default in the payment of premium, the public will be
notified through the newspapers.

Basics of Bank Lending

Banks extend credit to different categories of
borrowers for a wide variety of purposes. For many borrowers, bank credit is
the easiest to access at reasonable interest rates. Bank credit is provided to
households, retail traders, small and medium enterprises (SMEs), corporates,
the Government undertakings etc. in the economy.
Retail banking loans are accessed by consumers
of goods and services for financing the purchaseof consumer durables, housing
or even for day-to-day consumption. In contrast, the need forcapital investment,
and day-to-day operations of private corporates and the Government
undertakings are met through wholesale lending.
Loans for capital expenditure are usually extended
with medium and long-term maturities, while day-to-day finance requirements
are provided through short-term credit (working capital loans). Meeting the
financing needs of the agriculture sector is also an important role that Indian
banks play.
1. Principles of Lending and Loan policy
Principles of lending
To lend, banks depend largely on deposits
from the public. Banks act as custodian of public deposits. Since the depositors
require safety and security of their deposits, want to withdraw deposits
whenever they need and also adequate return, bank lending must necessarily
Be based on principles that reflect these concerns of the depositors.
These principles include:
1). safety
2). liquidity
3). profitability
4). and risk diversion.

Safety:
Banks need to ensure that advances are safe and money lent out by
them will come back. Since the repayment of loans depends on the borrowers'
capacity to pay, the banker must be satisfied before lending that the business for
which money is sought is a sound one. In addition, bankers many times insist on
security against the loan, which they fall back on if things go wrong for the
business.
The security must be adequate, readily marketable and free
of encumbrances.
Liquidity:
To maintain liquidity, banks have to ensure that money lent out by
them is not locked up for long time by designing the loan maturity period
appropriately. Further, money must come back as per the repayment schedule. If
loans become excessively illiquid, it may not be possible for bankers to meet
their obligations vis--vis depositors.
Profitability:
To remain viable, a bank must earn adequate profit on its investment.
This calls for adequate margin between deposit rates and lending rates. In this
respect, appropriate fixing of interests rates on both advances and deposits is
critical. Unless interest rates are competitively fixed and margins are adequate,
banks may lose customers to their competitors and become unprofitable.
Risk diversification:
To mitigate risk, banks should lend to a diversified customer base.
Diversification should be in terms of geographic location, nature of business
etc. If, for example, all the borrowers of a bank are concentrated in one region
and that region gets affected by a natural disaster, the bank's profitability can be
seriously affected.

Loan Policy
Based on the general principles of lending stated
above, the Credit Policy Committee (CPC) of individual banks prepares the
basic credit policy of the Bank, which has to be approved by the Bank's Board
of Directors.
The loan policy outlines lending guidelines and
establishes operating procedures in all aspects of credit management including
standards for presentation of credit proposals, financial covenants, rating
standards and benchmarks, delegation of credit approving powers, prudential
limits on large credit exposures, asset concentrations, portfolio management,
loan review mechanism, risk monitoring and evaluation, pricing of loans,
provisioning for bad debts, regulatory/ legal compliance etc.
The lending guidelines reflect the specific bank's
lending strategy (both at the macro level and individual borrower level) and
have to be in conformity with RBI guidelines.
The loan policy typically lays down lending guidelines in the following areas:
1). Level of credit-deposit ratio
2).Targeted portfolio mix
3). Hurdle ratings
4). Loan pricing
5). Collateral security

Credit Deposit (CD) Ratio Lending Rates

Banks are free to determine their own lending rates on
all kinds of advances except a few such as export finance; interest rates on these
exceptional categories of advances are regulated by the RBI. It may be noted
that the Section 21A of the BR Act provides that the rate of interest charged
by a bank shall not be reopened by any court on the ground that the rate of
interest charged is excessive.
The concept of benchmark prime lending rate (BPLR)
was however introduced in November 2003 for pricing of loans by commercial
banks with the objective of enhancing transparency in the pricing of their loan
products. Each bank must declare its benchmark prime lending rate (BPLR) as
approved by its Board of Directors. A bank's BPLR is the Interest rate to be
charged to its best clients; that is, clients with the lowest credit risk. Each bank
is also required to indicate the maximum spread over the BPLR for various
credit exposures.

However, BPLR lost its relevance over time as a

meaningful reference rate, as the bulk of loans were advanced below BPLR.
Further, this also impedes the smooth transmission of monetary signals by the
RBI. The RBI therefore set up a Working Group on Benchmark Prime Lending
Rate (BPLR) in June 2009 to go into the issues relating to the concept of BPLR
and suggest measures to make credit pricing more transparent.

Guidelines on Fair Practices Code for Lenders

RBI has been encouraging banks to introduce a
fair practices code for bank loans. Loan application forms in respect of all
categories of loans irrespective of the amount of loan sought by the borrower
should be comprehensive. It should include information about the fees/ charges,
if any, payable for processing the loan, the amount of such fees refundable in
the case of non acceptance of application, prepayment options and any other
matter which affects the interest of the borrower, so that a meaningful
comparison with the fees charged by other banks can be made and informed
decision can be taken by the borrower. Further, the banks must inform 'all-in
cost' to the customer to enable him to compare the rates charged with other
sources of finance.
Regulations relating to providing loans
The provisions of the Banking Regulation Act, 1949
(BR Act) govern the making of loans by banks in India. RBI issues directions
covering the loan activities of banks. Some of the major guidelines of RBI,
which are now in effect, are as follows:
1). Advances against bank's own shares: a bank cannot grant any loans and
advances against the security of its own shares.
2). Advances to bank's Directors: The BR Act lays down the restrictions on
loans and advances to the directors and the firms in which they hold substantial
interest.

3). Restrictions on Holding Shares in Companies: In terms of Section 19(2) of

the BR Act, banks should not hold shares in any company except as provided in
sub-section
(A) whether as pledgee, mortgagee or absolute owner, of an amount exceeding
30% of the paid-up share capital of that company or 30% of its own paid-up
share capital and reserves, whichever is less.
Following the recommendations of the Group, the Reserve
Bank has issued guidelines in February 2010. According to these guidelines, the
'Base Rate system' will replace the BPLR system with effect from July 01,
2010.All categories of loans should henceforth be priced only with reference to
the Base Rate. Each bank will decide its own Base Rate.
The actual lending rates charged to borrowers would be the
Base Rate plus borrower-specific charges, which will include product specific
operating costs, credit risk premium and tenor premium.
Since transparency in the pricing of loans is a key objective,
banks are required to exhibit the information on their Base Rate at all branches
and also on their websites. Changes in the Base Rate should also be conveyed to
the general public from time to time through appropriate channels.
Apart from transparency, banks should ensure that interest rates
charged to customers in the above arrangement are non-discriminatory in
nature. Guidelines on Fair Practices Code for Lenders RBI has been
encouraging banks to introduce a fair practices code for bank loans.
Loan application forms in respect of all categories of loans
irrespective of the amount of loan sought by the borrower should be
comprehensive. It should include information about the fees/ charges, if any,
payable for processing the loan, the amount of such fees refundable in the case
of non-acceptance of application, prepayment options and any other matter
which affects the interest of the borrower, so that a meaningful comparison with
the fees charged by other banks can be made and informed decision can be
taken by the borrower. Further, the banks must inform 'all-in-cost' to the
customer to enable him to compare the rates charged with other sources of
finance.

PROMOTION OF UNDER PRIVILEGED CLASSES

General principles of bank regulation
Banking regulations can vary widely across nations and
jurisdictions. This section of the article describes general principles of bank
regulation throughout the world.
Minimum requirements
Requirements are imposed on banks in order to promote the objectives of the
regulator. Often, these requirements are closely tied to the level of risk exposure
for a certain sector of the bank. The most important minimum requirement in
banking regulation is maintaining minimum capital ratios. To some extent, U.S.
banks have some leeway in determining who will supervise and regulate them.
Supervisory review
Banks are required to be issued with a bank license by the regulator in order to
carry on business as a bank, and the regulator supervises licensed banks for
compliance with the requirements and responds to breaches of the requirements
through obtaining undertakings, giving directions, imposing penalties or
revoking the bank's license.
Market discipline
The regulator requires banks to publicly disclose financial and other
information, and depositors and other creditors are able to use this information
to assess the level of risk and to make investment decisions. As a result of this,
the bank is subject to market discipline and the regulator can also use market
pricing information as an indicator of the bank's financial health.

Instruments and requirements of bank regulation

Capital requirement
The capital requirement sets a framework on how banks must handle
their capital in relation to their assets. Internationally, the Bank for International
Settlements' Basel Committee on Banking Supervision influences each
country's capital requirements. In 1988, the Committee decided to introduce a
capital measurement system commonly referred to as the Basel Capital Accords.
The latest capital adequacy framework is commonly known as Basel III.[5] This
updated framework is intended to be more risk sensitive than the original one,
but is also a lot more complex.
Reserve requirement
The reserve requirement sets the minimum reserves each bank must hold to
demand deposits and banknotes. This type of regulation has lost the role it once
had, as the emphasis has moved toward capital adequacy, and in many countries
there is no minimum reserve ratio. The purpose of minimum reserve ratios is
liquidity rather than safety. An example of a country with a contemporary
minimum reserve ratio is Hong Kong, where banks are required to maintain
25% of their liabilities that are due on demand or within 1 month as qualifying
liquefiable assets.
Reserve requirements have also been used in the past to
control the stock of banknotes and/or bank deposits. Required reserves have at
times been gold coin, central bank banknotes or deposits, and foreign currency.
Corporate governance
Corporate governance requirements are intended to encourage the bank to be
well managed, and is an indirect way of achieving other objectives. As many
banks are relatively large, with many divisions, it is important for management
to maintain a close watch on all operations. Investors and clients will often hold
higher management accountable for missteps, as these individuals are expected
to be aware of all activities of the institution. Some of these requirements may
include:

1. To be a body corporate (i.e. not an individual, a partnership, trust or other

unincorporated entity)
2. To be incorporated locally, and/or to be incorporated under as a particular
type of body corporate, rather than being incorporated in a foreign
jurisdiction.
3. To have a minimum Securities and Exchange Commission (SEC)
financial reporting standard Quarterly Disclosure Statements SarbanesOxley Act of 2002

Out of the 637 commercial banks in India in

1947, 200 were in Madras, 106 were in West Bengal and 40 were in Mumbai.
This left only 291 banks to cover all the rest of India (Reserve Bank of India
2008a).
However, before expansion of the banking system,
the government had to ensure a stable financial system. This led to the creation
of the Banking Regulations Act (1949), which came into effect on March 16th,
1949 (Banking Regulation Act 1949). The act formed separate legislation for
companies operating as banks. It also vested the RBI with further powers such
as:
(1) control over opening new banks and branches,

(2) power to inspect books of the companies that qualified as banks

under this act,
(3) prevent voluntary winding up of licensed banking companies,
(4) regularly reporting financial statements to the Reserve Bank of
India.