Slide - 01 DEFINITION OF BANKING AND FUNCTIONS OF BANKS

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Outline/Learning Objectives

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Definition of Banking and Banking Company. Primary Activities/Core Functions of Banks Ancillary/Subsidiary Activities of Banks Prohibited Activities for Banks in India Basic Principles of Banking Types of Banking Groups in India Traditional & Modern Functions of Banks Emerging Trends and Challenges in Banking

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Functions and Forms of Banking

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What do banks do for their customers? Why do banks perform those services? How do banks compare to other financial service organizations? What factors have affected the operations of commercial banks and other financial service organizations? What are the principal sources and uses of funds for banks? Mobilisation & Deployment of Resources by Banks Key Words/Terminologies/Glossary.

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DEFINITION OF BANK/BANKING u/r INDIAN LAW

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Definition of Banking as per Indian Banking Regulation Act, 1949 : Accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise. (Section 5b) A Banking Company is a Company which transacts the business of banking in India. (Section 5c) As per the above definition the following are the core or primary functions/activities of a Bank/Commercial Bank.

Acceptance of Deposits of money from the public And deploying such money either for the purpose of Lending i.e. giving loans Or for making Investments (Mandated/Statutory Investments for SLR Purposes known as SLR Investments and Non-SLR/NonMandated Investments)
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DEFINITION OF BANK/BANKING u/r INDIAN LAW

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The other salient features of this banking definition are : Subject to the obligation to repay the deposits to the customers on demand or otherwise as per the terms of the deposits. Thus the banker does not refund the money on its own accord, even if the period for which it was deposited expires. The depositor has to make a demand for the same . Deposits are withdrawable by means of any instrument in writing whether a Cheque, Draft and Order or otherwise (withdrawal slip, letter, voucher. Thus the demand should be made in a proper manner through an instrument in writing and not merely by a verbal order or a telephonic message. The phrase deposits of money from the public has great significance. The banker accepts deposits from the public i.e., who ever offers his money as deposit. However, a banker can refuse to open accounts for undesirable persons. Hence, moneylenders and indigenous bankers are Not considered as Banks.
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DEFINITION OF BANK/BANKING u/r INDIAN LAW

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The essential functions of a banking company are the acceptance of deposits, and lending and/or investing such deposits. If the purpose of acceptance of deposits is Not for lending or investing, the business cannot be called banking. Hence, a manufacturing company accepting deposits of money from public for financing its own business is not considered as a banking company. Its only a bank/banking company which can issue Cheques/Drafts, i.e., accepts chequable deposits. Hence, a Non-banking finance company (NBFC) accepting deposits of money from public and engaged in lending and/or investing such deposits are Not considered as banks as they cannot issue Cheques/Drafts.

The Use of word Bank (Sec. 7 of BR Act, 1949) : No company other than a banking company is permitted to use as part of its name words like Bank/Banker/Banking.

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Ancillary Permitted Banking Activities

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As per section 6 of BR act, 1949, Banks are authorised to carry out the following functions in addition to the above principal functions :

Discounting of Bills Collection of Cheques and Bills Payment Function/Remittance Services (DD, BC, MT, TT, ECS, NEFT, RTGS, SWIFT, Credit/Debit Card/Smart Card etc.) Safe Custody of Articles Hiring Safe Deposit Lockers Conducting Foreign Exchange Transactions Conducting Government Transactions Issuing Letter of Credit and Guarantees Merchant Banking Functions Collection of Utility Bills/School fees Distribution of Insurance and Mutual Fund Products
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PROHIBITED BANKING ACTIVITIES

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Section 8 of BR act prohibits a banking company from engaging in the following activities : Directly or indirectly in trading activities and undertaking trading risks Buying or Selling or Bartering of Goods directly or indirectly Section 9 prohibits a banking company from holding immovable properties, howsoever acquired, except as is required for its own use, for a period exceeding 7 years from the acquisition of the property. RBI may extend this period by another 5 years. Banking in India is governed by the following statutes : Banking Regulation Act, 1949 RBI Act, 1934 SBI Act, 1955 & SBI (Subsidiary Banks) Act, 1959 Banking Companies (Acquisitions & Transfer of Undertakings) Act, 1970 and 1980 (more popularly known as Bank Nationalisation Act)
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BASIC PRINCIPLES OF BANKING

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Principle of Intermediation Principle of Prudence Principle of Liquidity

Principle of Profitability
Principle of Solvency Principle of Trust

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TYPES OF BANKING GROUPS IN INDIA

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Scheduled and Non-Scheduled Banks

(a) Scheduled Banks : included in the 2nd schedule of the RBI Act, 1934. Paid up capital = or > Rs.5 lakh and they have convinced RBI that their affairs are Not conducted in a manner detrimental to the interest of their depositors. These Banks are required to maintain CRR and SLR. Scheduled Banks are classified as under : 1.1 Co-operative Banks (State and Urban Co-op Banks) 1.2 Commercial Banks 1.2.1 Foreign Scheduled Banks 1.2.2 Indian Scheduled Banks (a) Private Sector Scheduled Banks : Both Old and New (b) Public Sector Scheduled Banks (total 26 as of now) (i) State Bank Group : SBI + its 5 subsidiaries (ii) Nationalised Banks : 19 + IDBI Bank 1 (iii) Regional Rural Banks (RRBs) : about 84 as of now

(b) Non-Scheduled Banks : Not included in the 2nd schedule of the RBI act. Their No. has progressively reduced over the years.
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What do banks do for their customers?

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Role and Functions of Commercial Banks : (a) Traditional Functions : These are performed by almost every bank, irrespective of its size, ownership pattern and operational area. (b) Modern Functions : These are mostly performed by large sized/modern banks, situated in commercial centres or metro cities. Traditional Functions /(Core or Primary or Essential): Financial Intermediation : (a) Deposit Function/Accepting Deposits, (b) Loan Function/Making Loans and (c) Investment Function/Making Investments Payment & Settlement System : Remittances of Funds and settlement of financial/economic transactions within the country and across countries.
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What do banks do for their customers?

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Role and Functions of Commercial Banks : Traditional Functions/(Ancillary activities or Miscellaneous Financial Services) : These are agency services aka non-fund based/Off-Balance Sheet Services or fee-based services, e.g., Issue of Credit/Debit Cards, Issue of Travellers Cheques, Drafts, Letter of Credits (LC), Bank Guarantees (BG or LG), Collection of Cheques, Bills, Safe Custody of Valuables, Safe Deposit Lockers, Conducting Govt. Business (Cllection of Taxes/Payment of Pensions), Collection of Utility Bills/School fees etc.

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What do banks do for their customers?

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Modern Banking Functions :

(a) Cross-border fund raising services like : External Commercial Borrowings (ECB) Global Depository Receipts (GDRs)/American Depository Receipts (ADRs)/International Depository Receipts (IDRs) Non-Resident External (NRE) Rupee Accounts/Foreign Currency NonResident (FCNR) Accounts Syndication of Foreign Currency Loans (b) Cross-border Banking Services/International Trade Finance Import Financing/Leasing/ Export Financing/Forfaiting/Factoring/Leasing (c) Merchant Banking/Investment Banking Services : Non-fund based or fee-based services. Financial Dis-intermediation. Project Appraisal, Financial Advisory Services including Fund Raising Services in domestic and international markets
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What do banks do for their customers?

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(d) Portfolio Management Services (PMS)/Wealth Management and Private Banking Services like (i) Advisory Services : Flexible, unbiased investment advices customised to meet clients needs (ii) Transaction Support : Brokerage Services (3 in 1 account) (iii) Custodial Services : Demat Accounts for Shares/Bonds/Mutual Fund Units. (e) Bancassurance and Bank Mutual Fund Business : Banks have made entry into Insurance and Mutual Fund Business either with or without risk participation basis. Some Banks are floating Insurance (Life/Non-Life) Ventures and MF House and some banks are only marketing the Insurance and Mutual Fund Products by tying up with Insurance Companies and MF Houses.

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Why do banks perform those services?

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Banks are private firms with a public purpose. They seek to maximize shareholder wealth (represented by the market value of bank stock and dividends paid). Banking is the management of risk. By taking risks, they earn a profit.
-- Credit risk -- Interest rate risk -- Liquidity risk -- Price risk -- Foreign exchange risk -- Compliance risk -- Strategic risk -- Reputation risk

Various factors that affect banks include market, social, and legal and regulatory constraints.

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What factors have affected the operations of commercial banks and other financial service organizations?

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Inflation and volatile interest rates:

Rising interest rates caused shorter-term deposit costs to rise faster than longer-term loans. Also, as rates rose, the market value of their assets declined and borrowers defaulted on loans with greater frequency than normal. Banks are pooling loans for various kinds and selling securities with claims on these loans. Telecommunications and computers are increasing economies of scale and economies of scope for banks.

Securitization:

Technological advances:

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What factors have affected the operations of commercial banks and other financial service organizations?

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Fundamental Forces of Change in the Banking & Financial Sector :

Consumers/Customers have become better informed, more sophisticated, more demanding, less forgiving and less loyal. Capital and Money markets have increased their competition with banks in attracting firms seeking debt funds. Deregulation/Reregulation and Liberalisation : The elimination of laws that placed geographic limits on banks, their products and services, and the interest rates they can pay on deposits and charge on loans has increased banking risks for the customers as well as for the banks themselves and this has also stimulated bank mergers and consolidation. De-specialization and Rising competition among financial institutions with one-stop shopping centers leading to Universal or Umbrella Banking. Intense Competition from Banks as well as NonBanks and Capital & Money Markets
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What factors have affected the operations of commercial banks and other financial service organizations?

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Global integration of financial markets (Globalisation) and Privatisation of Banking Sector is increasing competition from foreign financial service firms. Disintermediation & Securitisation Technological Revolution/Convergence of Technology Financial Innovation/Service or Product Proliferation Rising Funding Costs and Shrinking Spreads Consolidation and Geographic Expansion Convergence of Business/Universal Banking Capital Corporate Governance Globalisation of Banking Need for Multi-Skilled Banking & Finance Professionals Increased risk of failure and weakness of Government Deposit Insurance System
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What are the principal sources and uses of funds for banks? Assets

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Loans commercial and industrial (C&I) loans real estate loans consumer loans Investments short-term, liquid securities (e.g., Govt. Treasury securities) long-term securities (Govt. as well as Corporate) Cash Other assets buildings, equipment, etc.

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What are the principal sources and uses of funds for banks?

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Liabilities

Deposits
Transactions or demand deposits Non-transactions or Term (Time) deposits

Non-deposit sources of funds (Borrowings/Refinancing) Relatively small compared to debt sources of funds. Highly leveraged compared to nonfinancial firms.

Equity

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Mobilisation of Resources and Deployment of Resources by Banks

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Mobilisation of Resources (Cost and Stability of Deposits Core or Stable Deposits and Non-Core or Unstable or Volatile Deposits) Deposits/Funds Raising Low Cost and No Cost Deposits like Current Deposit A/c and Savings Deposit A/c (CASA) Term (Time) or Fixed deposits Non-deposit sources of funds (Borrowings/Refinancing) Deployment of Resources Lending (Risk, Return, Maturity Profile, Credit Concentration or Exposure Norms, Diversification, Govt. of India/RBI Regulation, Banks Credit or Loan Policy) Directed Credit Like Priority Sector Credit, Credit to Export Sector etc. and Non-Priority Credit. Investments (Risk, Return, Maturity Profile, Concentration or Exposure Norms, Diversification, Govt. of India/RBI Regulation, Banks Investment Policy) SLR or Mandated or Directed Investments and Non-SLR or NonMandated Investments.

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Mobilisation of Resources and Deployment of Resources by Banks - 2

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CD Ratio : What it is Credit (Loans) to Deposit Ratio. During periods of high economic activity, credit demand/credit off take will be high leading to high CD ratio (CDR). Higher CDR means higher revenue and profit. What is credit off take or loan demand? Low and high credit off take. Relation between Deposit mobilisation and Credit Off take/Loan Demand. Relation between Credit Off take/Loan Demand and Economic activity/Business Confidence. Relation between Deposit mobilisation and Stock Market Performance/Sentiment/Level of Interest Rate (Bank Deposit Rates). When or under what circumstances CDR will go up and go down ? A higher CDR is better or a lower CDR is better for the bank. Relation between a Banks CD ratio and Banks Profitability.

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Mobilisation of Resources and Deployment of Resources by Banks - 2 ID Ratio : What it is Investment to Deposit Ratio. During periods of low economic activity/recession, credit demand/off take will be low; banks will deploy more money in Investment leading to higher ID ratio (IDR) and consequently lower CDR. On an average Credit/Loans earn higher return for the bank than the average investments, so a higher CDR is better for the bank. Relation between CD ratio and ID ratio. When or under what circumstances IDR will go up and go down ? A higher IDR is better or a lower IDR is better for the bank. Relation between a Banks ID ratio and Banks Profitability.

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EMERGING TRENDS & CHALLENGES IN BANKING

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UNIVERSAL BANKING (BANCASSURANCE/PARA BANKING ACTIVITIES) ELECTRONIC BANKING GLOBALISATION OF BANKING CRM IN BANKS
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KEY WORDS/TERMINOLOGIES/GLOSSARY

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Banking, Scheduled Banks, SLR, ECS, EFT, NEFT, RTGS, SWIFT Deregulation, Globalisation, CD ratio, ID ratio, Intermediation, Solvency Universal Banking, Bancassurance, Electronic Banking Primary or Core Banking Activities, Ancillary or Subsidiary Banking Activities, CASA Deposit & CASA ratio
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Home Task for Next Class For Self Check

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HOME TASK/CONCEPT CHECK QUESTIONS FOR SELF REVIEW : Question #1. Core or Primary activities of a Bank. Q. #2. Explain the Process of Financial Intermediation. Q. #3. Explain the concepts of SLR, CD ratio, ID Ratio. How CDR & IDR are related to economic activity and each other ?
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Topics for Next Class All of you Should get prepared before coming to the class

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Process of Financial Intermediation Different types of Intermediation and various risks of Financial Intermediation. Why Banks and FIs are special ? Why they are regulated ? Legal & Regulatory framework of Indian Banking System. Banking Regulation/Role and Functions of RBI.
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Web Resources

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For information on regulation of depository institutions and investment firms visit: SEBI www.sebi.gov.in RBI www.rbi.org.in IBA www.iba.org.in BIS www.bis.org IIBF www.iibf.org.in

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