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1 Commercial Bank: Definition, Function, Credit Creation and Significances!

Meaning of Commercial Banks:

A commercial bank is a financial institution which performs the

functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit.

In fact, commercial banks, as their name suggests, axe profit-seeking institutions, i.e., they do banking business to earn profit.

They generally finance trade and commerce with short-term loans. They charge high rate of interest from the borrowers but pay much less rate of Interest to their depositors with the result that the difference between the two rates of interest becomes the main source of profit of the banks.

Most of the Indian joint stock Banks are Commercial Banks such as Punjab National Bank, Allahabad Bank, Canara Bank, Andhra Bank, Bank of Baroda, etc.

Functions of Commercial Banks

The two most distinctive features of a commercial bank are borrowing and lending, i.e., acceptance of deposits and lending of money to projects to earn Interest (profit). In short, banks borrow to lend. The rate of

interest offered by the banks to depositors is called the borrowing rate while the rate at which banks lend out is called lending rate.

The difference between the rates is called ‘spread’ which is appropriated by the banks. Mind, all financial institutions are not commercial banks because only those which perform dual functions of (i) accepting

deposits and (ii) giving loans are termed as commercial banks. For example, post offices are not bank because they do not give loans.

Functions of commercial banks are classified in to two main categories—

(A) Primary functions and (B) Secondary functions.

Let us know about each of them:

(A) Primary Functions:

1. It accepts deposits:

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A commercial bank accepts deposits in the form of current, savings and fixed deposits. It collects the surplus balances of the Individuals, firms and finances the temporary needs of commercial transactions. The first task is, therefore, the collection of the savings of the public. The bank does this by accepting deposits from its customers. Deposits are the lifeline of banks.

Deposits are of three types as under:

(i) Current account deposits:

Such deposits are payable on demand and are, therefore, called demand deposits. These can be withdrawn by the depositors any number of times depending upon the balance in the account. The bank does not pay any Interest on these deposits but provides cheque facilities. These accounts are generally maintained by businessmen and Industrialists who receive and make business payments of large amounts through cheques.

(ii) Fixed deposits (Time deposits):

Fixed deposits have a fixed period of maturity and are referred to as time deposits. These are deposits for a fixed term, i.e., period of time ranging from a few days to a few years. These are neither payable on demand nor they enjoy cheque facilities.

They can be withdrawn only after the maturity of the specified fixed period. They carry higher rate of interest. They are not treated as a part of money supply Recurring deposit in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.

(iii) Savings account deposits:

These are deposits whose main objective is to save. Savings account is most suitable for individual households. They combine the features of both current account and fixed deposits. They are payable on demand and also withdraw able by cheque. But bank gives this facility with some restrictions, e.g., a bank may allow four or five cheques in a month.

Interest paid on savings account deposits in lesser than that of fixed deposit.

Difference between demand deposits and time (term) deposits:

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Two traditional forms of deposits are demand deposit and term (or time) deposit:

(i) Deposits which can be withdrawn on demand by depositors are called demand deposits, e.g., current account deposits are called demand

deposits because they are payable on demand but saving account

deposits do not qualify because of certain conditions on withdrawal. No interest is paid on them. Term deposits, also called time deposits, are deposits which are payable only after the expiry of the specified period.

(ii) Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest.

(iii) Demand deposits are highly liquid whereas time deposits are less liquid,

(iv) Demand deposits are chequable deposits whereas time deposits are not.

2. It gives loans and advances:

The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as reserve and gives (lends) the balance to the borrowers as loans and advances in the form of cash credit, demand loans, short-run loans, overdraft as

explained under.

(i) Cash Credit:

An eligible borrower is first sanctioned a credit limit and within that limit he is allowed to withdraw a certain amount on a given security. The withdrawing power depends upon the borrower’s current assets, the stock statement of which is submitted by him to the bank as the basis of security. Interest is charged by the bank on the drawn or utilised portion of credit (loan).

(ii) Demand Loans:

A loan which can be recalled on demand is called demand loan. There is no stated maturity. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. Those like security

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brokers whose credit needs fluctuate generally, take such loans on personal security and financial assets.

(iii) Short-term Loans:

Short-term loans are given against some security as personal loans to finance working capital or as priority sector advances. The entire amount is repaid either in one instalment or in a number of instalments over the period of loan.

Investment:

Commercial banks invest their surplus fund in 3 types of securities:

(i) Government securities, (ii) Other approved securities and (iii) Other securities. Banks earn interest on these securities.

(B) Secondary Functions:

Apart from the above-mentioned two primary (major) functions, commercial banks perform the following secondary functions also.

3. Discounting bills of exchange or bundles:

A bill of exchange represents a promise to pay a fixed amount of money at a specific point of time in future. It can also be encashed earlier

through discounting process of a commercial bank. Alternatively, a bill of exchange is a document acknowledging an amount of money owed in consideration of goods received. It is a paper asset signed by the debtor and the creditor for a fixed amount payable on a fixed date. It works like this.

Suppose, A buys goods from B, he may not pay B immediately but

instead give B a bill of exchange stating the amount of money owed and the time when A will settle the debt. Suppose, B wants the money

immediately, he will present the bill of exchange (Hundi) to the bank for discounting. The bank will deduct the commission and pay to B the

present value of the bill. When the bill matures after specified period, the bank will get payment from A.

4. Overdraft facility:

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An overdraft is an advance given by allowing a customer keeping current account to overdraw his current account up to an agreed limit. It is a facility to a depositor for overdrawing the amount than the balance amount in his account.

In other words, depositors of current account make arrangement with the banks that in case a cheque has been drawn by them which are not covered by the deposit, then the bank should grant overdraft and honour the cheque. The security for overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder, etc.

Difference between Overdraft facility and Loan:

(i) Overdraft is made without security in current account but loans are given against security.

(ii) In the case of loan, the borrower has to pay interest on full amount sanctioned but in the case of overdraft, the borrower is given the facility of borrowing only as much as he requires.

(iii) Whereas the borrower of loan pays Interest on amount outstanding against him but customer of overdraft pays interest on the daily balance.

5. Agency functions of the bank:

The bank acts as an agent of its customers and gets commission for performing agency functions as under:

(i) Transfer of funds:

It provides facility for cheap and easy remittance of funds from place-to- place through demand drafts, mail transfers, telegraphic transfers, etc.

(ii) Collection of funds:

It collects funds through cheques, bills, bundles and demand drafts on behalf of its customers.

(iii) Payments of various items:

It makes payment of taxes. Insurance premium, bills, etc. as per the directions of its customers.

(iv) Purchase and sale of shares and securities:

It buys sells and keeps in safe custody securities and shares on behalf of its customers.

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(v) Collection of dividends, interest on shares and debentures is made on behalf of its customers.

(iv) Acts as Trustee and Executor of property of its customers on advice of its customers.

(vii) Letters of References:

It gives information about economic position of its customers to traders and provides similar information about other traders to its customers.

6. Performing general utility services:

The banks provide many general utility services, some of which are as under:

(i) Traveller’s cheques .The banks issue traveler’s cheques and gift cheques.

(ii) Locker facility. The customers can keep their ornaments and important documents in lockers for safe custody.

(iii) Underwriting securities issued by government, public or private bodies.

(iv) Purchase and sale of foreign exchange (currency).

Credit (Money) Creation by Commercial bank

RBI produces money while commercial banks increase the supply of money by creating credit which is also treated as money creation.

Commercial banks create credit in the form of secondary deposits.

total deposits of a bank is of two types:

(i) Primary deposits (initial cash deposits by the public) and (ii)

Secondary deposits (deposits that arise due to loans given by the banks which are assumed to be redeposited in the bank.) Money creation by commercial banks is determined by two factors namely (i) Primary deposits i.e. initial cash deposits and (ii) Legal Reserve Ratio (LRR), i.e., minimum ratio of deposits which is legally compulsory for the

commercial banks to keep as cash in liquid form. Broadly when a bank receives cash deposits from the public, it keeps a fraction of deposits as cash reserve (LRR) and uses the remaining amount for giving loans. In the process of lending money, banks are able to create credit through

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secondary deposits many times more than initial deposits (primary deposits).

How? It is explained below.

Process of money (credit) creation:

Suppose a man, say X, deposits Rs 2,000 with a bank and the LRR is 10%, which means the bank keeps only the minimum required Rs 200 as cash reserve (LRR). The bank can use the remaining amount Rs 1800 (=

2000 – 200) for giving loan to someone. (Mind, loan is never given in cash but it is redeposited in the bank as demand deposit in favour of borrower.) The bank lends Rs 1800 to, say, Y who is actually not given loan but only demand deposit account is opened in his name and the amount is credited to his account.

This is the first round of credit creation in the form of secondary deposit (Rs 1800), which equals 90% of primary (initial) deposit. Again 10% of Y’s deposit (i.e., Rs 180) is kept by the bank as cash reserve (LRR) and the balance Rs 1620 (=1800 – 180) is advanced to, say, Z. The bank gets new demand deposit of Rs 1620. This is second round of credit creation which is 90% of first round of increase of Rs 1800. The third round of credit creation will be 90% of second round of 1620. This is not the end of story.

The process of credit creation goes on continuously till derivative deposit (secondary deposit) becomes zero. In the end, volume of total credit created in this way becomes multiple of initial (primary) deposit. The quantitative outcome is called money multiplier. If the bank succeeds in creating total credit of, says Rs 18000, it means bank has created 9 times of primary (initial) deposit of Rs 2000. This is what is meant by credit creation.

In short, money (or credit) creation by commercial banks is determined by (i) amount of initial (primary) deposits and (ii) LRR. The multiple is called credit creation or money multiplier.

Symbolically:

Total Credit creation = Initial deposits x 1/LPR.

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Money Multiplier:

It means the multiple by which total deposit increases due to initial (primary) deposit. Money multiplier (or credit multiplier) is the inverse of Legal Reserve Ratio (LRR). If LRR is 10%, i.e., 10/100or 0.1, then money multiplier = 1/0.1 = 10.

Smaller the LRR, larger would be the size of money multiplier credited to his account. He is simply given the cheque book to draw cheques when he needs money. Again, 20% of Sohan’s deposit which is considered a safe limit is kept for him by the bank and the balance Rs 640 (= 80% of 800) is advanced to, say, Mohan. Thus, the process of credit creation goes on continuously and in the end volume of total credit created in this way becomes multiple of initial cash deposit.

The bank is able to lend money and charge interest without parting with cash because the bank loan simply creates a deposit (or credit) for the borrower. If the bank succeeds in creating credit of, say, Rs 15,000, it means that the bank has created credit 15 times of the primary deposit of Rs 1,000. This is what is meant by credit creation.

Similarly, the bank creates credit when it buys securities and pays the seller with its own cheque. The cheque is deposited in some bank and a deposit (credit) is created for the seller of securities. This is also called credit creation. As a result of credit creation, money supply in the economy becomes higher. It is because of this credit creation power of commercial banks (or banking system) that they are called factories of credit or manufacturer of money.

Types of Commercial Banks:

The following chart depicts main types of commercial banks in India.

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Scheduled Banks and Non-scheduled Banks:

Commercial banks are classified in two broad categories—scheduled banks and non-scheduled banks.

Scheduled banks are those banks which are included in Second Schedule of Reserve Bank of India. A scheduled bank must have a paid-up capital and reserves of at least Rs 5 lakh. RBI provides special facilities

including credit to scheduled banks. Some of important scheduled banks are State Bank of India and its subsidiary banks, nationalised banks, foreign banks, etc.

Non-scheduled Banks:

The banks which are not included in Second Schedule of RBI are known as non-scheduled banks. A non-scheduled bank has a paid-up capital and reserves of less than Rs 5 lakh. Clearly, such banks are small banks and their field of operation is also limited.

A passing reference to some other types of commercial banks will be informative.

Industrial Banks provide finance to industrial concerns by subscribing (buying) shares and debentures of companies and also give long-term loans to acquire machinery, plants, etc. Foreign Exchange Banks are commercial banks which are branches of foreign banks and facilitate international financial transactions through buying and selling of foreign bills.

Agricultural Banks finance agriculture and provide long-term loans for buying tractors and installing tube-wells. Saving Banks mobilise small savings of the people in savings account, e.g., Post office saving bank.

Cooperative Banks are organised by the people for their own collective benefits. They advance loans to their members at fair rate of interest.

Significance of Commercial Banks:

Commercial banks play such an important role in the economic

development of a country that modern industrial economy cannot exist without them. They constitute nerve centre of production, trade and

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industry of a country. In the words of Wick-sell, “Bank is the heart and central point of modern exchange economy.”

The following points highlight the significance of commercial banks:

(i) They promote savings and accelerate the rate of capital formation.

(ii) They are source of finance and credit for trade and industry.

(iii) They promote balanced regional development by opening branches in backward areas.

(iv) Bank credit enables entrepreneurs to innovate and invest which accelerates the process of economic development.

(v) They help in promoting large-scale production and growth of priority sectors such as agriculture, small-scale industry, retail trade and export.

(vi) They create credit in the sense that they are able to give more loans and advances than the cash position of the depositor’s permits.

(vii)They help commerce and industry to expand their field of operation.

(viii) Thus, they make optimum utilisation of resources possible.

2 Credit Creation by Commercial Banks and It’s Limitations A central bank is the primary source of money supply in an economy through circulation of currency.

It ensures the availability of currency for meeting the transaction needs of an economy and facilitating various economic activities, such as production, distribution, and consumption.

However, for this purpose, the central bank needs to depend upon the reserves of commercial banks. These reserves of commercial banks are the secondary source of money supply in an economy. The most

important function of a commercial bank is the creation of credit.

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Therefore, money supplied by commercial banks is called credit money.

Commercial banks create credit by advancing loans and purchasing

securities. They lend money to individuals and businesses out of deposits accepted from the public. However, commercial banks cannot use the entire amount of public deposits for lending purposes. They are required to keep a certain amount as reserve with the central bank for serving the cash requirements of depositors. After keeping the required amount of reserves, commercial banks can lend the remaining portion of public deposits.

According to Benham’s, “a bank may receive interest simply by permitting customers to overdraw their accounts or by purchasing

securities and paying for them with its own cheques, thus increasing the total bank deposits.”

Let us learn the process of credit creation by commercial banks with the help of an example.

Suppose you deposit Rs. 10,000 in a bank A, which is the primary

deposit of the bank. The cash reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs. 1000 as reserve with the central bank and would use remaining Rs. 9000 for lending purposes.

The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as demand deposit account. However, this is not actually paid out to Mr. X. The bank has issued a check-book to Mr. X to withdraw money.

Now, Mr. X writes a check of Rs. 9000 in favor of Mr. Y to settle his earlier debts.

The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the central bank for bank B is 5%. Thus, Rs. 450 (5% of 9000) will be kept as reserve and the remaining balance, which is Rs.

8550, would be used for lending purposes by bank B.

Thus, this process of deposits and credit creation continues till the reserves with commercial banks reduce to zero.

This process is shown in the Table-1:

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From Table-1, it can be seen that deposit of Rs. 10,000 leads to a

creation of total deposit of Rs. 50,000 without the involvement of cash.

The process of credit creation can also be learned with the help of following formulae:

Total Credit Creation = Original Deposit * Credit Multiplier Coefficient Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash Reserve Ratio (CRR)

Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10 Total credit created = 10,000 *10 = 100000

If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20 Total credit creation = 10000 * 20 = 200000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher the CRR, lesser will be the credit creation. With the help of credit creation process, money multiplies in an economy.

However, the credit creation process of commercial banks is not free from limitations.

Some of the limitations of credit creation by commercial banks are shown in Figure-3:

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The limitations of credit creation process (as shown in Figure- 3) are explained as follows:

(a) Amount of Cash:

Affects the creation of credit by commercial banks. Higher the cash of commercial banks in the form of public deposits, more will be the credit creation. However, the amount of cash to be held by commercial banks is controlled by the central bank.

The central bank may expand or contract cash in commercial banks by purchasing or selling government securities. Moreover, the credit

creation capacity depends on the rate of increase or decrease in CRR by the central bank.

(b) CRR:

Refers to reserve ratio of cash that need to be kept with the central bank by commercial banks. The main purpose of keeping this reserve is to fulfill the transactions needs of depositors and to ensure safety and liquidity of commercial banks. In case the ratio falls, the credit creation would be more and vice versa.

(c) Leakages:

Imply the outflow of cash. The credit creation process may suffer from leakages of cash.

The different types of leakages are discussed as follows:

(i) Excess Reserves:

Takes place generally when the economy is moving towards recession. In such a case, banks may decide to maintain reserves instead of utilizing funds for lending. Therefore, in such situations, credit created by

commercial banks would be small as a large amount of cash is resented.

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(ii) Currency Drains:

Imply that the public does not deposit all the cash with it. The customers may hold the cash with them which affects the credit creation by banks.

Thus, the capacity of banks to create credit reduces.

(d) Availability of Borrowers:

Affects the credit creation by banks. The credit is created by lending money in form of loans to the borrowers. There will be no credit creation if there are no borrowers.

(e) Availability of Securities:

Refers to securities against which banks grant loan. Thus, availability of securities is necessary for granting loan otherwise credit creation will not occur. According to Crowther, “the bank does not create money out of thin air; it transmutes other forms of wealth into money.”

(f) Business Conditions:

Imply that credit creation is influenced by cyclical nature of an economy.

For example, credit creation would be small when the economy enters into the depression phase. This is because in depression phase,

businessmen do not prefer to invest in new projects. In the other hand, in prosperity phase, businessmen approach banks for loans, which lead to credit creation.

In spite of its limitations, we can conclude that credit creation by commercial banks is a significant source for generating income.

The essential conditions for creation of credit are as follows:

a. Accepting the fresh deposits from public b. Willingness of banks to lend money c. Willingness of borrowers to borrow.

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3.Non-performing assets (NPA)

Non-performing assets, also called non-performing loans, are loans, made by a bank or finance company, on which repayments or interest payments are not being made on time. Generally speaking, NPA is any asset of a bank which is not producing any income. Once the borrower has failed to make interest or principal payments for 90 days the loan is considered to be a non-performing asset.

But in terms of Agriculture / Farm Loans; the NPA is defined as under:

Short duration crop loan : Loan is termed as NPA in this scenario if the loan either in terms of installment or interest is not paid for 2 crop seasons, it would be termed as NPA. Example: Agri loans such as paddy, jowar, Bajra etc.

For Long Duration Crops, the above would be 1 Crop season from the due date.

Banks are required to classify NPAs further into Substandard, Doubtful and Loss assets.

1. Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.

2. Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.

3. Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”

Status of NPA

NPA problem is one of the most severe problem in the Indian

Banking sector posing questions over the stability of Indian Banking System. Raghuram Rajan, the ex-Governor of RBI has identified the NPA problem as a major challenge facing the Indian Banking Sector.

The problem which was largely hidden earlier as Banks used to do window dressing of their account statement has now come to the forefront after Rajan exhorted the banks to clean up their asset books by March 2017. Resultantly this led to 29 public sector banks writing off Rs1.14 Lakh Crore of bad debts between 2013 -2015, much more than what they had done in the preceding 9 years.

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Impact of NPAs on Banks:

On banks

1 It affects the profitability & liquidity of the banks as annual return on assets comes down and also the amount given as loan also gets

blocked which could have been used for some return earning asset otherwise

2 Extra time and effort to handle and manage NPAs with added cost 3 Credit loss - Bank is facing problem of NPA then it adversely affect the value of bank in terms of market credit. It will lose it’s goodwill and brand image and credit which have negative impact to the people who are putting their money in the banks..

4 The assets and liability mismatch will widen.

5 Bank shareholders are adversely affected On borrowers

1) The cost of capital will go up.

2) Piled-up NPAs become a big constraint for banks to pass on the RBI- induced rate reductions.

3) Banks tend to restrict credit to small and medium enterprises (SMEs) that are India's potential for prosperity of an entrepreneurial middle class.

4) Banks may begin charging higher interest rates on some products to compensate Non-performing loan losses.

On overall economy

It leads to a situation of low off take of funds from the security market due to increase in cose of capital. This will hurt the overall demand in the Indian economy. And, finally it will lead to lower growth rates and of course higher inflation because of the higher cost of capital. It becomes a vicious cycle.

Reason of increasing NPA Borrower’s side

1 Domestic economy slowdown - Lack of demand for their products as foreseen by the industrialists

2 Wilful defaulter

3 Diversion of funds by borrowers for purposes other than mentioned in loan documents.

4 Global economy slowdown

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5 volatility in prices of raw material and the shortage in availability of power etc. impacts the performance of the corporate sector

Bank’s side

1 Bad lending practices. Speculation is one of the major reason behind the default. Sometimes banks provide loans to borrowers with bad credit history. There is high probability of default in these cases.

2 Inadequate Capacity to evaluate projects – poor credit appraisal system

3 Absence of regular industrial visits.

Laws relating to NPA

SARFAESI – The Act empowers Banks/ Financial Institutions to recover

their NPAs without the intervention of the court, through acquiring and disposing secured assets without the intervention of the court in case of outstanding amounts greater than 1 lakh. SARFAESI, it is accused, has been used only against the small borrowers primarily from MSME sector

Recovery of Debts Due to Banks and Financial Institutions (DRT) Act: The Act provides setting up of Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs) for

expeditious and exclusive disposal of suits filed by banks / FIs for recovery of their dues in NPA accounts with outstanding amount of Rs. 10 lac and above. DRTs are overburdened leading to slow

disposal of cases

Lok Adalats: Section 89 of the Civil Procedure Code provides resolution of disputes through ADR methods such as Arbitration, Conciliation, Lok Adalats and Mediation. Lok Adalat mechanism offers expeditious, in-expensive and mutually acceptable way of settlement of dispute

Under banking regulation act 1949, RBI is empowered to monitor the asset quality of banks by inspecting record books Remedies proposed by RBI

1. RBI has directed banks to give loans by looking at CIBIL score and is encouraging banks to start sharing information amongst

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themselves. This is to deal with cases of information asymmetry. RBI has directed banks to report to Central Repository of Information on Large Credit (CRILC) when principle/interest payment not paid between 61-90 days 2. RBI has asked banks to conduct sector wise/activity wise

analysis of NPA

3. SEBI has eased norms for banks to convert debt of distressed borrowers into equity

4 5/25 scheme

4.1 For existing and new projects greater than 500 crores and also for existing projects which have been classified as bad debt or

stressed asset, bank can provide longer amortization periods of 25 years with the option of restructuring loans every 5 or 7 years.

4.2 The advantage of this scheme is that it provides for longer lending period with inbuilt flexibility. Shorter lending periods leads to companies stretching their balance sheet to pay back loans 4.3 From bank’s point of view it is helpful as freshly restructured asset is considered as bad debt and requires 15% provisioning by banks against such loans leading to erosion of profitability for banks.

7 Steps Advised by Finance Standing Committee of Parliament Finance standing committee of parliament’s recommendation on NPAs in its report has been adopted on 5th February 2016. Some of its key recommendations include:

Forensic audit

The committee has called for immediate forensic audit of all

restructured loans that had turned into bad debts. Forensic audit is also required for wilful defaults

Revive Development Financial Institutions (DFIs)

1 The panel also recommended the development of a “vibrant bond market” to finance infrastructure products.

2 Batting for large infrastructural projects, it said the Centre should revive Development Financial Institutions for long-term financing of such projects.

Reveal the names of Wilful defaulters

1 The panel asked the apex bank to form empowered committees at the level of RBI, banks and borrowers to monitor large loans.

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2 Name and shame the defaulters - There is no justification of keeping the names secret and asked the RBI to amend its guidelines.

3 It also recommended that a change in management must be made mandatory in cases involving wilful

4.Nationalization of banks

Nationalization refers to private assets being transferred to the public sector to be operated by or owned by the state. So there is no difference between a nationalized bank and a public sector Bank. The history of banking in India states that the post-independence, the Government of India initiated various measures to play an active role in the economic development of the nation which resulted in the establishment of the Reserve Bank of India in April 1935 and later nationalized the same during 1949 under the terms of the Reserve Bank of India Act of 1948 and another measure is the nationalization of banks in India. The government of India under the leadership of the then Prime Minister Indira Gandhi issued an ordinance to nationalize 14 largest commercial banks in India with effect from July 19, 1969, under the regulatory authority of the Reserve Bank of India. These 14 banks contained up to 85 percent of bank deposits in the country and most of them were privately owned. During 1980, 6 more commercial banks were nationalized.

At the time of britisher 3 Banks were established Bank of Bengal (1804), Bank of Bombay (1840) and Bank of madras (1842), which later all three banks were merged and known as imperial bank of India in 1921. This imperial bank of India which was renamed as state bank of India and get nationalised in 1955. Five associate of SBI are as under

1. State bank of Travancore 2. State bank of Patiala

3. State bank of Bikaner and Jaipur 4. State bank of mysore

5. State bank of hyderabad

List of nationalized banks in India

The Central Bank of India - RBI, in its official website has listed the following 19 banks as nationalized banks.

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Andhra Bank 1980, Allahabad Bank 1969, Bank of Baroda 1969, Bank of India 1969, Bank of Maharashtra 1969, Canara Bank 1969, Central Bank of India 1969, Corporation Bank 1980, Dena Bank 1969, Indian Bank 1969, Indian Overseas Bank 1969, Oriental Bank of Commerce 1980, Punjab & Sind Bank 1969, Punjab National Bank 1969, Syndicate Bank 1969, UCO Bank 1969, Union Bank of India 1969, United Bank of India 1969, Vijaya Bank 1969.

What factors that led to the nationalisation of banks

After independence, the Government of India (GOI) adopted planned economic development for the country. Nationalisation was in accordance with the national policy of adopting the socialistic pattern of society.

Nationalization came at the end of a troubled decade. India has suffered many economic as well as political shocks.

o There were two wars (with China in 1962 and Pakistan in 1965) that put immense pressure on public finances.

o Two successive years of drought had not only led to food shortages but also compromised national security because of the dependence on American food shipments (PL 480 program).

o Subsequently, a three-year plan holiday affected aggregate demand as public investment was reduced.

o The decade of 1960-70s was the lost decade for India as the economic growth barely outpaced population growth and average incomes stagnated.

o Industry’s share in credit disbursed by commercial banks almost doubled between 1951 and 1968, from 34% to 68% whereas agriculture received less than 2% of total credit.

Agriculture needed a capital infusion, with the initiation of the Green Revolution in India that aimed to make the country self-sufficient in food security.

0ther Reason for the Nationalization of Banks • For Social Welfare

• For Developing Banking Habits

• For Expansion of Banking Sector

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• For Controlling Private Monopolies

• To Reduce Regional Imbalances

 For priority sector lending Benefits of the nationalisation of bank

After the nationalization of banks, the branches of the public sector bank India rose to approximately 800% in deposits and advances took a huge jump by 11,000%.

Banking under government ownership gave the public implicit faith and immense confidence about the sustainability of the banks.

Banks were no longer confined to only metropolitan or cosmopolitan in India. In fact, the Indian banking system has reached even to the remote corners of the country.

o This is one of the main reasons for India’s growth process, particularly in the Green revolution.

o Purpose of nationalization is to promote rapid growth in agriculture, small industries and export, to encourage new entrepreneurs and to develop all backward areas.

Public deposits in the bank have increased so much that leaving it completely to the private sector might pose a challenge.

o Banks, by advancing loans to the speculators and non-priority sector, have created havoc in the economy.

Balance of payment crisis 1991 started an era of liberalization, privatization and globalisation. However, the political control of bank lending continued even after the 1991 reforms which today had culminated into the bad loan or Non-Performing Assets crisis that has slowed down India's growth trajectory.

5.Central Bank and It’s Functions

A central bank plays an important role in monetary and banking system of a country.

It is responsible for maintaining financial sovereignty and economic stability of a country, especially in underdeveloped countries.

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“A Central Bank is the bank in any country to which has been entrusted the duty of regulating the volume of currency and credit in that

country”-Bank of International Settlement.

It issues currency, regulates money supply, and controls different

interest rates in a country. Apart from this, the central bank controls and regulates the activities of all commercial banks in a country.

Some of the management experts have defined central bank in different ways, which are as follows:

According to Samuelson, “Every Central Bank has one function. It operates to control economy, supply of money and credit.”

According to Vera Smith, “The primary definition of Central Bank is the banking system in which a single bank has either a complete or residuary monopoly of note issue.”

According to Kent, “Central Bank may be defined as an institution which is charged with the responsibility of managing the expansion and

contraction of the volume of money in the interest of general public welfare.”

According to Bank of International Settlement, “A Central Bank is the bank in any country to which has been entrusted the duty of regulating the volume of currency and credit in that country.”

Bank of England was the world’s first effective central bank that was established in 1694. As per the resolution passed in Brussels Financial Conference, 1920, all the countries should establish a central bank for interest of world cooperation. Thus, since 1920, central banks are formed in almost every country of the world. In India, RBI operates as a central bank.

Central banks differ from the commercial banks in various ways, which are shown in Table-2:

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Functions of Central Bank:

The central bank does not deal with the general public directly. It performs its functions with the help of commercial banks. The central bank is accountable for protecting the financial stability and economic development of a country.

Apart from this, the central bank also plays a significant part in avoiding the cyclical fluctuations by controlling money supply in the market. As per the view of Hawtrey, a central bank should primarily be the “lender of last resort.”

On the other hand, Kisch and Elkins believed that “the maintenance of the stability of the monetary standard” as the essential function of

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central bank. The functions of central bank are broadly divided into two parts, namely, traditional functions and developmental functions.

These functions are shown in Figure-3:

The different functions of a central bank (as discussed in Figure-3) are explained as follows:

(a) Traditional Functions:

Refer to functions that are common to all central banks in the world.

The traditional functions of the central bank include the following:

(i) Bank of issue:

Possesses an exclusive right to issue notes (currency) in every country of the world. In the initial years of banking, every bank enjoyed the right of issuing notes. However, this led to a number of problems, such as notes were over-issued and the currency system became disorganized.

Therefore, the governments of different countries authorized central banks to issue notes. The issue of notes by one bank has led to

uniformity in note circulation and balance in money supply.

(ii) Government’s banker, agent, and advisor:

Implies that a central bank performs different functions for the

government. As a banker, the central bank performs banking functions for the government as commercial banks performs for the public by accepting the government deposits and granting loans to the

government. As an agent, the central bank manages the public debt, undertakes the payment of interest on this debt, and provides all other services related to the debt.

As an advisor, the central bank gives advice to the government regarding economic policy matters, money market, capital market, and

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government loans. Apart from this, the central bank formulates and implements fiscal and monetary policies to regulate the supply of money in the market and control inflation.

(iii) Custodian of cash reserves of commercial banks:

Implies that the central bank takes care of the cash reserves of commercial banks. Commercial banks are required to keep certain amount of public deposits as cash reserve, with the central bank, and other part is kept with commercial banks themselves.

The percentage of cash reserves is deeded by the central bank! A certain part of these reserves is kept with the central bank for the purpose of granting loans to commercial banks Therefore, the central bank is also called banker’s bank.

(iv) Custodian of international currency:

Implies that the central bank maintains a minimum reserve of international currency. The main aim of this reserve is to meet

emergency requirements of foreign exchange and overcome adverse requirements of deficit in balance of payments.

(v) Bank of rediscount:

Serve the cash requirements of individuals and businesses by

rediscounting the bills of exchange through commercial banks. This is an indirect way of lending money to commercial banks by the central bank.

Discounting a bill of exchange implies acquiring the bill by purchasing it for the sum less than its face value.

Rediscounting implies discounting a bill of exchange that was previously discounted. When owners of bill of exchange are in need of cash they approach the commercial bank to discount these bills. If commercial banks are themselves in need of cash they approach the central bank to rediscount the bills.

(vi) Lender of last resort:

Refer to the most crucial function of the central bank. The central bank also lends money to commercial banks. Instead of rediscounting of bills,

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the central bank provides loans against treasury bills, government securities, and bills of exchange.

(vii) Bank of central clearance, settlement, and transfer:

Implies that the central bank helps in settling mutual indebtness

between commercial banks. Depositors of banks give checks and demand drafts drawn on other banks. In such a case, it is not possible for banks to approach each other for clearance, settlement, or transfer of deposits.

The central bank makes this process easy by setting a clearing house under it. The clearing house acts as an institution where mutual indebtness between banks is settled. The representatives of different banks meet in the clearing house to settle inter-bank payments. This helps the central bank to know the liquidity state of the commercial banks.

(viii) Controller of Credit:

Implies that the central bank has power to regulate the credit creation by commercial banks. The credit creation depends upon the amount of deposits, cash reserves, and rate of interest given by commercial banks.

All these are directly or indirectly controlled by the central bank. For instance, the central bank can influence the deposits of commercial banks by performing open market operations and making changes in CRR to control various economic conditions.

(b) Developmental Functions:

Refer to the functions that are related to the promotion of banking system and economic development of the country. These are not compulsory functions of the central bank.

These are discussed as follows:

(i) Developing specialized financial institutions:

Refer to the primary functions of the central bank for the economic development of a country. The central bank establishes institutions that serve credit requirements of the agriculture sector and other rural

businesses.

Some of these financial institutions include Industrial Development Bank of India (IDBI) and National Bank for Agriculture and Rural

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Development (NABARD). These are called specialized institutions as they serve the specific sectors of the economy.

(ii) Influencing money market and capital market:

Implies that central bank helps in controlling the financial markets

Money market deals in short term credit and capital market deals in long term credit. The central bank maintains the country’s economic growth by controlling the activities of these markets.

(iii) Collecting statistical data:

Gathers and analyzes data related to banking, currency, and foreign exchange position of a country. The data is quite helpful for researchers, policymakers, and economists. For instance, the Reserve Bank of India publishes a magazine called Reserve Bank of India Bulletin, whose data is useful for formulating different policies and making macro-level decisions.

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6.Quantitative and qualitative method of credit control

Credit control is an important tool of the monetary policy used by Reserve Bank of India (central bank) to control the demand and supply of money and flow of credit in an economy. RBI keeps control over the credit created by commercial banks.

Objectives of Credit Control

The primary objective according to RBI is ‘to control inflationary tendencies present in the economy to ensure high economic growth with adequate level of liquidity and maximum utilization of resources’

To achieve internal price stability To achieve financial Stability i.e. stability in money market To achieve stability in foreign exchange rate

To meet the financial requirement during slump in the economy To maximize income, output and employment in the economy

To promote economic growth and development of the country

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These tools control the cost and quantity (volume) of credit.

(1) Reserve Ratios

Cash Reserve Ratio – Banks have to keep a certain minimum percentage of their total deposits (demand deposits + time deposits) with the RBI, that minimum percentage is called CRR. A change in CRR affects the credit creation capacity of the commercial banks.

An increase in CRR results in less liquid cash deposits with the commercial banks and a fall in the value of deposit multiplier which reduces the volume of credit in the economy and a decrease in CRR results in more liquid cash available with the banks and rise in the value of deposit multiplier which increases the volume of credit.

Statutory Liquidity Ratio – All banks are required to maintain a minimum percentage of their total deposits as liquid assets in form of

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cash, gold or securities with themselves known as SLR. A change in SLR has the same effect on volume of credit as in the case of

change in CRR.

Open Market Operations Buying and selling of government securities by the RBI in the open market is called open market operations.

When RBI buys government securities the volume of credit increases and when securities are sold the volume of credit decreases. When commercial banks make payment to the RBI for securities bought, their cash reserves reduce which leads to a reduction in their ability to create credit. This makes advancing loans to consumers difficult for commercial banks as they have limited funds. This leads to contraction of credit in the economy.

Bank Rate Policy – It is the policy under which RBI influences the volume of credit in the economy by manipulating the bank rate. Bank rate is the rate at which RBI lends money to the commercial banks. It the interest rate charged by the RBI when advancing loans to commercial banks against bills of exchange, commercial papers etc. An increase in bank rate is likely to increase all other market rates, which leads to contraction of credit while a decrease in bank rate leads to expansion of credit.

When RBI increases the bank rate, the commercial banks are discouraged from taking loans as now they have to pay a higher interest rate on loans from central bank then before. The

commercial banks in turn start charging

higher interest rate from consumers (traders and businesses) seeking loans which increases the cost of credit. The high cost of credit

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discourages consumers to take loans. This reduces the volume of credit in

the economy. The opposite happens when the bank rate is decreased.

• Liquidity Adjustment Facility – Under this facility, RBI provides liquidity to scheduled commercial banks and primary dealers or absorbs excess The interest rate at which RBI provides liquidity to banks under Liquidity

Adjustment Facility is known as Repo rate. An increase in repo rate increases the cost of credit for commercial banks

and leads to a reduction in amount of credit created in the economy. The

increase in reverse repo rate has the opposite effect on credit creation.

• Marginal Standing Facility – Under this facility the

commercial banks can borrow additional money from the RBI on overnight basis up to a certain limit of their Statutory Liquidity Reserve (SLR) (currently 2% of net time and demand deposits)at an penal interest rate(currently 0.25% above

repo rate). An increase in MSF has the same effect on credit as in case of increase in Bank Rate or Repo rate.

Current Reserve and Policy Rates in India %

Cash Reserve Ratio (CRR) 4% of NDTL*

Statutory Liquidity Ratio (SLR) 20.5% of NDTL

Bank Rate 6.50%

Repo Rate 6.25%

Reverse repo rate 6%

Marginal Standing Facility (MSF) 6.50%

Qualitative Measures of Credit Control

These tools control the use and direction (flow) of credit.

(1) Credit Rationing – Credit rationing is controlling the amount of credit

available for certain industrial sectors in order to ensure that all sectors get

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adequate amount of credit. Under this method RBI fixes ceiling (maximum

limit) on loans and advances for specific categories, which the commercial

banks cannot exceed.

(2) Moral Suasion – Moral suasion is the method by which RBI persuades

and convinces the commercial banks to undertake certain actions which are in the economic interests of the country. Under this method the RBI requests and persuades the commercial banks to work in cooperation with

the central bank in implementing its credit and monetary policies.

(3) Changing Margin Requirements – Under this method the RBI prescribes margin requirements that commercial banks have to maintain on

securities against which loans are provided to customers. RBI sets different

margin requirements for different types of securities. A change in margin requirements influences the flow or direction of credit. An increase in margin requirements; decreases the flow of credit while a decrease leads to an increase in flow of credit

(4) Regulating Consumer Credit – Consumer credit refers to loans taken

by people for purchase of goods and services. RBI regulates the total volume of credit that may be extended to customers by the commercial banks and fixes a minimum time period for repayment or increases down

payment required for specific categories to influence the flow of credit in a

particular direction.

(5) Direct Action – When all the methods mentioned above prove ineffective in controlling credit, RBI takes a direct action by laying down specific rules and regulations under which the commercial banks will operate. A strict action is taken against banks that refuse to follow the directions of the RBI.

Importance of Credit Control

It helps in achieving the primary objective of controlling inflation

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through

price stability (stable price level of goods and services) and financial stability (equalizing demand for money with supply of money).

It helps in boosting the economy by facilitating adequate flow and volume

of bank credit to different sectors and encourages growth of priority sectors by providing adequate credit to priority sectors essential for economic development

Encourages judicious delivery of credit by keeping check on credit granted for undesirable purposes by commercial banks.

References

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