Unit 2

BANKING INNOVATIONS

Evolution of Banking in India

Money lending developed as an occupation in India from 500 B.C. But the first modem bank
was set up in 1688 in Madras. 'Agency Houses' started by the British in India paved the way for
establishing joint stock banks in India. Bank of Hindustan was established in 1770 in Calcutta.
General Bank of India was established in 1786. Three presidency banks viz., Bank of Calcutta
(18061, Bank of Bombay (18401, Bank of Madras (1843) were established. These three banks
subsequently merged together to form the Imperial Bank of India in 192 1 which was
nationalised in 1955 and named as the State Bank of India. Many other banks like Allahabad
Bank (1865), Punjab National Bank (1894), Bank of India (1906), Indian Bank (1907), Bank of
Baroda (1909), Central Bank of India (191 1) came into existence. However, Indian banking
system experienced a series of crisis and as a consequence witnessed a number of bank failures.
This is more so during the post-world war I period. Reserve Bank of India was therefore
established in 1935 to regulate and control the banking system in India.

Definition of a Bank:

According to Section 5 of the Banking Regulation Act, 1949, "a Banking company means any
company which transacts the business of banking. Banking means the accepting for the purpose
of lending or investment, of deposits of money from the public, payable on demand or otherwise,
and withdrawal by cheque, draft or otherwise".

Meaning of Bank:

A Bank denotes a financial institution dealing in money. A bank is an institution that is prepared
to accept deposits of money and repay the same on demand.

Meaning of Banker:

A Banker (i.e., person or a corporation) deals in credit and money i.e. it accepts deposits from
those who want to commit their wealth to safety and earn interest thereon, and lends money to
the needy through cheques and advances and loans of various sorts.

Meaning of Banking:

Banking which involves in expanding its network of operations. It means accepting deposits for
the purpose of lending.

What is Commercial Bank?

A Commercial Bank is a kind of financial institution which carries all the operations related to
deposit and withdrawal of money for the general public, providing loans for investment, etc.
These banks are profit-making institutions and do business only to make a profit.
The two primary characteristics of a commercial bank are lending and borrowing. The bank
receives the deposits and gives money to various projects to earn interest (profit). The rate of
interest that a bank offers to the depositors is known as the borrowing rate, while the rate at
which banks lends the money is called the lending rate.
The following are the common services provided by commercial banks:

Role of Commercial Banks in economic development of our country

1. Capital Formation: Commercial banks help to increase the rate of capital formation in a

country. Capital formation means increasing the number of production units, technologies,
plants, and equipment. They fund projects responsible for increasing the rate of capital
formation.

2. Trade Development: Commercial banks provide capital, technical assistance, and other

facilities to traders as per their need which leads to growth in trade.

3. Agriculture Development: Commercial banks finance the most crucial sectors of the

developing economy, such as agriculture, short, medium, and long-term loans for seeds and
fertilizers, tube wells installation, warehouse construction, purchase of tractors and threshers.

4. Development of Foreign Trade: Commercial banks assist businessmen in conducting

business in two different countries. Credit certificates are issued by the importer’s bank to
the exporters to ensure payment. Banks also provide foreign exchange.

5. Transfer to money: Commercial banks make it possible to transfer funds from one place to
another which leads to the growth of trade.

6. More production: A good banking system ensures greater productivity in all areas of the
economy. It increases the productive capacity of the economy by strengthening the capital
structure and the division of labour.

7. Increasing in Saving: Commercial banks persuade people to save more. For this purpose,
various savings schemes with attractive interest rates have been introduced. Now-these-days
the bank has branches in urban and rural areas.
8. Use of Modern Technology: The use of modern technology in the least developed countries
is only possible in the presence of advanced commercial banking as it can be the main source
of their funds. These funds are used to import modern technology from developed countries.

9. Export Promotion Cells: To boost the country’s exports, banks have set up export
promotion centres to provide information and guidance to exporters.

10. Economic Prosperity: The economic prosperity of a country depends on various factors

including the development of commercial banking. A sound banking system promotes
people’s economic position by providing short, medium, and long term loans.

11. Employment Generation: After the nationalization of big banks, banking industry has
grown to a great extent. Bank’s branches are opened frequently, which leads to the creation
of new employment opportunities.

12. Credit Creation: Commercial banks are called credit factories. They go much further than
collections from people in the form of deposits. Through the process of creating credit,
commercial banks provide money to all sectors of the economy, so that they are more
advanced than before.

13. Help in Monetary Policy: The commercial banks help the economic development of a
country by faithfully following the monetary policy of the central bank. In fact, the central
bank depends upon the commercial banks for the success of its policy of monetary
management in keeping with requirements of a developing economy.

14. Finance to Government: Government is acting as the promoter of industries in

underdeveloped countries for which finance is needed for it. Banks provide long-term
credit to Government by investing their funds in Government securities and short-term
finance by purchasing Treasury Bills.

15. Banks Promote Entrepreneurship: In recent days, banks have assumed the role of
developing entrepreneurship particularly in developing countries like India by inducing new
entrepreneurs to take up the well-formulated projects and provision of counselling services
like technical and managerial guidance. Banks provide 100% credit for worthwhile projects,
which is also technically feasible and economically viable. Thus commercial banks help for
the development of entrepreneurship in the country.
Functions of Commercial Banks:
Investment Norms (or) Policies (or) Principles of Commercial Banks

1. Principles of Liquidity
A commercial bank offers two types of deposits
 Demand deposits which the bank has to repay on demand like a Savings Account.
 Time deposits which the bank has to repay after the expiry of a certain period.
Further, on a daily basis, customers withdraw as well as deposit cash. Therefore, all commercial
banks have to keep a certain amount of cash in their custody to meet the cash demands of
customers.

2. Principles of Solvency
Commercial banks must be financially sound. Further, they need to maintain a certain required
capital for running the business.

3. Principles of Safety
A commercial bank accepts deposits from its customers and then invests it. However, since it is
investing the investor’s money it keeps the safety of the money first.
4. Principles of Loans and Investment Policy
A commercial bank primarily earns money through its lending and investing activities. It also
ensures that the investor’s money is invested in viable projects. Therefore, banks need strong
loans and investment policies to earn a good profit.

5. Principles of Secrecy
Commercial banks ensure that they keep the accounts of their clients secret. Also, access to the
accounts is given only to legitimized persons.

6. Safety and security: Commercial banks must pay a special attention to the principle of
safety and security. In a developing country like India in case there is any kind of loss than it
will lead to decrease in public faith towards banks and impacts the overall deposits of the
banks. So, the banks must ensure investing the amount in safe and secure sectors. Investment
in unsafe and insecure sectors with the hope of getting more returns is to compromise with
the security of capital.

7. Profitability: The profit of commercial bank mainly depends on the interest rate, volume of
loan, its time period and nature of investment in different securities. It is a fact that a
commercial bank can maximize its volume of wealth through maximization of return on their
investment and lending so, they must invest their funds to gain maximum profit. Ambition of
profit to commercial bank seems reasonable as the bank has to cover all the expenses and
make payment in the forms dividend to the shareholders who contribute to building up of
bank’s capital and interest to the depositors. For this the bank calculates the cost of fund and
likely return.

8. Diversification / Diversity: “A bird should not lay all its eggs in the same basket.” This
saying is very important to the bank and it should be always careful not to grant loan in only
one sector. To minimize risk, a bank must diversify its investment on different sectors.
Diversification of loan helps to sustain loss according to the law of average; if the security of
a company is divided off there may be an appreciation in the securities of other companies.

9. Principles of Tax-Exemption of Investments: