SUBHASISH MAJUMDAR 

INTRODUCTION

A bank is an institution that deals in money and its substitutes and provides other financial services.
Banks accept deposits and make loans or make an investment to derive a profit from the difference in
the interest rates paid and charged, respectively.

In India the banks are being segregated in different groups. Each group has their own benefits and
limitations in operating in India. Each has their own dedicated target market. Few of them only work in
rural sector while others in both rural as well as urban. Many even are only catering in cities. Some
are of Indian origin and some are foreign players.

India’s economy has been one of the stars of global economics in recent years. It has grown by more
than 9% for three years running. The economy of India is as diverse as it is large, with a number of
major sectors including manufacturing industries, agriculture, textiles and handicrafts, and services.
Agriculture is a major component of the Indian economy, as over 66% of the Indian population earns
its livelihood from this area. Banking sector is considered as a booming sector in Indian economy
recently. Banking is a vital system for developing economy for the nation.

However, Indian banking system and economy has been facing various challenges and problems
which have discussed in other parts of project.

INDIAN BANKING SYSTEM

Without a sound and effective banking system in India it cannot have a healthy economy. The
banking system of India should not only be hassle free but it should be able to meet new challenges
posed by the technology and any other external and internal factors. For the past three decades
India's banking system has several outstanding achievements to its credit. The most striking is its
extensive reach. It is no longer confined to only metropolitans or cosmopolitans in India. In fact, Indian
banking system has reached even to the remote corners of the country. This is one of the main
reasons of India's growth process. The government's regular policy for Indian bank since 1969 has
paid rich dividends with the nationalization of 14 major private banks of India.

Not long ago, an account holder had to wait for hours at the bank counters for getting a draft
or for withdrawing his own money. Today, he has a choice. Gone are days when the most efficient
bank transferred money from one branch to other in two days. Now it is simple as instant messaging
or dial a pizza. Money has become the order of the day.

The first bank in India, though conservative, was established in 1786. From 1786 till today,
the journey of Indian Banking System can be segregated into three distinct phases. They are as
mentioned below:

Early phase from 1786 to 1969 of Indian Banks

Nationalization of Indian Banks and up to 1991 prior to Indian banking sector Reforms.

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New phase of Indian Banking System with the advent of Indian Financial & Banking Sector
Reforms after 1991.

After 1991, under the chairmanship of M Narasimham, a committee was set up by his name
which worked for the liberalization of banking practices. The country is flooded with foreign banks and
their ATM stations. Efforts are being put to give a satisfactory service to customers. Phone banking
and net banking is introduced. The entire system became more convenient and swift. Time is given
more importance than money. This resulted that Indian banking is growing at an astonishing rate, with
Assets expected to reach US$1 trillion by 2010.

“The banking industry should focus on having a small number of large players that can
compete globally and can achieve expected goals rather than having a large number of fragmented
players."

KINDS OF BANKS

Financial requirements in a modern economy are of a diverse nature, distinctive variety and large
magnitude. Hence, different types of banks have been instituted to cater to the varying needs of the
community. Banks in the organized sector may, however, be classified in to the following major forms:

Commercial banks

Co-operative banks

Specialized banks

Central bank

COMMERCIAL BANKS

Commercial banks are joint stock companies dealing in money and credit. In India, however there is a
mixed banking system, prior to July 1969, all the commercial banks-73 scheduled and 26 non-
scheduled banks, except the state bank of India and its subsidiaries-were under the control of private
sector. On July 19, 1969, however, 14 major commercial banks with deposits of over 50 Corers were

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nationalized. In April 1980, another six commercial banks of high standing were taken over by the
government.

At present, there are 20 nationalized banks plus the state bank of India and its 7 subsidiaries
constituting public sector banking which controls over 90 per cent of the banking business in the
country.

CO-OPERATIVE BANKS

Co-operative banks are a group of financial institutions organized under the provisions of the Co-
operative societies Act of the states. The main objective of co-operative banks is to provide cheap
credits to their members. They are based on the principle of self-reliance and mutual co-operation.
Co-operative banking system in India has the shape of a pyramid a three tier structure, constituted by:

SPECIALIZED BANKS

There are specialized forms of banks catering to some special needs with this unique nature of
activities. There are thus,

Foreign exchange banks,

Industrial banks,

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Development banks,

Land development banks,

Exim bank.

CENTRAL BANK

A central bank is the apex financial institution in the banking and financial system of a country. It is
regarded as the highest monetary authority in the country. It acts as the leader of the money market.
It supervises, control and regulates the activities of the commercial banks. It is a service oriented
financial institution.

India’s central bank is the Reserve Bank of India established in 1935. A central bank is usually
state owned but it may also be a private organization. For instance, the Reserve Bank of India (RBI),
was started as a shareholders’ organization in 1935, however, it was nationalized after
independence, in 1949. It is free from parliamentary control.

CHALLENGES FACED BY INDIAN BANKING INDUSTRY

The banking industry in India is undergoing a major transformation due to changes in economic
conditions and continuous deregulation. These multiple changes happening one after other has a
ripple effect on a bank trying to graduate from completely regulated sellers market to completed
deregulated customers market.

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DEREGULATION

This continuous deregulation has made the Banking market extremely competitive with greater
autonomy, operational flexibility, and decontrolled interest rate and liberalized norms for foreign
exchange. The deregulation of the industry coupled with decontrol in interest rates has led to entry of
a number of players in the banking industry. At the same time reduced corporate credit off take thanks
to sluggish economy has resulted in large number of competitors battling for the same pie.

NEW RULES

As a result, the market place has been redefined with new rules of the game. Banks are transforming
to universal banking, adding new channels with lucrative pricing and freebees to offer. Natural fall out
of this has led to a series of innovative product offerings catering to various customer segments,
specifically retail credit.

EFFICIENCY

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This in turn has made it necessary to look for efficiencies in the business. Banks need to access low
cost funds and simultaneously improve the efficiency. The banks are facing pricing pressure, squeeze
on spread and have to give thrust on retail assets.

DIFFUSED CUSTOMER LOYALTY

This will definitely impact Customer preferences, as they are bound to react to the value added
offerings. Customers have become demanding and the loyalties are diffused. There are multiple
choices; the wallet share is reduced per bank with demand on flexibility and customization. Given the
relatively low switching costs; customer retention calls for customized service and hassle free,
flawless service delivery.

MISALLIGNED MINDSET

These changes are creating challenges, as employees are made to adapt to changing conditions.
There is resistance to change from employees and the Seller market mindset is yet to be changed
coupled with Fear of uncertainty and Control orientation. Acceptance of technology is slowly creeping
in but the utilization is not maximized.

COMPETENCE GAP

Placing the right skill at the right place will determine success. The competency gap needs to be
addressed simultaneously otherwise there will be missed opportunities. The focus of people will be on
doing work but not providing solutions, on escalating problems rather than solving them and on
disposing customers instead of using the opportunity to cross sell.

STRATEGIES OPTIONS WITH BANKS TO COPE WITH THOSE CHALLENGES

Leading players in the industry have embarked on a series of strategic and tactical initiatives to
sustain leadership. The major initiatives include:

Investing in state of the art technology as the back bone of to ensure reliable service delivery

Leveraging the branch network and sales structure to mobilize low cost current and savings deposits

Making aggressive forays in the retail advances segment of home and personal loans

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Implementing organization wide initiatives involving people, process and technology to reduce the
fixed costs and the cost per transaction

Focusing on fee based income to compensate for squeezed spread, (e.g. CMS, trade services)

Innovating Products to capture customer ‘mind share’ to begin with and later the wallet share

Improving the asset quality as per Basel II norms

INDIAN ECONOMY

The Indian Economy is consistently posting robust growth numbers in all sectors leading to
impressive growth in Indian GDP. The Indian economy has been stable and reliable in recent times,
while in the last few years it’s experienced a positive upward growth trend.

A consistent 8-9% growth rate has been supported by a number of favorable economic indicators
including a huge inflow of foreign funds, growing reserves in the foreign exchange sector, both an IT
and real estate boom, and a flourishing capital market. All of these positive changes have resulted in
establishing the Indian economy as one of the largest and fastest growing in the world.

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The process of globalization has been an integral part of the recent economic progress made by
India. Globalization has played a major role in export-led growth, leading to the enlargement of the job
market in India.

As a new Indian middle class has developed around the wealth that the IT and BPO industries have
brought to the country, a new consumer base has developed. International companies are also
expanding their operations in India to service this massive growth opportunity. The same thing has
followed by international banks that are entering in Indian market and pulling their huge investments
in Indian economy. This is helping to accelerate the growth of Indian economy.

Economy can be studied from two points of views…

MICRO ECONOMIC POINT OF VIEW

The branch of economics that analyzes the market behavior of individual consumers and firms in an
attempt to understand the decision-making process of firms and households. It is concerned with the
interaction between individual buyers and sellers and the factors that influence the choices made by
buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the
determination of price and output in individual markets. Microeconomics looks at the smaller picture
and focuses more on basic theories of supply and demand and how individual businesses decide how
much of something to produce and how much to charge for it.

MACRO ECONOMIC POINT OF VIEW

It is a field of economics that studies the behavior of the aggregate economy.

Macroeconomics examines economy-wide phenomena such as changes in unemployment, national
income, rate of growth, gross domestic product, inflation and price levels. Macroeconomics looks at
the big picture (hence "macro"). It focuses on the national economy as a whole and provides a basic
knowledge of how things work in the business world. For example, people who study this branch of
economics would be able to interpret the latest Gross Domestic Product figures or explain why a 6%
rate of unemployment is not necessarily a bad thing.

Thus, for an overall perspective of how the entire economy works, you need to have an understanding
of economics at both the micro and macro levels.

ECONOMIC SYSTEMS

An economic system is loosely defined as country’s plan for its services, goods produced, and the
exact way in which its economic plan is carried out. In general, there are three major types of
economic systems prevailing around the world they are...

Market Economy

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Planned Economy

Mixed Economy

MARKET ECONOMY

In a market economy, national and state governments play a minor role. Instead, consumers and their
buying decisions drive the economy. In this type of economic system, the assumptions of the market
play a major role in deciding the right path for a country’s economic development. Market economies
aim to reduce or eliminate entirely subsidies for a particular industry, the pre-determination of prices
for different commodities, and the amount of regulation controlling different industrial sectors. The
absence of central planning is one of the major features of this economic system. Market decisions
are mainly dominated by supply and demand. The role of the government in a market economy is to
simply make sure that the market is stable enough to carry out its economic activities properly.

PLANNED ECONOMY

A planned economy is also sometimes called a command economy. The most important aspect of this
type of economy is that all major decisions related to the production, distribution, commodity and
service prices, are all made by the government. The planned economy is government directed, and
market forces have very little say in such an economy. This type of economy lacks the kind of
flexibility that is present a market economy, and because of this, the planned economy reacts slower
to changes in consumer needs and fluctuating patterns of supply and demand. On the other hand, a
planned economy aims at using all available resources for developing production instead of allotting
the resources for advertising or marketing.

MIXED ECONOMY

A mixed economy combines elements of both the planned and the market economies in one cohesive
system. This means that certain features from both market and planned economic systems are taken
to form this type of economy. This system prevails in many countries where neither the government
nor the business entities control the economic activities of that country – both sectors play an
important role in the economic decision-making of the country. In a mixed economy there is flexibility
in some areas and government control in others. Mixed economies include both capitalist and
socialist economic policies and often arise in societies that seek to balance a wide range of political
and economic views.

IMPORTANT BANKING AND ECONOMIC INDICATORS

CASH RESERVE RATIO

Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides
to increase the percent of this, the available amount with the banks comes down. RBI is using this
method (increase of CRR rate), to drain out the excessive money from the banks. The amount of
which shall not be less than three per cent of the total of the Net Demand and Time Liabilities (NDTL)
in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher
rate not exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act,
1934.

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STATUTORY LIQUIDITY RATIO

In terms of Section 24 (2-A) of the B.R. Act, 1949 all Scheduled Commercial Banks, in addition to the
average daily balance which they are required to maintain in the form of….

In cash,

Or

In gold valued at a price not exceeding the current market price,

Or

In unencumbered approved securities valued at a price as specified by the RBI from time to time.

REPO RATE

Repo rate, also known as the official bank rate, is the discounted rate at which a central bank
repurchases government securities. The central bank makes this transaction with commercial banks
to reduce some of the short-term liquidity in the system. The repo rate is dependent on the level of
money supply that the bank chooses to fix in the monetary scheme of things. Repo rate is short for
repurchase rate. The entity borrowing the security is often referred to as the buyer, while the lender of
the securities is referred to as the seller. The central bank has the power to lower the repo rates while
expanding the money supply in the country. This enables the banks to exchange their government
security holdings for cash. In contrast, when the central bank decides to reduce the money supply, it
implements a rise in the repo rates. At times, the central bank of the nation makes a decision
regarding the money supply level and the repo rate is determined by the market.

The securities that are being evaluated and sold are transacted at the current market price plus any
interest that has accrued. When the sale is concluded, the securities are subsequently resold at a
predetermined price. This price is comprised of the original market price and interest, and the pre-
agreed interest rate, which is the repo rate.

BANK RATE

Bank rate is referred to the rate of interest charged by premier banks on the loans and advances.
Bank rate varies based on some defined conditions as laid down the governing authority of the banks.
Bank rates are levied to control the money supply to and from the bank. From the consumer's point of
view, bank rate ordinarily denotes to the current rate of interest acquired from savings certificate of
Deposit. It is most frequently used by the consumers who are concerned in mortgage

Some commonest types of bank interest rates are as follows:

Bank rate on CD, i.e., on certificate of deposit

Bank rate on the credit of a credit card or other kind of loan

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Bank rate on real estate loan

INTERBANK RATE

The rate of interest charged on short-term loans made between banks. Banks borrow and lend money
in the interbank market in order to manage liquidity and meet the requirements placed on them. The
interest rate charged depends on the availability of money in the market, on prevailing rates and
on the specific terms of the contract, such as term length.

Banks are required to hold an adequate amount of liquid assets, such as cash, to manage any
potential withdrawals from clients. If a bank can't meet these liquidity requirements, it will need to
borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have
excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the
interbank market, receiving interest on the assets. There is a wide range of published interbank
rates, including the LIBOR & MIBOR, which is set daily based on the average rates on loans made
within the London interbank market & Mumbai Interbank Market.

GROSS DOMESTIC PRODUCT

The monetary value of all the finished goods and services produced within a country's
borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all
of private and public consumption, government outlays, investments and exports less imports that
occur within a defined territory.

GDP = C + G + I + NX

Where:

"C" is equal to all private consumption, or consumer spending, in a nation's economy.

"G" is the sum of government spending.

"I" is the sum of all the country's businesses spending on capital.

"NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports -
Imports)

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GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a
country's standard of living.

INFLATION

Inflation can be defined as a rise in the general price level and therefore a fall in the value of money.
Inflation occurs when the amount of buying power is higher than the output of goods and services.
Inflation also occurs when the amount of money exceeds the amount of goods and services available.
As to whether the fall in the value of money will affect the functions of money depends on the degree
of the fall. Basically, refers to an increase in the supply of currency or credit relative to the availability
of goods and services, resulting in higher prices. Therefore, inflation can be measured in terms of
percentages. The percentage increase in the price index, as a rate per cent per unit of time, which is
usually in years. The two basic price indexes are used when measuring inflation, the producer price
index (PPI) and the consumer price index (CPI) which is also known as the cost of living index
number.

DEFLATION

It is a condition of falling prices accompanied by a decreasing level of employment, output and

income. Deflation is just the opposite of inflation. Deflation occurs when the total expenditure of the
community is not equal to the existing prices. Consequently, the supply of money decreases and as a
result prices fall. Deflation can also be brought about by direct contractions in spending, either in the
form of a reduction in government spending, personal spending or investment spending. Deflation has
often had the side effect of increasing unemployment in an economy, since the process often leads to
a lower level of demand in the economy.

DISINFLATION

When prices are falling due to anti-inflationary measures adopted by the authorities, with no
corresponding decline in the existing level of employment, output and income, the result of this is
disinflation. When acute inflation burdens an economy, disinflation is implemented as a cure.
Disinflation is said to take place when deliberate attempts are made to curtail expenditure of all sorts
to lower prices and money incomes for the benefit of the community.

REFLATION

Reflation is a situation of rising prices, which is deliberately undertaken to relieve a depression.

Reflation is a means of motivating the economy to produce. This is achieved by increasing the supply
of money or in some instances reducing taxes, which is the opposite of disinflation. Governments can
use economic policies such as reducing taxes, changing the supply of money or adjusting the interest
rates; which in turn motivates the country to increase their output. The situation is described as semi-
inflation or reflation.

STAGFLATION

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Stagflation is a stagnant economy that is combined with inflation. Basically, when prices are
increasing the economy is deceasing. Some economists believe that there are two main reasons for
stagflation. Firstly, stagflation can occur when an economy is slowed by an unfavourable supply, such
as an increase in the price of oil in an oil importing country, which tends to raise prices at the same
time that it slows the economy by making production less profitable. In the 1970's inflation and
recession occurred in different economies at the same time. Basically, what happened was that there
was plenty of liquidity in the system and people were spending money as quickly as they got it
because prices were going up quickly. This gave rise to the second reason for stagflation.

FOREIGN INSTITUTIONAL INVESTMENTS

Foreign Institutional Investors (FIIs), Non-Resident Indians (NRIs), and Persons of Indian Origin
(PIOs) are allowed to invest in the primary and secondary capital markets in India through the portfolio
investment scheme (PIS). Under this scheme, FIIs/NRIs can acquire shares/debentures of Indian
companies through the stock exchanges in India.

The ceiling for overall investment for FIIs is 24 per cent of the paid up capital of the Indian company
and 10 per cent for NRIs/PIOs. The limit is 20 per cent of the paid up capital in the case of public
sector banks, including the State Bank of India.

FOREIGN EXCHANGE RESERVES

Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign
currency deposits held by central banks and monetary authorities. However, the term in popular
usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader
figure is more readily available, but it is more accurately termed official reserves or international
reserves. These are assets of the central bank held in different reserve currencies, such as the
dollar, euro and yen, and used to back its liabilities, e.g. the local currency issued, and the various
bank reserves deposited with the central bank, by the government or financial institutions.

Large reserves of foreign currency allow a government to manipulate exchange rates - usually to
stabilize the foreign exchange rates to provide a more favorable economic environment.

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ROLE OF BANKS IN DEVELOPING OF ECONOMY

A safe and sound financial sector is a prerequisite for sustained growth of any economy.
Globalization, deregulation and advances in information technology in recent years have brought
about significant changes in the operating environment for banks and other financial institutions.
These institutions are faced with increased competitive pressures and changing customer demands.
These, in turn, have engendered a rapid increase in product innovations and changes in business
strategies. While these developments have enabled improvement in the efficiency of financial
institutions, they have also posed some serious risks.

Banks play a very useful and dynamic role in the economic life of every modern state. A study of the
economic history of western country shows that without the evolution of commercial banks in the 18th
and 19th centuries, the industrial revolution would not have taken place in Europe. The economic
importance of commercial banks to developing countries may be viewed thus:

Promoting capital formation

Encouraging innovation

Monetsation

Influence economic activity

Facilitator of monetary policy

Above all view we can see in briefly, which are given below:

PROMOTING CAPITAL FORMATION

A developing economy needs a high rate of capital formation to accelerate the tempo of economic
development, but the rate of capital formation depends upon the rate of saving. Unfortunately, in
underdeveloped countries, saving is very low. Banks afford facilities for saving and, thus encourage
the habits of thrift and industry in the community. They mobilize the ideal and dormant capital of the
country and make it available for productive purposes.

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ENCOURAGING INNOVATION

Innovation is another factor responsible for economic development. The entrepreneur in innovation is
largely dependent on the manner in which bank credit is allocated and utilized in the process of
economic growth. Bank credit enables entrepreneurs to innovate and invest, and thus uplift economic
activity and progress.

MONETSATION

Banks are the manufactures of money and they allow many to play its role freely in the economy.
Banks monetize debts and also assist the backward subsistence sector of the rural economy by
extending their branches in to the rural areas. They must be replaced by the modern commercial
bank’s branches.

INFLUENCE ECONOMIC ACTIVITY

Banks are in a position to influence economic activity in a country by their influence on the rate
interest. They can influence the rate of interest in the money market through its supply of funds.
Banks may follow a cheap money policy with low interest rates which will tend to stimulate economic
activity.

FACILITATOR OF MONETARY POLICY

Thus monetary policy of a country should be conductive to economic development. But a well-
developed banking system is on essential pre-condition to the effective implementation of monetary
policy. Under-developed countries cannot afford to ignore this fact.

A fine, an efficient and comprehensive banking system is a crucial factor of the developmental
process of economy.

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RESERVE BANK OF INDIA AS A REGULATORY INSTITUTION IN INDIAN ECONOMY

The RBI was established under the Reserve Bank of India Act, 1934 on April 1, 1935 as a private
shareholders' bank but since its nationalization in 1949, is fully owned by the Government of India.
The Preamble of the Reserve Bank describes the basic functions as 'to regulate the issue of Bank
notes and keeping of reserves with a view to securing monetary stability in India and generally, to
operate the currency and credit system of the country to its advantage'. The twin objectives of
monetary policy in India have evolved over the years as those of maintaining price stability and
ensuring adequate flow of credit to facilitate the growth process. The relative emphasis between the
twin objectives is modulated as per the prevailing circumstances and is articulated in the policy
statements by the Reserve Bank from time to time. Consideration of macro-economic and financial
stability is also subsumed in the mandate. The Reserve Bank is also entrusted with the management
of foreign exchange reserves (which include gold holding also), which are reflected in its balance
sheet.

While the Reserve Bank is essentially a monetary authority, its founding statute mandates it to be the
manager of market borrowing of the Government of India and banker to the Government.

The Reserve Bank's affairs are governed by a Central Board of Directors, consisting of fourteen non-
executive, independent directors nominated by the Government, in addition to the Governor and up to
four Deputy Governors. Besides, one Government official is also nominated on the Board who
participates in the Board meetings but cannot vote.

IMPORTANT FUNCTIONS PLAYED BY RESERVE BANK OF INDIA IN ECONOMY

MAIN FUNCTIONS

MONITORY AUTHORITY

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The Reserve Bank of India formulates implements and monitors the monetary policy. Its main
objective is maintaining price stability and ensuring adequate flow of credit to productive sectors.

REGULATOR AND SUPERVISOR OF FINANCIAL SYSTEM

Prescribes broad parameters of banking operations within which the country’s banking and financial
system functions. Their main objective is to maintain public confidence in the system, protect
depositors’ interest and provide cost-effective banking services to the public.

MANAGER OF EXCHANGE CONTROL

The manager of the exchange control department manages the Foreign Exchange Management Act,
1999. Its main objective is to facilitate external trade and payment and promote orderly development
and maintenance of foreign exchange market in India.

ISSUER OF THE CURRENCY

The person who is issuer issues and exchanges or destroys currency and coins not fit for
circulation. His main objective is to give the public adequate quantity of supplies of currency notes
and coins and in good quality.

DEVELOPMENTAL ROLE

The reserve bank of India performs a wide range of promotional functions to support national
objectives. The promotional functions are such as contests, coupons, maintaining good public
relations, and many more…..

RELATED FUNCTIONS

There are also some of the relating functions to the above mentioned main functions. They are such
as Banker to the Government, Banker to banks etc….

BANKER TO THE GOVERNMENT

It performs merchant banking function for the central and the state governments; also acts as their
banker.

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BANKER TO THE BANKS

Maintains banking accounts of all scheduled banks.

SUPERVISORY FUNCTIONS

The Reserve Bank act, 1934 and the Banking Regulation act, 1949 have given the RBI wide powers
of supervision and control over commercial and co-operative banks, relating to licensing and
establishments, branch expansion, liquidity of their asset, management and methods of working,
amalgamation, reconstruction, and liquidation.

The RBI is authorized to carry out periodical inspections of banks and to call for returns and
necessary information from them. The supervisory functions of the RBI have helped a great deal in
improving the standard of banking in India to develop on sound lines and to improve the methods of
their operation.

PROMOTIONAL FUNCTIONS

With economic growth assuming a new urgency since Independence, the range of the Reserve
Bank’s functions has steadily widened. The bank now performs a variety of developmental and
promotional functions, which, at one time were regarded as outside the normal scope of central
banking. The RBI was asked to promote banking habit, extend banking facilities to rural and semi-
urban areas, and establish and promote new specialized financing agencies.

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PROBLEMS FACED BY INDIAN ECONOMY

Macro-economic environment in India has taken a serious turn since the beginning of the year.
Unprecedented rise in crude prices, surge in inflation and continued strong growth in money supply
(M3) have forced the government and RBI to take strong fiscal and monetary measures leading to
liquidity tightening, significant rise in interest rates and slowdown in economic growth.

Economic shocks are events which adversely affect the economy and the government’s
macroeconomic objectives such as growth, inflation, unemployment and the balance of payments.

CERTAIN PROBLEMS FACED BY INDIAN ECONOMY

FALL IN SAVINGS RATIO

The savings ratio is the % of income that is saved not spent. A fall in the savings ratio implies that
consumer spending is increasing; often this is financed through increased borrowing.

EFFECTS OF FALL IN SAVINGS RATIO

HIGHER LEVEL OF CONSUMPTION

This results in increase in Aggregate Demand. The increase in AD will cause an increase in economic
growth and lower unemployment. However, rising Aggregate Demand may cause inflation. Inflation
will occur when growth is faster than the long run trend rate. This is now a potential problem in the
India. Inflation has recently gone above 12%

BOOM AND BUST

A fall in the savings ratio is usually accompanied by a rise in confidence. It is the rise in confidence
which encourages borrowing and consumers to run down savings. Therefore, there is always a
danger that a falling savings ratio can be a precursor to a boom and bust situation.

ECONOMY MORE SENSITIVE TO INTEREST RATES

With a fall in the savings ratio interest rate changes will have a bigger effect in reducing spending.
This is because levels of borrowing are higher and therefore a rise in interest rates has a significant
impact on increasing interest repayments. Also, higher rates will not be increasing incomes from
savings as much.

BALANCE OF PAYMENT

With higher levels of consumer spending, there will be an increase in imports. Therefore this will lead
to deterioration in the current account. The current account deficit could put downward pressure on
the exchange rate in the long term.

However, some people argue a fall in the savings ratio is not a problem, but, it is just a reflection of
strong economy and booming housing market, which increases scope for equity withdrawal.

INFLATION

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Inflation is posing a serious challenge to the economic growth of India. Since Jan’08 onwards,
inflation in the country has surged by 8.2% to hit a 13-year high of ~12%. M3 growth in the economy
too continued to remain strong at 20% (in July’08), well above the RBI’s comfort level of 17%.

The WPI inflation rate flared up during the period driven by significant increase in the prices of
commodities, primary articles and manufactured products, even though very small part of global crude
price increase has been passed on to the Indian consumers.

GLOBAL RECESSION

It appears that Europe, Japan and the US are entering into recession. Falling house prices, crisis in
the financial system, and lower confidence could lead to a sharp downturn, with the worst still to
come. Many argue that India’s growth is not so dependent on growth in the West. However, the Indian
stock markets have been hit by the global crisis. India’s growing service sector and manufacturing
sector would be adversely impacted by a global downturn.

RISE IN CRUDE PRICES

How global crude prices would behave probably has no easy answers; however we believe that the
current challenging and uncertain macro-economic conditions does not lead Indian financials into a
state of crisis. But continued rise in crude prices and its resultant impact on inflation, interest rates and
government finances has the potential to do so. Hence, crude price remains the key risk to our
positive stance on the Indian financials.

In the last couple of months oil prices have surged by 45% from US$ 100 to US$ 145 (and now back
to US$ 115). India currently imports 70% of its crude requirement, resulting in pressure on
government coffers on back of rising crude prices.

DEPRICIATING INR

Surge in crude prices has severely impacted current account deficit of the country. This coupled with
the outflow of FII investments has resulted in INR to depreciate sharply against dollar further fueling
inflation.

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IMPACT OF ECONOMIC PROBLEMS ON INDIAN FINANCIALS

The current macro-economic conditions are expected to result in

SLOWDOWN IN CREDIT GROWTH

IMPACT ON MARGINS OF BANKS

PREASURE ON CREDIT QUALITY

SLOWDOWN IN CREDIT GROWTH

While the rise in interest rates should lead to a moderation in demand for credit, Indian banks too are
exercising caution while lending. Credit growth of 18% in FY09E and 17% in FY10E vs. 22% in FY08.
Risks and uncertainties in the system have increased given the higher crude and commodity prices
and its inflationary impact. This would curtail consumption, which would impact economic growth
adversely. Further higher rates will not only impact the profitability of Indian corporate but also impact
IRRs of various proposed capex projects. This coupled with elections next year could lead to some
postponement of capex plans of corporate, leading to negative impact on demand for credit.

Higher rates have particularly impacted retail loan growth. As can be seen in the exhibit below, retail
loan growth has slowed down significantly from 26.5% in FY07 to ~13% in FY08. SLR Ratio of the
system has started rising since mid FY08 and currently stands at 28.7%. Given the expected negative
impact on credit growth.

IMPACT ON MARGINS OF BANKS

During the past 18 months, CRR has increased by 400 bps to 9.0% currently and RBI has also
discontinued with interest payment on CRR balances. Every 50 bps hike in CRR generally negatively
impacts margins by ~5 bps. Till June’08, most of the banks had restrained from hiking lending rates
despite significant monetary tightening. However on account of recent measures by RBI, banks have
resorted to hiking PLRs in July/August by 50-150 bps to preserve their margins.

In fact in an environment, where liquidity is tight, interest rates are at elevated levels and risk
premiums have increased, the banks tend to regain the pricing power. This would not only help the
banks to adequately price in risks but also help protect their margins. Apart from hiking PLRs, banks
are also resorting to reprising (in fact right-pricing) the loans that were sanctioned well below PLRs.
Significant portion of fixed rate loans would also get re-priced over the period of 12-18 months.

PRESSURE ON CREDIT QUALITY

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Higher lending rates are expected to impact credit quality for the banking system. The extent of the
impact on credit quality would also be bank specific given the loan mix (retail vs. corporate),
proportion of unsecured lending, credit profile of corporate loan book and industry wise exposure.
Indian banks’ fundamentals are relatively resilient with better risk management systems, dramatically
improved asset quality, stronger recovery mechanisms (legal provisions) and with adequate
capitalization and provisioning.

Even Certain sectors (like real estate, airlines industry) might feel the stress due to the changing
macro environment and rise in interest rates. Many companies where crude forms a key raw material
component are expected to get hit more severely. Similarly, sectors like real estate and SMEs, which
are interest rate sensitive, would face higher delinquencies if interest rates strengthen further by 100-
200 bps.

NECESSARY INITIATIVES TAKEN BY RBI & MINISTRY OF FINANCE TO TACKLE ECONOMIC

PROBLEMS

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As most of economists feel that the most horrible problem which India is facing currently is
inflation which has crossed 12%. To come out of these problems RBI and ministry of finance and
other relevant government and regulatory entities are taking various initiatives which are as follows...

RBI MONITORY POLICY

With the introduction of the Five year plans, the need for appropriate adjustment in monetary and
fiscal policies to suit the pace and pattern of planned development became imperative. The monitory
policy since 1952 emphasized the twin aims of the economic policy of the government:

Spread up economic development in the country to raise national income and standard of living, and

To control and reduce inflationary pressure in the economy.

This policy of RBI since the First plan period was termed broadly as one of controlled expansion, i.e.;
a policy of “adequate financing of economic growth and at the same time the time ensuring
reasonable price stability”. Expansion of currency and credit was essential to meet the increased
demand for investment funds in an economy like India which had embarked on rapid economic
development. Accordingly, RBI helped the economy to expand via expansion of money and credit and
attempted to check in rise in prices by the use of selective controls.

OBJECTIVES OF MONITORY POLICY

PRICE STABILITY

MONITORY TARGETTING

INTEREST RATE POLICY

RESTRUCTURING OF MONEY MARKET

REGULATION OF FOREIGN EXCHANGE MARKET

WEAPONS OF MONITORY POLICY

Central banks generally use the three quantitative measures to control the volume of credit in an
economy, namely:

Raising bank rates

Open market operations and

Variable reserve ratio

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However, there are various limitations on the effective working of the quantitative measures of credit
control adapted by the central banks and, to that extent, monetary measures to control inflation are
weakened. In fact, in controlling inflation moderate monetary measures, by themselves, are relatively
ineffective. On the other hand, drastic monetary measures are not good for the economic system
because they may easily send the economy into a decline.

In a developing economy there is always an increasing need for credit. Growth requires credit
expansion but to check inflation, there is need to contract credit. In such a encounter, the best course
is to resort to credit control, restricting the flow of credit into the unproductive, inflation-infected sectors
and speculative activities, and diversifying the flow of credit towards the most desirable needs of
productive and growth-inducing sector. It should be noted that the impression that the rate of
spending can be controlled rigorously by the contraction of credit or money supply is wrong in the
context of modern economic societies. In modern community, tangible, wealth is typically represented
by claims in the form of securities, bonds, etc., or near moneys, as they are called. Such near moneys
are highly liquid assets, and they are very close to being money. They increase the general liquidity of
the economy. In these circumstances, it is not so simple to control the rate of spending or total outlays
merely by controlling the quantity of money. Thus, there is no immediate and direct relationship
between money supply and the price level, as is normally conceived by the traditional quantity
theories. When there is inflation in an economy, monetary restraints can, in conjunction with other
measures, play a useful role in controlling inflation.

FISCAL POLICY

Fiscal policy is another type of budgetary policy in relation to taxation, public borrowing, and public
expenditure. To curve the effects of inflation and changes in the total expenditure, fiscal measures
would have to be implemented which involves an increase in taxation and decrease in government
spending. During inflationary periods the government is supposed to counteract an increase in private
spending. It can be cleared noted that during a period of full employment inflation, the aggregate
demand in relation to the limited supply of goods and services is reduced to the extent that
government expenditures are shortened.

Along with public expenditure, governments must simultaneously increase taxes that would effectively
reduce private expenditure, in an effect to minimise inflationary pressures. It is known that when more
taxes are imposed, the size of the disposable income diminishes, also the magnitude of the
inflationary gap in regards to the availability of the supply of goods and services. In some instances,
tax policy has been directed towards restricting demand without restricting level of production. For
example, excise duties or sales tax on various commodities may take away the buying power from the
consumer goods market without discouraging the level of production. However, some economists
point out that this is not a correct way of combating inflation because it may lead to a regressive
status within the economy.

As a result, this may lead to a further rise in prices of goods and services, and inflation can spread
from one sector of the economy to another and from one type of goods and services to another.
Therefore, a reduction in public expenditure, and an increase in taxes produces a cash surplus in the
budget. Keynes, however, suggested a programme of compulsory savings, such as deferred pay as
an anti-inflationary measure. Deferred pay indicates that the consumer defers a part of his or her
wages by buying savings bonds (which, of course, is a sort of public borrowing), which are
redeemable after a particular period of time, this is sometimes called forced savings. Additionally,
private savings have a strong disinflationary effect on the economy and an increase in these is an
important measure for controlling inflation. Government policy should therefore, include devices for

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increasing savings. A strong savings drive reduces the spendable income of the consumers, without
any harmful effects of any kind that are associated with higher taxation. Furthermore, the effects of a
large deficit budget, which is mainly responsible for inflation, can be partially offset by covering the
deficit through public borrowings. It should be noted that it is only government borrowing from non-
bank lenders that has a disinflationary effect. In addition, public debt may be managed in such a way
that the supply of money in the country may be controlled. The government should avoid paying back
any of its past loans during inflationary periods, in order to prevent an increase in the circulation of
money. Anti-inflationary debt management also includes cancellation of public debt held by the central
bank out of a budgetary surplus.

Fiscal policy by itself may not be very effective in combating inflation; therefore a combination of fiscal
and monetary tools can work together in achieving the desired outcome.

DIRECT MEASURES

Direct controls refer to the regulatory measures undertaken to convert an open inflation into a
repressed one. Such regulatory measures involve the use of direct control on prices and rationing of
scarce goods. The function of price control is a fix a legal ceiling, beyond which prices of particular
goods may not increase. When ceiling prices are fixed and enforced, it means prices are not allowed
to rise further and so, inflation is suppressed. Under price control, producers cannot raise the price
beyond a specified level, even though there may be a pressure of excessive demand forcing it up.

In times of the severe scarcity of certain goods, particularly, food grains, government may have to
enforce rationing, along with price control. The main function of rationing is to divert consumption from
those commodities whose supply needs to be restricted for some special reasons; such as, to make
the commodity more available to a larger number of households. Therefore, rationing becomes
essential when necessities, such as food grains, are relatively scarce. Rationing has the effect of
limiting the variety of quantity of goods available for the good cause of price stability and distributive
impartiality.

Another control measure that was suggested is the control of wages as it often becomes necessary in
order to stop a wage-price spiral. During galloping inflation, it may be necessary to apply a wage-profit
freeze. Ceilings on wages and profits keep down disposable income and, therefore the total effective
demand for goods and services. On the other hand, restrictions on imports may also help to increase
supplies of essential commodities and ease the inflationary pressure. However, this is possible only to
a limited extent, depending upon the balance of payments situation. Similarly, exports may also be
reduced in an effort to increase the availability of the domestic supply of essential commodities so that
inflation is eased.

In general, monetary and fiscal controls may be used to repress excess demand but direct controls
can be more useful when they are applied to specific scarcity areas. As a result, anti-inflationary
policies should involve varied programmes and cannot exclusively depend on a particular type of
measure only.

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RECENT INNOVATIONS IN INDIAN BANKING

HDFC Bank’s ‘Net Safe’ card is a one-time use card with a limit that’s specified, taken from Tendon’s
credit or debit card. Even if Tandon fails to utilize the full amount within 24 hours of creating the card,
the card simply dies and the unspent amount in the temporary card reverts to his original credit or
debit card. Welcome to one of the myriad ways in which bankers have been trying to innovate.
They’re bringing ATMs, cash and even foreign exchange to their customers’ doorsteps. Indeed,
innovation has become the hottest banking game in town.

Want to buy a house but don’t want to go through the hassles of haggling with brokers and the
mounds of paperwork? Not to worry. Your bank will tackle all this. It’s ready to come every step of the
way for you to buy a house. Standard Chartered, for instance, has property advisors to guide a
customer through the entire process of selecting and buying a house. They also lend a hand with the
cumbersome documentation formalities and the registration.

Don’t fret if you’ve already bought your house or car – you can do other things with both. You can
leverage your new house or car these days with banks like ICICI Bank and Stanchart ready to extend
loans against either, till it’s about five years old. Loans are available to all car owners for almost all
brands of cars manufactured in India that are up to five years old.

Last month, Kotak Mahindra Bank introduced a variant of the sweep-in account. If the balance tops
Rs 1.5 lakh, the excess runs into Kotak’s liquid mutual fund. “Even if the money is there only for the
weekend, a liquid fund can earn you a clean 4.5 per cent per annum,” points out Shashi Arora, vice
president, marketing, Kotak Mahindra Bank. That’s not a small gain considering that your current
account does not pay you any interest. And if, meanwhile, you want to buy a big-ticket home theatre
system, the minute you swipe your card the invested sum will return to your account.

Banks are also attempting to reach out to residents of metropolitan cities where people are pressed
for time (what with long commuting hours, traffic jams and both spouses working), beyond
conventional banking hours. ICICI Bank, for example, introduced eight to eight banking hours, seven

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days of the week, in major cities. Not to be outdone, some of the other private banks have also done
this too. HDFC Bank even has a 24-hour branch at Mumbai’s international airport.

INDIAN BANKING IN 2010

The interplay between policy and regulatory interventions and management strategies will determine
the performance of Indian banking over the next few years. Legislative actions will shape the
regulatory stance through six key elements: industry structure and sector consolidation; freedom to
deploy capital; regulatory coverage; corporate governance; labor reforms and human capital
development; and support for creating industry utilities and service bureaus. Management success
will be determined on three fronts: fundamentally upgrading organizational capability to stay in tune
with the changing market; adopting value-creating M&A as an avenue for growth; and continually
innovating to develop new business models to access untapped opportunities.

Through these scenarios, we can paint a picture of the events and outcomes that will be the
consequence of the actions of policy makers and bank managements. These actions will have
dramatically different outcomes; the costs of inaction or insufficient action will be high. Specifically, at
one extreme, the sector could account for over 7.7 per cent of GDP with over Rs.. 7,500 billion in
market cap, while at the other it could account for just 3.3 per cent of GDP with a market cap of Rs.
2,400 billion. Banking sector intermediation, as measured by total loans as a percentage of GDP,
could grow marginally from its current levels of ~30 per cent to ~45 per cent or grow significantly to
over 100 per cent of GDP. In all of this, the sector could generate employment to the tune of 1.5
million compared to 0.9 million. Today availability of capital would be a key factor — the banking
sector will require as much as Rs. 600 billion (US$ 14 billion) in capital to fund growth in advances,
non-performing loan (NPL) write offs and investments in IT and human capital up gradation to reach
the high-performing scenario. Three scenarios can be defined to characterize these outcomes:

HIGH PERFORMANCE

In this scenario, policy makers intervene only to the extent required to ensure system stability and
protection of consumer interests, leaving managements free to drive far reaching changes. Changes
in regulations and bank capabilities reduce intermediation costs leading to increased growth,
innovation and productivity. Banking becomes an even greater driver of GDP growth and employment

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and large sections of the population gain access to quality banking products. Management is able to
overhaul bank organizational structures, focus on industry consolidation and transform the banks into
industry shapers.

In this scenario we witness consolidation within public sector banks (PSBs) and within private sector
banks. Foreign banks begin to be active in M&A, buying out some old private and newer private
banks. Some M&A activity also begins to take place between private and public sector banks. As a
result, foreign and new private banks grow at rates of 50 per cent, while PSBs improve their growth
rate to 15 per cent. The share of the private sector banks (including through mergers with PSBs)
increases to 35 per cent and that of foreign banks increases to 20 per cent of total sector assets. The
share of banking sector value adds in GDP increases to over 7.7 per cent, from current levels of 2.5
per cent. Funding this dramatic growth will require as much as Rs. 600 billion in capital over the next
few years.

EVOLUTION

Policy makers adopt a pro-market stance but are cautious in liberalizing the industry. As a result of
this, some constraints still exist. Processes to create highly efficient organizations have been initiated
but most banks are still not best-in-class operators. Thus, while the sector emerges as an important
driver of the economy and wealth in 2010, it has still not come of age in comparison to developed
markets. Significant changes are still required in policy and regulation and in capability-building
measures, especially by public sector and old private sector banks.

In this scenario, M&A activity is driven primarily by new private banks, which take over some old
private banks and also merge among themselves. As a result, growth of these banks increases to 35
per cent. Foreign banks also grow faster at 30 per cent due to a relaxation of some regulations. The
share of private sector banks increases to 30 per cent of total sector assets, from current levels of 18
per cent, while that of foreign banks increases to over 12 per cent of total assets. The share of
banking sector value adds to GDP increases to over 4.7 per cent.

STAGNATION

In this scenario, policy makers intervene to set restrictive conditions and management is unable to
execute the changes needed to enhance returns to shareholders and provide quality products and
services to customers. As a result, growth and productivity levels are low and the banking sector is
unable to support a fast-growing economy. This scenario sees limited consolidation in the sector and
most banks remain sub-scale. New private sector banks continue on their growth trajectory of 25 per
cent. There is a slowdown in PSB and old private sector bank growth. The share of foreign banks
remains at 7 per cent of total assets. Banking sector value adds meanwhile, is only 3.3 per cent of
GDP.

NEED TO CREATE A MARKET DRIVEN BANKING SECTOR WITH ADEQUATE FOCUS ON

SOCIAL DEVELOPMENT

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The term “policy makers”, refers to the Ministry of Finance and the RBI and includes the other relevant
government and regulatory entities for the banking sector. The coordinated efforts between the
various entities are required to enable positive action. This will spur on the performance of the sector.
The policy makers need to make coordinated efforts on six fronts:

Help shape a superior industry structure in a phased manner through “managed consolidation” and by
enabling capital availability. This would create 3-4 global sized banks controlling 35-45 per cent of the
market in India; 6-8 national banks controlling 20-25 per cent of the market; 4-6 foreign banks with 15-
20 per cent share in the market, and the rest being specialist players (geographical or product/
segment focused).

Focus strongly on “social development” by moving away from universal directed norms to an explicit
incentive-driven framework by introducing credit guarantees and market subsidies to encourage
leading public sector, private and foreign players to leverage technology to innovate and profitably
provide banking services to lower income and rural markets.

Create a unified regulator, distinct from the central bank of the country, in a phased manner to
overcome supervisory difficulties and reduce compliance costs.

Improve corporate governance primarily by increasing board independence and accountability.

Accelerate the creation of world class supporting infrastructure (e.g., payments, asset reconstruction
companies (ARCs), credit bureaus, back-office utilities) to help the banking sector focus on core
activities.

Enable labor reforms, focusing on enriching human capital, to help public sector and old private banks
become competitive.

NEED FOR DECISIVE ACTION BY BANK MANAGEMENT

Management imperatives will differ by bank. However, there will be common themes across classes
of banks:

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SUBHASISH MAJUMDAR 

PSBs need to fundamentally strengthen institutional skill levels especially in sales and mar marketing,
service operations, risk management and the overall organizational performance ethic. The last, i.e.,
strengthening human capital will be the single biggest challenge.

Old private sector banks also have the need to fundamentally strengthen skill levels. However, even
more imperative is their need to examine their participation in the Indian banking sector and their
ability to remain independent in the light of the discontinuities in the sector.

New private banks could reach the next level of their growth in the Indian banking sector by
continuing to innovate and develop differentiated business models to profitably serve segments like
the rural/low income and affluent/ HNI segments; actively adopting acquisitions as a means to grow
and reaching the next level of performance in their service platforms. Attracting, developing and
retaining more leadership capacity would be key to achieving this and would pose the biggest
challenge.

Foreign banks committed to making a play in India will need to adopt alternative approaches to win
the “race for the customer” and build a value-creating customer franchise in advance of regulations
potentially opening up post 2009. At the same time, they should stay in the game for potential
acquisition opportunities as and when they appear in the near term. Maintaining a fundamentally long-
term value-creation mindset will be their greatest challenge.

The extent to which Indian policy makers and bank managements develop and execute such a clear
and complementary agenda to tackle emerging discontinuities will lay the foundations for a high-
performing sector in 2010.

CONCLUSION

We can conclude that the financial sector is a nerve system of Indian economy. Banking plays an
important role in development of economy. For steady growth in economy innovations and
development in financial sector is very important.

Economy of any country faces lots of challenges and problems. To tackle those problems financial
sector plays a vital role. The financial sector makes the economy efficient to the extent where it can
rival other developed economies in the world.

Financial sector also faces lots of problems but it should develop certain strategies to come out of
these problems which is very important for healthy growth of economy.

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BIBLIOGRAPHY

FINANCIAL SRVICES AND MARKET

GORDAN AND NATRAJAN

INDIAN BANKING SYSTEM

V.K. BHALLA

INTRODUC TION TO ECONOMIC ANALYSIS

R. PRESTON MCAFEE

MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE

D.M.MITHANI

BANKING AND PRACTICE

P.N.VARSHNEW

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MONEYCONTROL.COM

MONEYPORE.COM

RBI.ORG.IN

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