BANKING OPERATIONS AND INSURANCE

FINANCE
Module 1 — Study Notes

Introduction to the Indian Financial System

A detailed, easy-to-understand guide with real-life examples and a glossary of every abbreviation and technical
term used.
1. The Indian Financial System — Meaning and Features
Every economy needs a way to move money from people who have extra of it (savers) to people or businesses
who need it (borrowers). The financial system is exactly that — the network of institutions, markets, instruments,
and services that makes this movement of money possible in an organised, safe, and efficient way.

In India, this system is not run by one single body. Different parts of it are supervised by different independent
regulators: banking is regulated mainly by the RBI (Reserve Bank of India), capital markets by SEBI (Securities
and Exchange Board of India), and insurance by IRDA (Insurance Regulatory and Development Authority). Each
regulator makes sure its part of the system runs fairly and safely.

Example: Think of the financial system like a city's water supply network. Savers are like reservoirs holding
water (money). Borrowers are like homes and factories that need water (money) to function. Banks and
financial markets are the pipes and pumping stations that move the water from the reservoir to the people
who need it. Regulators (RBI, SEBI, IRDA) are like the water board making sure the pipes are clean, safe,
and nobody's water gets cut off unfairly.

Because it connects savers and investors, mobilises idle savings, and channels them into productive use (like
building factories, funding startups, or giving home loans), the financial system plays a central role in a country's
economic growth.

Features of the Indian Financial System

• Plays a vital role in economic development — by making sure money keeps flowing to productive uses, it
fuels the growth of industries, infrastructure, and jobs.
• Encourages both savings and investment — it gives people a safe place to save money (like bank deposits)
and gives investors a way to grow their money (like shares or mutual funds).
• Links savers and investors — it acts as the bridge connecting someone who has surplus money to someone
who needs money for a project or business.
• Helps in capital formation — capital formation simply means building up a stock of money/assets that can
be used for future production, e.g. money collected from many small investors being used to build a factory.
• Helps in allocation of risk — through instruments like insurance and derivatives, risk can be transferred
from someone who cannot bear it to someone willing to take it on for a price.
• Facilitates expansion of financial markets — by increasing the number of participants, instruments, and
volume of transactions over time.

2. The Four Components of the Indian Financial System

The Indian Financial System (often abbreviated as IFS) is made up of four major building blocks that work
together:
 • Financial Institutions — the organisations (like banks and insurance companies) that act as middlemen
between savers and borrowers.
• Financial Markets — the marketplaces (physical or virtual) where financial claims like shares and bonds are
bought and sold.
• Financial Instruments / Assets / Securities — the actual 'products' being traded, such as shares, bonds, and
treasury bills.
• Financial Services — services like insurance, leasing, and credit rating that support and add value to the
financial system.
Example: Imagine a vegetable market. The vendors are the Financial Institutions (banks, LIC, etc.). The
market itself — the physical space with stalls — is the Financial Market. The vegetables being sold are the
Financial Instruments (shares, bonds). And services like home delivery, weighing, or bagging are the
Financial Services that make the whole experience smoother.

3. Financial Institutions
Financial Institutions (FIs) are business organisations that deal in financial resources. They collect money by
accepting deposits from individuals and businesses, and then lend that money out to trade, industry, and other
borrowers. In short, they mobilise (i.e. gather up and put to use) the savings of savers, and act as purveyors
(suppliers) of credit or finance to those who need it. They also buy, sell, and even create financial instruments,
and provide a variety of financial services to the community.

Financial institutions are classified into three types based on the nature of their activities:

3.1 Regulatory and Promotional Institutions

These are the 'referees' of the financial system. They make and enforce the rules that every other institution,
market, instrument, and service must follow. In India, several bodies play this role, including the Ministry of
Finance, the Company Law Board, the RBI, SEBI, IRDA, the Department of Economic Affairs, and the
Department of Company Affairs.

However, the two most powerful regulatory bodies are:

• RBI (Reserve Bank of India) — India's central bank. It is the apex (topmost) institution of the entire
financial system, and all other financial institutions function under its oversight.
• SEBI (Securities and Exchange Board of India) — the regulator of India's capital/securities markets, such as
the stock exchanges.
Both RBI and SEBI administer, legislate (make rules/laws), supervise, monitor, control, and discipline the
financial system. Their policies and guidelines are updated from time to time to keep the financial system on the
right track — for example, changing interest rates when inflation rises.

3.2 Banking Institutions

Banking institutions mobilise the savings of the public and provide a mechanism for the smooth exchange of
goods and services in the economy. A very important feature of banks (unlike non-banking institutions) is that
they don't just supply existing credit — they can also create credit. This happens because when a bank lends out a
deposit, that borrowed money is often redeposited elsewhere in the banking system, and a portion of it gets lent
out again, and so on — effectively multiplying the original deposit into a much larger amount of total credit in the
economy.

There are three basic categories of banking institutions:

• Commercial banks — e.g. SBI, HDFC Bank, ICICI Bank — that accept deposits and lend to the public and
businesses.
• Co-operative banks — owned and run by their own members (often farmers or small traders) on a not-for-
profit, mutual-help basis.
• Developmental banks — set up specifically to fund long-term projects in a particular sector, such as
industrial or agricultural development.

3.3 Non-Banking Institutions

Non-banking financial institutions also mobilise financial resources from the public, directly or indirectly, and
then lend those resources out. The key difference from banks: they lend funds but do NOT create credit — they
simply move existing money from savers to borrowers, without the multiplying effect that banks have.

Companies that fall into this category include:

• LIC (Life Insurance Corporation of India) — India's largest life insurance company (government-owned).
• GIC (General Insurance Corporation of India) — handles non-life/general insurance (like vehicle, health,
and property insurance) and reinsurance.
• UTI (Unit Trust of India) — one of India's oldest mutual fund institutions.
• Development Financial Institutions — bodies that provide long-term finance for industrial or infrastructure
projects.
• Organisations managing Pension and Provident Funds — that collect and invest retirement savings.
Non-banking financial institutions can be further grouped as: investment companies, housing companies, leasing
companies, hire purchase companies, specialised financial institutions (like the EXIM Bank — the Export-Import
Bank of India, which finances foreign trade), other investment institutions, and state-level institutions.

Remember: Financial institutions in general are called financial intermediaries — 'intermediary' means
something that sits in the middle. They sit in the middle between savers and investors: collecting money from
one side (savings) and lending it to the other (investment).

Example: You deposit ₹1,00,000 in an HDFC Bank savings account (a banking institution). The bank lends
₹80,000 of it to a small business as a loan, and that business deposits the ₹80,000 in another bank account,
which can again lend out a portion of it. This is credit creation. Compare this to buying an LIC (a non-
banking institution) life insurance policy — LIC collects your premium and invests it in bonds or shares, but
it does not multiply that money through repeated lending like a bank does.
4. Financial Markets
Financial markets are the centres or arrangements — physical places like a stock exchange building, or
virtual/electronic systems — that provide the facilities needed for buying and selling financial claims and
services. They are markets where money itself, as well as claims on money (like shares, bonds, and cheques), gets
traded.

Financial markets exist wherever financial transactions take place — this includes a company issuing new shares,
someone buying bonds in the secondary market, a person depositing money in a bank account, or even
transferring funds from a current account to a savings account. The participants in these markets are corporations,
financial institutions, individuals, and the government, and they trade either directly with each other or through
brokers and dealers (middlemen who arrange the trade for a fee).

Functions of Financial Markets

• To facilitate the creation and allocation of credit and liquidity (liquidity = how easily an asset can be
converted into cash).
• To serve as intermediaries for the mobilisation of savings — collecting scattered small savings and
channelling them productively.
• To assist the process of balanced economic growth across sectors.
• To provide financial convenience to participants.
• To cater to the various credit needs of business houses (companies).

Classification of Financial Markets

Financial markets can be looked at through six different lenses. Each lens classifies the same overall market
system in a different way, based on a different feature.

(1) On the basis of the type of financial claim

Debt market: This is the market for fixed claims, i.e. debt instruments where the amount owed and the interest
rate are fixed in advance (e.g. bonds, debentures).

Equity market: This is the market for residual claims, i.e. equity instruments (shares), where the return is not fixed
— shareholders get a portion of profit (dividend) only after all fixed obligations (like debt interest) are paid.

Example: If you buy a company bond, you are in the debt market — you're promised a fixed 8% interest
regardless of how the company performs. If you buy that company's shares instead, you're in the equity
market — your return depends entirely on how well the company does; you could earn much more, or lose
money.

(2) On the basis of maturity of claims

Money market: The market where short-term funds (with a maturity of one year or less) are borrowed and lent. It
deals in highly liquid, short-term monetary assets. Main participants are banks, financial institutions, and the
government. Examples include the Treasury Bill market, the call money market, and the commercial bill market.
Capital market: The market for long-term funds, dealing in claims, securities, and stocks with a maturity of more
than one year. This is where companies raise the long-term, 'productive' capital needed for industrial projects.
Examples include the stock market, the government bond market, and the derivatives market.

Example: A company needing ₹50 lakh for just 60 days to pay salaries might issue commercial paper in the
money market. The same company wanting ₹50 crore to build a new factory over 10 years would instead
raise long-term funds in the capital market, e.g. by issuing shares or long-term bonds.

(3) On the basis of seasoning of the claim (how 'new' the security is)
Primary market: Deals only in new securities — this is why it's also called the 'new issue market'. These are
securities being issued for the very first time, directly by the company to investors. The primary market helps
mobilise fresh savings and supply additional capital to businesses.

Secondary market: Deals in existing securities — ones that have already been issued earlier and are now simply
changing hands between investors. The secondary market mainly consists of stock exchanges, which are self-
regulatory bodies working under the overall supervision of the Government/SEBI.

Example: When a company launches an IPO (Initial Public Offering) and sells its shares to the public for
the very first time, that's the primary market. Once those shares start trading on the NSE (National Stock
Exchange) or BSE (Bombay Stock Exchange) between different investors, that's the secondary market.

(4) On the basis of structure or arrangements

Organised markets: Financial markets where transactions happen within well-established exchanges, following a
systematic and orderly structure (rules, regulations, transparency).

Unorganised markets: Financial markets where transactions happen outside such established exchanges, without a
systematic or orderly structure — for example, informal lending by local moneylenders.

(5) On the basis of timing of delivery

Cash/Spot market: The market where goods, stocks, or securities are bought/sold and delivered immediately after
the transaction.

Forward/Future market: The market where participants agree today to buy or sell stocks/commodities at a
predetermined price, but the actual delivery happens at a specified time in the future.

Example: Buying gold from a jeweller and taking it home the same day is a spot market transaction. Signing
a contract today to buy gold at today's price, but only receiving and paying for it 6 months later, is a
forward/future market transaction — useful for protecting against price changes.

(6) Other types of financial markets

Foreign exchange market: The market where one country's currency is traded for another's — essentially, the
marketplace for buying and selling foreign currencies (e.g. converting Indian Rupees to US Dollars).

Derivatives market: A derivative is a financial instrument whose value is 'derived' from (based on) some other
underlying asset, like a stock, index, or commodity. This market allows individuals and firms who want to avoid
or reduce risk (hedgers) to trade with others who are willing to accept that risk for a price (speculators). Important
types of derivatives include forwards, futures, options, and swaps.
Summary Table: Classification of Financial Markets
Basis of Classification Categories Simple Example

Buying a bond (debt) vs buying shares

Type of financial claim Debt market / Equity market
(equity)

A 91-day T-Bill vs a 10-year government

Maturity of claims Money market / Capital market
bond

Buying shares in an IPO vs buying them

Seasoning of claim Primary market / Secondary market
later on NSE

BSE trading vs an informal village

Structure/arrangement Organised / Unorganised
moneylender

Buying gold today vs a 6-month gold

Timing of delivery Cash/Spot / Forward-Future
futures contract

Foreign exchange market / Derivatives Converting INR to USD; trading a Nifty

Other types
market futures contract

5. Financial Instruments
Financial instruments are financial assets, securities, and claims — essentially, documents that represent a
financial claim on assets. A financial asset represents a claim to receive a sum of money at some point in the
future (repayment of the principal amount) and/or a periodic payment such as interest or dividend.

Financial instruments fall into two broad groups based on tradability:

• Non-tradable financial assets — such as bank deposits, post office deposits, insurance policies, NSCs
(National Savings Certificates), provident funds, and pension funds. These cannot easily be bought/sold to
another party.
• Tradable securities — such as equity shares, debentures, government securities, and bonds. These CAN be
bought and sold, and are therefore also called transferable.
In short, financial instruments are the tools/documents through which a company raises finance. Common
examples include the Bill of Exchange, Promissory Note, and Treasury Bill.

Types of Financial Instruments

Capital market instruments: Used to raise capital through the capital market, with a maturity period of more than
one year. Examples: equity shares, preference shares, warrants, debentures, and bonds.

Money market instruments: Used to raise/supply money for a short period (not exceeding one year) through the
money market. Examples: treasury bills, commercial paper, call money, short-notice money, certificates of
deposit, commercial bills, and money market mutual funds.

Hybrid instruments: Instruments that combine features of both equity and debt/debentures. Examples: convertible
debentures (start as debt but can later convert into shares) and warrants (which give the right to buy shares at a
fixed price in future).
Cash instruments vs Derivative instruments: Cash instruments are financial instruments whose value is
determined directly by the markets (e.g. a share's price). Derivative instruments are financial instruments that
derive their value from some other underlying financial instrument or variable (e.g. a futures contract on that
share).

Primary instruments vs Secondary instruments: Primary instruments are issued directly by the ultimate
borrower/investor to the ultimate saver — for example, a company issuing shares/debentures directly to the
public. Secondary instruments are issued by financial intermediaries to the ultimate savers — for example, UTI
(Unit Trust of India) or a mutual fund issuing 'units' to the public, where the intermediary itself invests the pooled
money elsewhere.

Characteristics of Financial Instruments

• Liquidity — Financial instruments can be easily and quickly converted into cash.
• Marketing (Marketability) — They facilitate easy trading because they have a ready market of buyers and
sellers.
• Collateral value — They can be pledged (offered as security) to obtain loans.
• Transferability — They can be easily transferred from one person to another.
• Maturity period — This may be short-term, medium-term, or long-term depending on the instrument.
• Transaction cost — The cost involved in buying and selling (called transaction cost) is usually low for
financial instruments.
• Risk — All financial instruments carry some risk, since there's always uncertainty about whether the
principal, interest, or dividend will actually be paid.
• Future trading — Financial instruments facilitate future trading, which helps participants hedge against
(protect themselves from) price or interest rate fluctuations.
Example: A 5-year government bond is a capital market instrument, tradable (you can sell it to someone else
before maturity), and carries low risk since the government is unlikely to default. A 90-day Commercial
Paper issued by a company to raise short-term working capital is a money market instrument — riskier than
a government bond, but still fairly liquid and short-term.

6. Financial Services
The efficiency of a financial system depends heavily on the quality and variety of financial services provided by
financial intermediaries. Financial services can be defined as activities, benefits, and satisfactions connected with
the sale of money, that provide financial value to users and customers. The main sectors offering these services
are banks, financial institutions, and NBFCs (Non-Banking Financial Companies).

Financial services offered by financial institutions, commercial banks, and merchant bankers are broadly
classified into two categories:

• Asset-based / Fund-based services — where the institution actually commits its own money/assets.
 • Fee-based / Advisory services — where the institution earns a fee for providing advice or professional
services, without directly lending money.

6.1 Asset-Based / Fund-Based Services

1. Equipment Leasing / Lease Financing
Leasing is an arrangement that gives a firm the use and control of an asset without having to buy and own it —
essentially, a form of renting an asset. The firm is interested in using the asset, not owning it, so leasing may be
preferred over buying. When comparing leasing with buying, the cost of leasing should be compared against the
cost of financing a purchase through normal sources (debt/equity), since paying lease rentals is similar to paying
interest on a loan — lease financing is treated as equivalent to debt.

Example: A logistics company needs 20 trucks but doesn't want to spend a huge amount buying them
outright. It leases the trucks from a leasing company instead, paying a monthly rental — freeing up cash for
other business needs, while still getting full use of the trucks.

2. Hire Purchase and Consumer Credit

Hire purchase is a transaction where goods are bought and sold under specific terms: (i) payment is made in
installments, (ii) possession of the goods is given to the buyer immediately, (iii) ownership of the goods remains
with the seller until the last installment is paid, (iv) the seller can repossess (take back) the goods if the buyer
defaults on a payment, and (v) each installment is treated as a hire charge until the final installment, at which
point ownership transfers.

Consumer credit includes all asset-based financing plans offered to individuals to help them acquire durable
consumer goods (like appliances or vehicles). The buyer pays part of the price upfront at delivery, and pays the
remaining balance (with interest) over an agreed period.

Example: Buying a refrigerator on EMI (Equated Monthly Instalment) through a finance company like Bajaj
Finserv is a classic hire purchase / consumer credit transaction — you get to use the fridge immediately, but
full legal ownership only transfers once you've paid the final EMI.

3. Venture Capital (VC)

Venture Capital is a type of private equity financing where investors fund early-stage startups and small
businesses that have high growth potential but may lack a track record for a traditional bank loan. It is a relatively
recent entrant in the Indian capital market, and there is significant scope for VC in India due to the growing
number of technically skilled entrepreneurs who lack capital of their own. Venture Capital Firms (VCFs) provide
the risk capital entrepreneurs need to meet the 'promoter's contribution' required by financial institutions, and
beyond just money, VCFs often take an active interest in guiding and mentoring the businesses they invest in.

Example: A VC firm invests ₹5 crore in a two-year-old food-delivery startup in exchange for a 15%
ownership stake, betting that the startup will grow rapidly and that stake will become far more valuable in a
few years.

4. Insurance Services
Insurance is a contract in which the insurer (the insurance company) agrees, in exchange for a sum of money
called the premium, to make good the loss suffered by the insured (the policyholder) if a specified risk occurs
(like fire), or to pay a benefit to the insured/beneficiaries on the happening of a specified event (like an accident or
death). The written contract between insurer and insured is called the policy. The property being insured is called
the subject matter of insurance, and the financial interest the insured person has in that subject matter is called
insurable interest (i.e. you can only insure something you'd genuinely suffer a loss from if it were damaged/lost).

Depending on the subject matter, insurance is divided into two types: (i) Life insurance and (ii) General insurance
(covering things like health, motor vehicles, property, and fire).

Example: You pay a ₹6,000/year premium for a health insurance policy. If you're later hospitalised and the
bill comes to ₹3,00,000, the insurance company (insurer) pays that amount (or a large part of it) on your
behalf — that's the insurable interest and risk-transfer at work.

5. Factoring
Factoring is a fund-based financial service that provides resources to finance a business's receivables (money
owed to it by customers) and also helps in collecting those receivables. It is a method of raising short-term finance
through account receivable credit, offered by commercial banks and specialised 'factors' (financial institutions). A
factor essentially buys/discounts a business's unpaid invoices, giving the business immediate cash instead of
having to wait 30-90 days for customers to pay.

Example: A garment manufacturer has sold goods worth ₹10 lakh to a retailer on 60-day credit. Instead of
waiting 60 days for payment, the manufacturer sells this invoice to a factoring company for ₹9.5 lakh in cash
today. The manufacturer gets immediate working capital, and the factor collects the full ₹10 lakh from the
retailer later, earning the ₹50,000 difference as its fee.

6.2 Fee-Based / Advisory Services

(i) Merchant Banking
Merchant banking includes all the fee-based advisory services rendered by merchant bankers, who play a crucial
role in the financial services sector. A merchant bank is a financial institution that conducts underwriting
(guaranteeing the sale of new securities), loan services, financial advising, and fundraising for large corporations
and HNWIs (High-Net-Worth Individuals). Merchant banks are non-depository, meaning they don't accept
regular public deposits like commercial banks, and they play a significant role in international finance. Examples
of large global merchant banks include JPMorgan Chase, Goldman Sachs, and Citigroup.

As defined under the SEBI Act, a 'Merchant Banker' is any person engaged in the business of issue management
— i.e. arranging the selling, buying, or subscribing of securities, or acting as a manager, consultant, or adviser in
relation to such issue management. Merchant banks are essentially 'issue houses' that manage the new issue of
shares/securities for companies entering the capital market.

According to the Banking Commission (1972), merchant banking institutions offer services like: loan syndication
(arranging a large loan from a group/syndicate of lenders), promotion of new projects, investment management,
and advisory services, along with providing funds and trusts. In fact, merchant banking covers a wide range of
specialist services:

• Loan syndication — arranging large loans by bringing together multiple lenders.

• Financial and management consultancy.
• Project counselling — advising companies on setting up new projects.
• Portfolio management — managing an investor's basket (portfolio) of investments.
 • Formulation of schemes of rehabilitation — helping revive financially sick companies.
• Guidance on foreign trade financing.
• Guidance to NRIs (Non-Resident Indians) for investment in India.

(ii) Credit Rating

Credit rating is the opinion given by a rating agency about the relative ability and willingness of a debt issuer to
meet its debt obligations (i.e., to repay what it owes) as and when they fall due. As a fee-based financial advisory
service, credit rating is useful to investors, corporates (borrowers), banks, and other financial institutions in
judging how safe it is to lend to or invest in a particular entity.

In simple terms, a credit rating is an independent evaluation of an entity's (a borrower's, a corporation's, or even a
sovereign government's) creditworthiness and default risk. It predicts the borrower's ability to repay debt,
functioning much like a report card for financial reliability and borrowing capacity.

CRAs (Credit Rating Agencies) are the independent organisations that carry out this evaluation, assigning grades
— such as AAA (highest safety) down to C or D (high risk of default) — that estimate the likelihood of the issuer
defaulting on its debt.

Major credit rating agencies operating in India include:

• CRISIL — Credit Rating Information Services of India Limited.

• ICRA — Investment Information and Credit Rating Agency of India Limited.
• CARE — Credit Analysis & Research.
• ONICRA — Onida Individual Credit Rating Agency of India.
• Fitch India.
• BWR — Brickwork Ratings.
• SMERA — SME Rating Agency of India Limited.
A related but different concept is the credit score — a 3-digit number (typically between 300 and 900) that
measures an individual borrower's creditworthiness. Banks use it as a 'financial report card' to assess how risky it
is to lend money to that person, predicting how likely they are to repay loans and credit cards on time. Rough
score bands are: Poor (300–579), Fair (580–669), Good (670–739), Very Good (740–799), and Excellent (800–
850).

Example: Company A's bonds are rated AAA by CRISIL, meaning very low risk of default — so it can
borrow money at a lower interest rate. Company B's bonds are rated BBB, indicating moderate risk — so it
must offer a higher interest rate to attract investors, to compensate them for the extra risk.

(iii) Stock-Broking
Before SEBI was set up, stock exchanges were supervised by the Ministry of Finance under the SCRA (Securities
Contracts Regulation Act) and largely operated as self-regulatory organisations. As malpractices crept into
trading, the need for reform grew, leading to the creation of SEBI to protect investors' interests and ensure that
stock exchanges properly perform their self-regulatory role. Since then, stock broking has developed into a full
professional advisory service.
Stockbroking is the professional service of buying and selling financial securities — such as stocks, bonds, and
mutual funds — on behalf of retail (individual) or institutional (large organisations') clients. Since individual
investors typically cannot trade directly on major exchanges, brokers act as licensed intermediaries who execute
trades on the client's behalf and provide market access and research.

A stockbroker is a member of a recognised stock exchange who buys, sells, or deals in shares/securities. Every
stockbroker must be registered with SEBI in order to legally act as a broker, and SEBI has the power to impose
conditions while granting this registration certificate.

Example: When you place a buy order for Reliance Industries shares through a broker like Zerodha or
ICICI Direct, the broker (a SEBI-registered stockbroker) executes that trade for you on the NSE/BSE, since
you as an individual cannot directly place orders on the exchange.

7. Commercial Banks
Commercial banks are banks that carry out commercial banking operations — mainly, accepting deposits from
the public that are repayable on demand or after a short period, and granting short-term credit primarily to trade,
commerce, and industry. They typically operate through a wide network of branches spread across the country.

The functions of commercial banks are divided into two broad categories: Primary functions and Secondary
functions.

7.1 Primary Functions

Primary functions include accepting deposits and lending money — these are the 'core' functions that define what
a commercial bank does.

A. Accepting Deposits
Through this function, banks pool together the scattered savings of society so that these savings can be put to
productive use. There are four main types of deposit accounts:

Savings Account
Savings deposits are intended to encourage a saving habit among the general public. These accounts are typically
opened by middle- and low-income groups who want to save part of their current income for future needs.
Customers can deposit any amount, any number of times, but there are usually restrictions on the number of
withdrawals and the amount that can be withdrawn in a given period. Cheque facilities are also provided to
savings account holders.

Current Account
Current deposits are accounts into which money can be deposited and from which money can be withdrawn any
number of times, with no restrictions. These accounts are generally maintained by traders and businessmen who
need to make numerous payments in a single day. Since the money is repayable on demand, these are also called
demand deposits. Current account holders can withdraw money by issuing cheques.
Fixed Deposit (FD)
Fixed deposits are amounts deposited for a fixed period of time, which can only be withdrawn after that period
expires. Since the money is locked in for a set period, the interest rate offered on FDs is higher than on other
deposit types. At the time of making a fixed deposit, the bank issues a Fixed Deposit Receipt to the depositor,
which records the deposit amount, the depositor's name, the interest rate, and the maturity date. This receipt must
be surrendered to the bank on the due date to get the deposit back.

Recurring Deposit (RD)

Recurring deposits are accounts in which the depositor deposits a fixed amount of money every month for an
agreed period. At the end of the specified period, the depositor receives back the total amount deposited, plus the
interest accrued (earned) on it. The interest rate on RDs is almost the same as that on fixed deposits.

Example: Ramesh saves ₹5,000 every month in an RD for 2 years — a disciplined way to build savings
gradually. Meanwhile, his father invests ₹5,00,000 as a lump sum in a 3-year FD to earn a higher,
guaranteed interest rate on money he doesn't need immediately.

B. Lending Money
The second major function of a bank is to advance loans to the public. Banks lend money through various
methods:

(i) Overdraft
An overdraft is a temporary financial arrangement under which a current account holder is allowed by the bank to
draw (withdraw) more money than the amount actually standing to their credit in the account. The account holder
can draw money up to a limit agreed with the bank.

Example: A shopkeeper has ₹20,000 in his current account but needs ₹35,000 urgently to pay a supplier.
With an overdraft facility of ₹50,000, he can withdraw the extra ₹15,000 beyond his balance, and pays
interest only on the amount actually overdrawn.

(ii) Cash Credit

A cash credit is a financial arrangement where a borrower is allowed an advance under a separate 'cash credit
account' up to a specified limit (the cash credit limit). Such loans are usually given against the hypothecation
(pledging without transferring possession) or pledge of agricultural or industrial goods. The borrower can
withdraw money from the cash credit account as needed, and interest is charged only on the amount actually
withdrawn — not on the entire sanctioned limit.

(iii) Discounting of Bills of Exchange

A Bill of Exchange is a written assurance given by a debtor to a creditor to pay a specified amount by the end of a
stated period. Discounting a bill of exchange is a form of lending in which the bank pays the amount of the bill
(minus a small commission) to the holder before its actual due date. When the bill matures, the bank collects the
full amount from the person who originally accepted the bill (the debtor).

Example: A supplier holds a bill worth ₹1,00,000 due in 90 days. Needing cash now, they get it discounted
at the bank, which pays them ₹97,000 today (after deducting its commission). When the 90 days are up, the
bank collects the full ₹1,00,000 from the original debtor.
(iv) Money at Call and at Short Notice
This is a type of loan given by one bank to another bank or financial institution. These are very short-period loans
that can be recalled (called back) by the lending bank at very short notice, ranging from one day to fourteen days.

(v) Term Loans

Term loans are loans granted by a bank for a period exceeding one year. The loan amount is either paid directly or
credited to the borrower's account. Interest is charged on the entire loan amount, and it is repaid either at maturity
(in one lump sum) or in installments.

Example: A business takes a 5-year term loan of ₹20 lakh from a bank to buy new machinery, repaying it
through fixed monthly installments over those 5 years.

(vi) Bridge Loans

A bridge loan is a form of short-term, temporary financing used by an individual or business until more
permanent, long-term financing is arranged. As the name suggests, it 'bridges the gap' between two more
permanent methods of financing, and is needed whenever a company or individual temporarily runs out of funds.
Bridge loans are useful for venture capitalists, the real estate industry, and small investors — for instance,
someone selling one property and buying another can use a bridge loan to cover the timing gap between the sale
and the purchase. Bridge loans are also called swing loans.

Key features of bridge loans:

• It is a short-term loan, typically for a period of 2 weeks to 3 years.

• Its purpose is to provide an immediate flow of capital during times of unexpected financial need.
• It is expected to be repaid quickly, since it's taken only for a very short period.
• It is relatively expensive, due to the high rate of interest charged on such loans.

7.2 Secondary Functions

Secondary functions of commercial banks include agency services and general utility services — these are
additional, supportive services beyond the bank's core deposit-and-lending business.

A. Agency Services
Here, banks act as agents on behalf of their customers, providing services such as:

• Transfer of funds — helping customers transfer money from one place to another through cheques, drafts,
etc.
• Collection of cheques, bills, and promissory notes — accepting these on behalf of customers for collection.
• Execution of standing orders — a standing order is a written instruction from a customer to the bank to
make certain regular payments (like subscriptions, rent, or insurance premiums) automatically on their
behalf.
• Purchase and sale of securities — undertaking the buying/selling of shares, stocks, bonds, and debentures on
behalf of customers.
• Collection of dividend on shares — collecting dividend on shares and interest on debentures for customers.
• Income tax consultancy — helping customers prepare their income tax returns and advising on tax matters.
 • Acting as trustee and executor — preserving customers' wills and executing (carrying out) them after their
death.

B. General Utility Services

A modern bank provides several other services beyond agency services, including:

• Providing locker facilities — a bank locker is a secure place where customers can keep valuables and
important documents.
• Issuing traveller's cheques — to let customers travel without fear of theft or loss of cash.
• Issuing Letters of Credit — an important document in foreign/international trade, through which a bank
certifies the creditworthiness of its customer to a foreign trading partner.
• Collection and dissemination of information — banks gather important trade, commerce, industry, money,
and banking information, and publish it in bulletins and journals.
• Underwriting securities — banks underwrite (guarantee the sale of) securities issued by the government or
public/private bodies.
• Dealing in foreign exchange — enabling foreign trade by dealing in foreign currencies.
• Acting as a referee — customers may quote their bank's name as a reference when someone wants to verify
their financial position/business reputation.
• Issuing ATM cards — allowing customers to withdraw cash 24 hours a day.
• Merchant banking — commercial banks' merchant banking divisions offer financial, technical, and
managerial advisory services (as covered in Section 6).
• Lease finance — providing lease financing to industries, where a person acquires the use of an asset by
paying a predetermined 'rental' periodically.
• Housing finance — providing housing finance facilities to individuals/institutions building residential
houses, often at concessional (discounted) interest rates.
• Factoring services — purchasing customers' book debts/receivables to help with collection, management,
and related services (as covered in Section 6).

8. Reserve Bank of India (RBI)

The RBI (Reserve Bank of India) is the central bank of the country and sits at the very centre of the Indian
financial and monetary system. As the apex (topmost) institution, it has been guiding, monitoring, regulating,
controlling, and promoting the development of the entire IFS (Indian Financial System) since its inception
(founding).

Main Objectives / Functions of the RBI

• To maintain monetary stability, so that business and economic life can deliver the welfare benefits of a
properly functioning mixed economy.
 • To maintain financial stability and ensure sound financial institutions, so monetary stability can be safely
pursued and economic units can conduct business with confidence.
• To maintain a stable payments system, so that financial transactions can be executed safely and efficiently.
• To promote the development of financial infrastructure (markets and systems) and enable it to operate
efficiently — i.e., to help build a sound financial system so RBI can carry out its regulatory role effectively.
• To ensure that credit allocation by the financial system broadly reflects national economic priorities and
societal concerns.
• To regulate the overall volume of money and credit in the economy, in order to maintain a reasonable
degree of price stability.

Roles of the RBI

1. Notes Issuing Authority
Since its inception, the RBI has held the sole right (monopoly) to issue currency notes, other than one-rupee notes
and coins, and coins of smaller denominations (which are issued by the Government of India but circulated
through the RBI). Currently, the RBI issues notes in denominations of Rs 2, 5, 10, 20, 50, 100, and 500. These
currency notes are legal tender everywhere in India, meaning they must legally be accepted for payment. The RBI
is responsible not just for putting currency into circulation or withdrawing it, but also for exchanging notes/coins
of one denomination for another, as demanded by the public. All matters relating to note issue are handled
through its dedicated Issue Department.

2. Banker to the Government

The RBI acts as the banker to both the Central Government and State Governments. It provides them with all
standard banking services: accepting deposits, allowing withdrawal of funds by cheque, making payments,
collecting receipts on the government's behalf, transferring funds, and managing public debt. Notably, the RBI
receives government deposits free of interest, and is not paid any remuneration (fee) for conducting the
government's ordinary banking business.

Any deficit or surplus in the Central Government's account with the RBI is managed through the creation and
cancellation of ad hoc Treasury Bills. As banker to the government, the RBI can also provide 'Ways and Means
Advances' — temporary advances meant to bridge the short-term gap between the government's receipts and
payments — to both central and state governments, with a maximum maturity of three months.

3. Banker to Other Banks

The RBI has the authority to guide, help, and direct other commercial banks across the country. It can control the
volume of banks' reserves, and allow other banks to create credit in proportion to those reserves. Every
commercial bank must maintain a portion of its reserves with the RBI. In turn, when banks urgently need funds,
they approach the RBI — which is why the RBI is called the 'lender of the last resort' (i.e. the final source of
funds when no one else will lend).

4. Exchange Rate Management

It is an essential RBI function to maintain the stability of the rupee's external value (its value compared to foreign
currencies). It does this through domestic policies and by regulating the foreign exchange market. The RBI
administers foreign exchange control by managing the exchange rate between the rupee and other currencies,
managing exchange reserves, and negotiating with the monetary authorities of other countries and international
bodies such as the IMF (International Monetary Fund), the World Bank, and the Asian Development Bank.

5. Credit Control Function

As the nation's central bank, the RBI regulates the credit-creation capacity of commercial banks using various
credit control tools — these are covered in detail in Section 9.

6. Supervisory Function
The RBI has extensive powers to supervise and control commercial and co-operative banks, in order to develop
an adequate and sound banking system. Its supervisory powers include:

• Issuing licences for the establishment of new banks.

• Issuing licences for setting up new bank branches.
• Prescribing minimum requirements for paid-up capital, reserves, transfer to reserve funds, and maintenance
of cash reserves and other liquid assets.
• Inspecting the working of banks in India and abroad — covering organisational setup, branch expansion,
deposit mobilisation, investments, credit portfolio management, credit appraisal, regional performance,
profit planning, and manpower training.
• Conducting ad hoc (as-needed) investigations into complaints, irregularities, and frauds involving banks.
• Controlling how banks operate, so they don't waste funds on improper investments or reckless advances.
• Controlling the appointment, re-appointment, and termination of the Chairman and CEOs of private sector
banks.
• Approving or blocking bank amalgamations (mergers).

Developmental / Promotional Functions of the RBI

Beyond regulation, the RBI also actively promotes the development of the financial system:

1. Development of the Financial System

The RBI has encouraged the establishment of major banking and non-banking institutions to serve the credit
needs of different sectors of the economy.

2. Development of Agriculture
The RBI has successfully increased the flow of credit to the agricultural sector. As part of this effort, it established
NABARD (National Bank for Agriculture and Rural Development) in July 1963, to provide medium-term and
long-term finance for agriculture. It also helped establish an Agricultural Finance Corporation.

3. Provision of Industrial Finance

The RBI has provided short-term and long-term funds to small-scale, medium, and large industries, as well as the
export sector, through specialised financial institutions such as ICICI Ltd, IDBI (Industrial Development Bank of
India), SIDBI (Small Industries Development Bank of India), and EXIM Bank (Export-Import Bank of India). It
also coordinates efforts among banks, financial institutions, and government agencies to rehabilitate (revive)
financially sick industrial units.
4. Provision of Training
The RBI has consistently worked to provide essential training to staff working in the banking industry.

5. Collection of Data
The RBI collects, processes, and disseminates (spreads/shares) statistical data on topics such as interest rates,
inflation, savings, and investments — data that is highly useful to researchers and policymakers.

6. Publication of Reports
A dedicated RBI department collects and publishes data on various sectors of the economy through regularly
published reports and bulletins, such as the RBI Weekly Report and the RBI Annual Report. This information is
also made available to the public at low cost.

9. Credit Control Measures of the RBI

Credit control measures are the tools the RBI uses to regulate the amount of credit (loans/money) available in the
economy, with the main aims of maintaining financial stability and controlling inflation. These tools include
setting interest rates, setting reserve requirements for banks, and controlling the overall money supply. Through
these, the RBI influences the demand for credit, and in turn, the overall level of economic activity.

Objectives of Credit Control

• To control inflation — by regulating how much credit is available in the economy, keeping prices in check.
• To stabilize the economy — preventing overheating during strong growth periods, or stimulating growth
during a recession (slowdown).
• To promote financial stability — preventing financial bubbles, reducing the risk of bank failures, and
ensuring the stability of the financial system as a whole.
Credit control measures fall into two categories: Quantitative measures (which affect the overall amount of
money/credit) and Qualitative measures (which affect who gets credit, or under what conditions).

9.1 Quantitative Measures

Quantitative measures are tools used by central banks like the RBI to control the overall money supply and
interest rates in the economy. They are sometimes also referred to in the context of monetary policy tools.

1. Bank Rate
The bank rate (also called the discount rate) is the interest rate at which the RBI lends money to commercial
banks. It's a key tool for controlling the overall level of interest rates in the economy. When the bank rate is high,
commercial banks must pay more to borrow from the RBI, so they in turn charge higher interest to their own
customers — this reduces the demand for credit and slows down economic activity. When the bank rate is low,
borrowing becomes cheaper for banks, they charge lower interest to customers, and this increases demand for
credit and speeds up economic activity.
2. CRR — Cash Reserve Ratio
The CRR (Cash Reserve Ratio) is the percentage of their total deposits that commercial banks are required to hold
as reserves with the RBI, in cash form, which cannot be lent out. When the CRR is increased, banks must hold a
larger share of deposits as reserves, leaving less money available to lend — this reduces overall credit and slows
the economy. When the CRR is decreased, banks have more money available to lend, increasing credit and
speeding up economic activity.

3. SLR — Statutory Liquidity Ratio

The SLR (Statutory Liquidity Ratio) is the percentage of deposits that commercial banks must maintain in the
form of liquid assets — such as cash, gold, or government securities — as a proportion of their total deposits.
Increasing the SLR forces banks to keep more of their deposits as liquid assets, reducing what's available to lend
and slowing the economy; decreasing the SLR frees up more money for banks to lend, speeding up economic
activity. Note: SLR is generally set higher than CRR, since SLR measures a bank's liquidity position, while CRR
measures more of its solvency-related reserve position.

4. Repo Rate and Reverse Repo Rate

The Repo Rate (repurchase rate) is the rate at which commercial banks borrow money from the RBI, by selling
their securities to the RBI with an agreement to repurchase (buy back) them at a later date. It's a key policy rate.
When the repo rate rises, it becomes more expensive for banks to borrow from the RBI, so they raise the interest
rates charged to customers — reducing credit demand and slowing the economy. When the repo rate falls,
borrowing from RBI becomes cheaper, banks lower their lending rates, and credit demand rises, speeding up the
economy.

The Reverse Repo Rate is the rate at which commercial banks lend money TO the RBI, by buying securities from
the RBI with an agreement to resell them later. When the reverse repo rate rises, it becomes more attractive for
banks to park (deposit) their money with the RBI rather than lend it out to the public — this decreases the overall
credit in the economy and slows economic activity. When the reverse repo rate falls, banks find it less attractive to
park money with RBI, so more money flows into lending, increasing credit and speeding up the economy. The
reverse repo rate acts as a 'floor' for the interest rate corridor — the gap between the repo rate and reverse repo
rate forms the range within which short-term money market interest rates fluctuate.

5. Open Market Operations (OMO)

OMO (Open Market Operations) is a monetary policy tool where the RBI buys or sells government securities in
the open market to control the money supply and interest rates. When the RBI buys government securities, it
injects money into the economy — increasing the money supply, decreasing interest rates, increasing overall
credit, and speeding up economic activity. When the RBI sells government securities, it withdraws money from
the economy — decreasing the money supply, increasing interest rates, reducing overall credit, and slowing down
economic activity.

9.2 Qualitative Measures

Unlike quantitative measures (which affect the overall volume of credit), qualitative measures are more selective
— they influence the direction, purpose, or terms of credit rather than just the total amount.
1. Margin Requirement
A margin requirement is the minimum amount of collateral (security/deposit) that an investor or borrower must
set aside to open or maintain a leveraged position (i.e., a position partly funded by borrowed money). This is a
form of risk management used by financial institutions to protect themselves if the value of the collateral falls. In
trading, it's the minimum cash/eligible securities an investor must deposit with a broker to open and maintain a
position. In borrowing generally, it's the percentage of a loan's value that the borrower must contribute themselves
as collateral, ensuring the borrower has a genuine stake in repaying the loan.

2. Moral Suasion
Moral suasion is a non-binding (i.e. not legally compulsory) method of persuasion used by central banks like the
RBI to influence the behaviour of commercial banks and other financial institutions. Instead of formal regulations
or financial incentives, the RBI uses persuasion techniques — verbal advice, public statements, and suggestions
— to encourage banks to adopt certain policies. For example, the RBI might use moral suasion to encourage
banks to lend more to a particular sector of the economy, or to maintain a certain level of reserves.

The advantage of moral suasion is that it lets the RBI influence bank behaviour without imposing costly, time-
consuming formal regulations. However, since it relies on the voluntary cooperation of banks, it can be less
effective than binding tools — it's generally considered a weaker tool than quantitative measures, but useful as a
complement to them.

3. Credit Rationing
Credit rationing is a situation where the demand for credit exceeds the supply of credit available — essentially,
there isn't enough credit to go around, so lenders are forced to limit how much credit they provide to borrowers.
This can happen due to economic downturns, financial crises, regulatory limits on how much banks/institutions
can lend, or a lender's own financial constraints (e.g., if a bank's own capital is low). When credit rationing
occurs, lenders have to choose which borrowers to lend to, and on what terms, based on factors like
creditworthiness, collateral, or the purpose of the loan — meaning some borrowers may be denied credit entirely,
or offered less favourable terms. This can slow down economic growth and increase the cost of borrowing overall.

Summary Table: RBI Credit Control Tools

Tool What it is Effect of an Increase

Costlier bank borrowing → higher

Bank Rate Rate at which RBI lends to banks
loan rates → less credit

% of deposits banks must keep as cash reserve with Less money left to lend → credit
CRR
RBI shrinks

% of deposits banks must hold as liquid assets Less money free to lend → credit
SLR
(cash/gold/govt securities) shrinks

Rate banks pay to borrow from RBI (against Costlier borrowing for banks →
Repo Rate
securities) higher loan rates → less credit

Banks prefer parking with RBI over

Reverse Repo Rate Rate RBI pays banks for parking funds with it
lending → less credit

OMO RBI buying/selling government securities in the open RBI selling withdraws money →
market less credit; RBI buying injects
 money → more credit

Higher margin → borrower must put

Margin Requirement Minimum collateral/deposit required for a loan or
in more of their own money →
(Qualitative) leveraged position
credit growth slows
10. Glossary — Abbreviations and Key Terms Explained
This section spells out every abbreviation used in this module, and gives a plain-language explanation of every
technical/jargon term.

Abbreviations (Full Forms)

Abbreviation Full Form / Explanation

RBI Reserve Bank of India — India's central bank.

SEBI Securities and Exchange Board of India — regulator of India's stock/capital markets.

IRDA Insurance Regulatory and Development Authority (of India) — regulator of the insurance sector.

LIC Life Insurance Corporation of India — India's largest (government-owned) life insurer.

GIC General Insurance Corporation of India — handles general/non-life insurance and reinsurance.

UTI Unit Trust of India — one of India's oldest mutual fund institutions.

EXIM Bank Export-Import Bank of India — provides finance for foreign trade.

Non-Banking Financial Company — a company providing banking-like services (loans,

NBFC
investments) without holding a full banking licence.

IFS Indian Financial System.

FD Fixed Deposit — a lump-sum deposit locked for a fixed period at a fixed interest rate.

RD Recurring Deposit — a fixed amount deposited every month for an agreed period.

NSC National Savings Certificate — a government-backed fixed-income savings instrument.

VC / VCF Venture Capital / Venture Capital Firm — investors funding early-stage, high-growth startups.

HNWI High-Net-Worth Individual — a person with a very large amount of investable wealth.

CRA Credit Rating Agency — an independent organisation that rates the creditworthiness of borrowers.

CRISIL Credit Rating Information Services of India Limited — a major Indian credit rating agency.

ICRA Investment Information and Credit Rating Agency of India Limited.

CARE Credit Analysis & Research (Ltd) — a credit rating agency.

ONICRA Onida Individual Credit Rating Agency of India — a credit rating agency.

BWR Brickwork Ratings — a credit rating agency.

SMERA SME Rating Agency of India Limited — rates small and medium enterprises.

Securities Contracts (Regulation) Act — the law that originally governed stock exchanges before
SCRA
SEBI.

NSE National Stock Exchange (of India).

BSE Bombay Stock Exchange.

IPO Initial Public Offering — the first time a company sells its shares to the public.

National Bank for Agriculture and Rural Development — set up by RBI in 1963 for agricultural
NABARD
credit.

Industrial Credit and Investment Corporation of India (now ICICI Bank/ICICI Ltd) — a major
ICICI
financial institution/bank.

IDBI Industrial Development Bank of India — a development finance institution for industry.

SIDBI Small Industries Development Bank of India — supports small-scale industries.

International Monetary Fund — a global organisation promoting monetary cooperation and

IMF
financial stability.

CRR Cash Reserve Ratio — % of bank deposits that must be kept as cash reserves with the RBI.

Statutory Liquidity Ratio — % of bank deposits that must be held in approved liquid assets (cash,
SLR
gold, government securities).

OMO Open Market Operations — RBI buying/selling government securities to control money supply.

NRI Non-Resident Indian — an Indian citizen living outside India.

Key Jargon and Concepts Explained

Term Meaning

To gather up scattered, idle savings from many small savers and bring them into the
Mobilise (savings)
financial system so they can be put to productive use.

An institution that sits 'in between' savers and borrowers/investors — collecting funds from
Financial Intermediary
one side and channelling them to the other (e.g., a bank).

Building up a stock of money or assets that can be used for future production — e.g.,
Capital Formation
pooling investor money to build a new factory.

Liquidity How quickly and easily an asset can be converted into cash without losing much value.

Taking an action (often using derivatives) to protect against, or reduce the risk of, future
Hedging
price or interest rate changes.

A financial instrument whose value is based on ('derived from') some other underlying
Derivative
asset, such as a stock, index, or commodity.

A financial institution guaranteeing to buy any unsold portion of a new securities issue,
Underwriting
effectively guaranteeing the issuer will raise the funds it needs.

Pledging an asset as security for a loan without giving up physical possession of it

Hypothecation
(common with goods used to secure a cash credit loan).

Legal Tender Currency that must, by law, be accepted as payment for a debt.

The topmost authority in a hierarchy — e.g., the RBI is the apex institution of India's
Apex Institution
banking system.
 A term for the RBI's role of lending to banks when they cannot obtain funds from anywhere
Lender of Last Resort
else.

Ways and Means Short-term, temporary loans the RBI gives to the government to bridge a temporary gap
Advances between its receipts and payments.

Special short-term government securities used to manage temporary deficits/surpluses in

Ad hoc Treasury Bills
the government's account with the RBI.

Rehabilitation (of sick

The process of financially reviving a company or industrial unit that is struggling or failing.
units)

The portion of a project's funding that must come from the company's own
Promoter's Contribution
promoters/founders, before financial institutions will fund the rest.

The financial stake a person has in the thing being insured — you can only insure
Insurable Interest
something you would genuinely suffer a financial loss from if it were damaged or lost.

Subject Matter of
The actual property, life, or risk that is being insured under a policy.
Insurance

Money owed to a business by its customers for goods/services already delivered but not yet
Receivables
paid for.

Debts owed to a business, as recorded in its own account books — essentially another term
Book Debts
closely related to receivables.

A deposit (like a current account) that must be repaid by the bank whenever the depositor
Demand Deposit
demands it.

The ability of an institution to meet its long-term financial obligations — having more
Solvency
assets than liabilities.

The range between the repo rate (ceiling/upper rate) and reverse repo rate (floor/lower
Interest Rate Corridor
rate), within which short-term market interest rates are expected to move.

A general, sustained rise in the price level of goods and services in an economy over time,
Inflation
reducing the purchasing power of money.

The set of actions a central bank takes (like adjusting interest rates or money supply) to
Monetary Policy
control inflation, manage growth, and maintain financial stability.

Insurance that an insurance company itself buys from another insurer, to protect itself
Reinsurance
against very large claims.

End of Module 1 Notes.