INDIAN ACADEMY OF LAW

AND MANAGEMENT

Introduction to Banking
MODULE-1

IALM

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 Module-1
Introduction to Banking
The word Bank is derived from the word “Bancus or Banque” meaning Bench. In olden days the Jew’s
used to carry out their business of money changing in Lombardy at the market place sitting in benches.
When the banker was unable to meet his obligation, the bench on which he was carrying on the
business of banking was broken into pieces and that led to the origin of the word bankrupt. The earliest
record of the activities of money changing, lending and other banking function goes back to as early as
2000 B.C in ancient Babylon. At that time, the Babylonian temples were in the banking business, lending
gold and silver which had been left with them for safe – keeping at high rates of interest. The Bank of
Barcelona in Spain established in 1401 was the first bank in the world.

In India the origin of banking dates back to the Vedic Period. During the Vedic Period there are
evidences of giving loans to others. Banking was synonymous with money lending. The Manusmrithi
speaks of deposits, pledges, loans and interest rates. The money lenders and indigenous bankers played
an important part in the Indian society as purveyors of money and credit from time immemorial. The
money lenders provided loans to people in times of need mainly for consumption purposes while the
indigenous bankers extended credit for financing trade and industry. The Indigenous Bankers were for
long the trusted custodians of the deposits of the people and the royalty alike. Besides meeting the
requirements of royal treasuries, they were mainly the source of finance for agriculture, industry and
trade. But the importance of money lenders and indigenous bankers was reduced to some extent with
the establishment of agency houses and presidency banks patronized by the English East India Company
towards the close of seventeenth century. It is considered to be the birth of modern banking in India.
Banking in India, as we see today, is the result of a slow and gradual development. Though India had a
system of Indigenous banking from very early times, it was not similar to the banking of the modern
times. The modern commercial banking originated in India during the latter part of the 19 th Century and
the early 20th Century, mainly due to the development of foreign trade and the convergence of
organized commercial and industrial sectors. Till the advent of the Presidency Banks, the European
Agency Houses acted as bankers. They accepted deposits from British officers serving in India and the
Europeans who had served in India. They financed trade with such funds and at certain times even
helped the Government.

The concept of limited liability was put on the statute books for the first time by the Companies Act,
[Link] then the banks had to put either operate under unlimited liability or obtain a special charter
from the Crown to operate. At that time, the Bank of Bengal in 1806, the Bank of Bombay in 1840 and
the Bank of Madras in 1843 were started. These banks were called the Presidency Banks.

A notable development in the history of Indian Banking was the amalgamation of the three Presidency
Banks into the Imperial Bank of India in 1921 by the passing of the Imperial Bank of India Act, 1920. The
Imperial Bank of India was given practically all types of Commercial Banking functions except dealing in
foreign exchange and the Central Banking Functions except dealing in note issue. With the passing of the
Reserve Bank of India Act, 1934 the Reserve Bank of India came into being in India in April 1935 to act as
the Central Bank of the country. It acquired the right to issue notes and acted as the Banker to the
Government in place of the Imperial Bank of India.

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The Reserve Bank of India was originally a shareholders bank. But it was nationalized by the Reserve
Bank (Amendment) Act, 1948 consequent to the nationalization of the Bank of England in 1946. After
the Independence, there was a strong demand for the nationalization of the Imperial Bank. The Rural
Credit Survey Committee also recommended the nationalization of the bank and accordingly the State
Bank of India took over the assests and liabilities of the Imperial Bank of India on 1st July ,1955 as per the
provisions of the State Bank of India Act, 1955.

The latest development in the Indian Banking system is the establishment of new private sector banks.
The Narasimham Committee recommended that there should be no barriers to new banks being set up
in the Private Sector. In recognition of the need to introduce greater competition to achieve higher
productivity and efficiency the banking system was liberalized during the early 90’s. Following this
recommendation, the Reserve Bank of India issued a set of guidelines in January 1993 for the entry of
new private sector banks. Accordingly eight new private sector banks started operations in April 1985.

Types of Banks

The following are the various types of Banks. They are:

a) Central Bank:
The Central Bank of a country is that institution which is vested with certain prerogative powers by
an Act of Parliament to regulate the monetary system in the country. It occupies a central position in
the monetary and banking structure of the country. It acts as a leader of the money market in
supervising, controlling and regulating the activities of all commercial banks and other financial
institutions. The objectives and functions of the Central Bank is to control the banking system
without making profit and to support the economic policy of the Government.

b) Commercial Banks:
The primary objective of the Commercial Bank is to earn profit. A Commercial Bank receives money
from the depositors and lends it to trade, industry and commerce. When the bank borrows money
from the depositors through various deposit schemes, it allows interest on such deposits. Similarly
when the banker lends money to the industry or business by way of overdraft cash credit, loans and
advances or by any other means he charges interest on such borrowings. The difference between
the lending rates and the borrowing rates is his profit. The interest rates are governed by the
Reserve Bank of India.

c) Co – Operative Banks:
India is an agricultural country. Co – Operative Banks are institutions established with the principle
of co- operation. The objectives of such organizations are to facilitate rural credit and to promote
thrift and self – help among economically weaker sections of the society. Like Commercial Banks the
Co – Operative Banks also receive deposits and lend money. But they lend money and make
incidental profits, although their sole objective is not profit earning.

d) Industrial Banks:
The economic development of a country depends on the development of its industries. The
advanced countries like United Kingdom, United States of America, Japan, and Germany are the
pioneers in the field of Industrial Development. Some countries like Japan and Germany started
banks exclusively to meet the needs of the industries.

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 The Industrial Banks provide long term loans and supply fixed capital to industrial concerns by
subscribing to the shares and debentures floated by the Companies. As they have financed the share
capital, the industrial banks play an important role in the management and administration of the
Companies. The Industrial Banks have acted as underwriters in the floatation of new industrial
concerns. In addition to this, they also arrange for medium term loans. But in India, we have a
number of financial corporations, development corporations and investment corporations acting as
industrial development banks.

e) Land Development Banks:

India being an agricultural country needs to develop the agricultural operations. The funds needed
by Indian Farmers are classified into short term, medium term and long term loans. Short term loans
are needed by them to buy seeds, fodder and to pay wages for the agricultural labourers. Medium
term loans are needed for buying cattle, agricultural implements and for the reclamation of land.
Medium term loans range from 2 to 5 years. Finally they require long term loans to make
permanent improvements in the land or even to purchase additional land These loans are for long
periods ranging from10 to 20 years.

f) Exchange Banks:
Exchange Banks are also commercial banks engaged in the foreign exchange transactions. They also
receive deposits and lend money. They build up balances abroad by purchasing claims to foreign
currencies. They also sell these proceeds to the importers. They act as businessmen in buying and
selling foreign currencies or claims to foreign exchange.

Role of Banks in Economic Development

Banking system is the driving force for all economic activities. Banks through their control over the
volume of money in circulation influence production, consumption and distribution. Banks play an active
role in the economic progress of a country, as they are the major instruments behind the mobilization of
resources, investment and on operational efficiency of various segments of the economy.

The Role of Banking is as follows:

a. Promoting Infrastructural facilities – Banks play a vital role in developing comprehensive

infrastructural facilities including the social, educational, fiscal etc in the country which is the life
blood of economic development.

b. Mobilizing Savings and Capital Formation - The Capital Formation depends upon the
mobilization of savings. The banks nowadays have brought out novel schemes to encourage the
habits of thrift. This capital mobilized by the banks is made available for productive purposes,
which in turn gives lots of scope for economic development.

c. Rural Development – India is a land of villages. Banks adopt certain measures to improve rural
areas and undertake developmental activities, which in turn will develop the whole nation.

d. Balancing International Trade – Banks by helping the entrepreneur increase the export surplus
and thereby improve the balance of trade of the country. The Banks help the exporters by
quickly obtaining money from foreign buyers and also by providing easy credit to the exporters.

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 e. Facilitating with a good medium of exchange (Cheque System) – The Cheque system provided by
the banks as a medium of exchange is of great use for all sorts of transactions and helps in the
promotion of trade and industry.

f. Acting as a bridge between various sectors – Banking system acts as a bridge between various
sectors (organized and unorganized) and thereby helps for overall economic development of the
country.

g. Control the Trade Cycle – With the help of effective banking system the Government can control
and regulate the circulation of money and thereby controls the effect of the trade cycle to a
certain extent.

Functions of RBI

The Reserve Bank of India is the Central Bank of India. The functions of Reserve Bank of India are as
follows:

a. Bank of Issue
The Central Bank has been entrusted with the monopoly of note issue in accordance with Section 22 of
the Reserve Bank of India Act. It started the Note Issue function from 1st April, 1935. The notion of
granting the Note Issue function to the Reserve Bank of India was approved by the Central Government
on the recommendation of the Central Board. It issues borrowed from the Bank of England. The design,
form and material of bank notes should be notes of all denominations except one rupee notes which are
issued by the Ministry of Finance, Government of India. There are different method of note issue which
is being followed in different countries, such as fixed fiduciary system, maximum fiduciary system,
proportional reserve system and minimum reserve system. There are two departments with respect to
the issuance of notes namely Issue Department and Banking Department. The notes are issued by the
Issue Department on demand by the Banking Department. Whenever the currencies are issued by the
Issue Department, the Issue Department gets Cash Reserves against the currency issued.
The following are the main reasons for granting the exclusive monopoly of Note Issue to the Central
Bank. They are:

(i) The Bank can expand or contract the supply of money according to the needs of the economy.
(ii) It provides uniformity in Note Issue.
(iii) The Central Bank can exercise control over the functions of other commercial banks as it is the
supplier of cash to them.

b. Banker, Adviser and Agent to the Government

The second important function of the Reserve Bank is to act as a Government’s Banker, Agent and
Customer. Under Sections 20, 21 and 21A of the RBI Act, 1938 the RBI is obliged to act as a banker to the
Government by which it undertakes the responsibility of receiving money on behalf of the Government
and to allow the Government to make necessary payments through them. The RBI provides the
Government with the necessary foreign exchange for making payments abroad.

The Central Bank is generally called upon to perform various services as the Governments financial
agent thereby acting as the Governments agent. As an advisor of the Government, the Central Bank also
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gives advice to the Government on important matters of economic policy like deficit financing,
devaluation of currency, trade policy, foreign exchange policy etc.

c. Custodian of Cash Reserves

The Commercial Banks are required to maintain a certain fixed percentage of both time and demand
liabilities with the Central Bank. The Central Bank in turn allocates transfer of funds from one bank to
another for the clearance of cheques on the basis of these deposits. Thus the Central Bank is not only
the custodian of Government funds and wealth, but also custodian of cash reserves of commercial
banks.

d. Lender of Last Resort

The Central Bank act as the banker’s bank. Every scheduled commercial bank is required to maintain a
certain percentage of its total demand and time liabilities with the Central Bank. This provision has two
objectives. First of all every schedule bank is expected to maintain a certain percentage of cash reserves
against deposits so as to protect the interest of the depositors. Secondly, this provision helps to
centralize the banking reserves of the country so as to enable the Central Bank to regulate and control
the credit position in the country.

e. Credit Control
Credit Control refers to the regulation of the lending policy of the Commercial Banks by the Central Bank
in order to achieve integrated growth and development of all the sectors of the economy. The financial
and economic stability of a country is achieved through proper control of the power of credit creation of
commercial banks by the Central Bank to the control credit creation.

f. Types of Credit Control

There are two types of Credit Control namely Quantitative Credit Control and Qualitative Credit Control.
Quantitative Credit Control comprises of Bank Rate Policy, Open Market Operations and Variable
Reserve Ratio. Qualitative Credit Control comprises of Regulation of Margin Requirements, Regulation of
Consumer Credit, Rationing of Credit, Direct Action, Moral Suasion,Publicity.

Quantitative Credit Control

The following are the Quantitative methods of Credit Control. They are:

a. Bank Rate Policy

Bank rate is the official rate at which the Central Bank of a country is prepared to rediscount the
approved bills of exchange or to lend on approved securities. The mechanism is very simple,
increase in bank rates leads to lesser demand for credit and reduced volume of credit which reduces
the quantum of credit money, leading to fall in prices. Similarly decrease in bank rate leads to easy
credit and increase in price level.

Thus a change in the Bank Rate Policy by the Central Bank brings about a change in the interest rates
on the loans to customers by the Commercial Banks and thus a chain of action and reaction begins.
An increase in the bank rate increases the interest rates of banks and vice versa. The Central Bank
makes use of the bank rate either to expand or to contract the credit by the commercial banks and
thus it indirectly controls the currency flow in any economy.

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b. Open Market Operations

The term Open Market Operations refers to the act of buying and selling government securities. The
Central Bank during boom conditions sells the Government and other approved securities in the
market to reduce the aggregate money supply in the economy. Buyers of these securities pay the
Central Bank by drawing on their deposits in the banks. Hence there is reduction in the size of the
member bank deposits held with the Central Bank. Because of this reduction banks are compelled to
reduce their loans.

When there is a slump in the economy, the Central Government buys the securities in the market
and pays for these securities by issuing cheques drawn on the individuals and institutional sellers of
these securities. The individuals deposit these cheques with the Commercial Banks and the
Commercial Banks realize the proceeds of the cheques issued by RBI and their reserves are
increased. The banks use these additional reserves to extend more loans. Thus the Open Market
Operations affect the quantity of money supply in the economy.

c. Variable Reserve Ratio

The term Variable Reserve Ratio refers to the minimum reserves with the Central Bank by the
Commercial Banks, the cash reserves may be a percentage of its time and demand deposits
separately or of total deposits. The Commercial Banks have more reserves than required by law. If
the banks are required to maintain a higher cash reserve by the Central Bank then their capacity for
credit creation would come down and vice – versa.

Qualitative Credit Control

The following are the Qualitative Credit Control measures. They are:

1. Margin Requirements:

The term Margin refers to the difference between the loan value and the market value of the security.
The object of prescribing margin requirements is to restrict speculative dealing in stock exchanges.
Higher margin reduces the volume of credit. This method engages the banks to direct their funds to
productive investments.

2. Regulation of Consumer Credit:

This is another method which is used as Credit Control through the regulation of consumer hire
purchase finances granted to the depositors. The Central Bank would increase the down payments and
decrease the installment repayment period if a particular sector was facing inflationary conditions.
Similarly when deflationary forces are at work, they can be encountered by easing the terms.

3. Rationing of Credit:
The Rationing of Credit refers to the control exercised by the Central Bank in regulating the purposes for
which the credit is granted among the various applicants. Credit Rationing is of two types namely
Variable Portfolio Ceiling and Variable Capital Assest Ratio. Variable Portfolio Ceiling refers to fixation of
ceiling by the Central Bank on the loans and advances granted by commercial banks, the banks cannot
extend the loans and advances beyond the ceiling.
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Variable Capital Assests Ratio indicates the capital ratio of commercial bank to its total assests which has
been fixed by the Central Bank.

Functions of Banks

The functions of Banks are classified into two types mainly Primary and Secondary Functions. The
Primary function of Banks is acceptance and lending of deposits. The Banks receive deposits from its
customers and lend it to Industries and Companies. The deposits received by banks are classified into
two types namely Time and Demand Liabilities. Fixed, Recurring and Miscellaneous Deposits constitute
Time Liabilities and Savings Bank Account and Current Account constitute Demand Liabilities. The Banks
lend funds in the nature of Overdrafts, Cash Credits, Discounting Bills of Exchange and Loans and
Advances.

In order to facilitate the customers the banks accept standing instructions from their customers either
to make payments on their behalf or collect money or effect transfer of money. Such functions are
called as Agency Functions which are the secondary functions of the Banks. The various Secondary
Functions of banks are as follows:

a. Payment of Rent, Insurance Premium, Subscription etc on behalf of the customer as per his
prior instructions on the appropriate dates. The payment will be made from the customer’s
account.

b. The Banks are often involved in transferring the funds of their customers electronically from one
account to another using latest communication technology.

c. With the introduction of computers in Indian Banks and with arrangements of shared payment
network system services are provided across the banks. Customers need not visit the banks to
do the banking transaction when their banks provide them electronic banking, tele banking or
remote banking facilities.

d. The Commercial Banks provide safe custody facilities. Under this facility, the valuables may be
handed over to the banker as per the regulations. The banker will verify the value of the items
deposited with him and keeps them in his locker. He gives an acknowledgement for the
valuables he has received from the customer stating the description and value of the items. The
bank charges depend on the period for which the valuables are kept with the bank and the value
of the items kept under safe custody.

Special Types of Bank Customers

Banks deal with accounts of large number of customers in the course of their business. There are certain
types of customer’s accounts which require special care. When an account is opened a contract arises
between the banker and the customer. The Contract is valid only when both the parties are competent
to enter into a contract. Hence the banker has to be very careful about the character, capacity and
competency of his customers at the time of opening and operation of their accounts. The Banker should
deal with them differently according to the situation.
The following are the Special Types Of Customers. They are:

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Minors
A Minor is a person who has not attained the age of majority. According to Section 3 of the Indian
Majority Act, 1875 a minor is a person who has not completed the age of 18 years and in case of a
guardian appointed by the Court the age of majority extends to 21 years. Section 11 of the Indian
Contracts Act, 1872 declares a minor as incompetent to enter into any contract. Therefore, a contract
with a minor is void and unenforceable. The Banker should be very careful with minors as money lent to
minors cannot be recovered even if he falsely represents himself as a major. The following are certain
types of privileges enjoyed by a minor. They are:

i. A Minor cannot be compelled to repay the loan unless it is for the necessaries of his life.
ii. Even without repaying the loan the minor has the right to get back the securities pledged
with the bank.
iii. A minor can never be appointed as Trustee but he can sign as witness in a contract provided
he is able to understand the contract.
iv. A minor can be a partner in a partnership firm and enjoy the benefits of partnership firm.
But he is not liable for the debts of the firm.

Lunatics
Lunatics are persons of unsound mind. According to Section 12 of the Indian Contracts Act, 1872
persons of unsound mind are disqualified from entering into a valid contract. However, his
disqualifications does not apply to contracts entered into by lunatics during the period of sanity or
contracts which are ratified during such periods. A Banker shall take the following pre -cautions while
opening an account in the name of lunatics.

i. First of all, the banker should confirm whether the applicant is a lunatic or not. He should
not be carried away by rumor’s or gossips or hearsay information’s.

ii. Once the banker comes to know of such defect in a person, it would be good for the bank to
avoid such person as their customer.

iii. An existing customer may become insane in such a case the Banker should be doubly
cautious. He cannot presume that a customer is insane. The banker should get an official
proof of his insanity. Once he gets the official confirmation, the banker should immediately
stop paying his orders.

iv. In the case of an existing account – holder, the banker can act in the usual manner so long
as he has no knowledge about his insanity.

v. When the banker comes to know of such problem in a customer the banker should not act
in haste.

vi. If he is recovered from his mental illness, the banker must obtain a certificate from two
medical officers certifying his mental soundness before resuming operations on the account.

Illiterate Persons
An illiterate person is one who cannot sign his name. Such person cannot read or write or understand
the text. He may not be able to operate the bank account by his own. Such person should come to the
Bank with his Pass Book for with drawl of money from his account. He cannot be given cheque books.
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While opening an account in the name of the illiterate person, a banker should get his left hand thumb
impression in the presence of two persons known to the bank for identification in the application. The
banker should explain to the illiterate person about the nature of the account he intends to open, the
implications and conditions for operation of the account to the account holder clearly.

The Banker should note two identification marks in the bank record for future reference. Two copies of
recent photograph attested by a first class magistrate should be obtained. One should be kept with the
specimen signature file and the other should be affixed in his Pass Book. The Banker should also obtain a
good introduction.

Married Woman
A Married Woman can open an account in her name. She can enter into contract and bind her separate
estate. In the case of an overdraft granted to a married woman, the banker has no remedy unless she
has a separate estate. Even her husband cannot be made liable unless the banker has obtained his
personal guarantee or the amount has been drawn for the purpose of necessities of her life.

Bankrupt
A banker should not open an account in the name of an undischarged bankrupt. If a banker comes to
know of an existing customer becoming bankrupt, he is expected to stop all operations of the account
and inform the Official Assignee appointed by the Court.

Relationship between Banker and Customer

In addition to the primary functions, a banker undertakes to do certain agency services. In some cases,
he may act as a bailee or lessee. In all these cases, there is a contractual relationship between banker
and customer. The relationship between the banker and the customer is primarily that of a Debtor and
Creditor relationship.

1. Debtor and Creditor Relationship:

The primary functions of the Commercial Banks are to receive deposits from the public and lend the
same to the borrowers at higher rates of interest. When the banker receives deposits from a customer,
the banker is a debtor and the customer is the creditor. The Customer continues to be a Creditor so long
as his account shows a credit balance. Once his account shows debit balance the customer becomes a
debtor. Once his account shows a debit balance the customer becomes a debtor.

2. Trustee and Beneficiary

A Trustee is one who holds money or assests of the beneficiary and performs certain functions in the
interest of the beneficiary. The Banker acts as a Trustee when the banker, makes purchases or
investments out of the customers money on behalf of the customer under the customers instructions
the Banker acts as the Trustee and the Customer acts as the Beneficiary.

3. Lessor and Lessee

In the case of safe deposit locker facilities offered by banks, the relation between a banker and a
customer is that of the Lessor and Lessee. In this case the banker is the lessor and the customer is the
lessee. The Banker lets out his premises (locker) for the use of his customers. In case of loss of assests
kept in the locker the banker is not directly responsible. The banker has no lien over the assests kept in
the locker as long as the rent is paid regularly to the bank.

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4. Principal and Agent
The Commercial Banks also undertake agency services like purchase and sale of securities, collection of
cheques etc on behalf of customers. Due to stiff competition, the Commercial Banks compete with one
another to undertake wide range of agency services. In order to facilitate the customers, the banks
accept standing instructions from their customers either to make payments on their behalf or receive
money or effect transfer of money. The relationship between banker and customer in this case is that
of Principal and Agent.
Types Of Banking Systems

The structure and organization of Commercial Banks differ from one country to another according to the
nature of the economic, political and social conditions of each country.

The well-known systems of Banking are:

a. Branch Banking
It is a system of banking in which one bank carries on its business through a network of branches spread
all over the country. Sometimes such branches are even opened in foreign countries. In this system, the
bank is owned by one group of shareholders and controlled by a single Board of Directors. The branches
are controlled from a central office known as the head office in a particular office. This type of banking
system is found in England, Scotland, Canada, Australia and India.

b. Unit Banking
It is a system of banking in which the operations of a unit bank are confined in general to a single office
situated in a particular place. The business is limited to a small area within which it is established. The
Banking system of United States is a classic example for this kind of banking system. They have either no
branches or very few branches.

c. Chain Banking
It is an arrangement by which an individual, group of individuals, or the members of a family control the
operations of two or more banks by either holding majority shares or interlocking directorship.
Nevertheless each bank retains its identity, capital and personnel.

d. Group Banking
It is a system in which a holding company controls the operation of two or more banks. The main
difference between Chain Banking and Group Banking is that in the former the shares of the banks are
held by individuals or group of individuals whereas in the latter they are held by the holding company.

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