Introduction to Banking Business - BASIX Introduction Bankin… · Web viewEarly history apart...

Chapter-4: Introduction to banking business

CHAPTER-4INTRODUCTION TO BANKING BUSINESS

Outline of the Chapter

4.1 Objectives4.2 Introduction4.3 Brief History4.4 Business of Banking4.5 Banker Customer Relationship4.6 Bank Deposits

4.1 Objectives

After going through this chapter you will be able to: Understand the role of banking sector. Identify the features of banking business that distinguish it from other businesses. Describe the functions performed by commercial banks. Identify the business prohibited for banking companies. Understand the relationship between banker and customer. Enumerate the types of deposits accepted by banks.

4.2 Introduction

'Money makes the mare go' is an old saying which is relevant even today. Money and credit provide the pivot around which all the economic activities cluster. Banks are institutions that accept various types of deposits and use these funds for granting loans. By pooling the savings of widely scattered economically surplus units, banks form a vast pool of social capital. This helps in capital formation and capital accumulation. However, banks are not merely the storehouses of the country's wealth but they are reservoirs of resources necessary for economic development-be it building of infrastructure, setting up of basic and key industries, modernization of agricultural sector, boosting domestic and international trade, and so on. By discharging this function efficiently and effectively, a commercial bank increases the productive capacity of the nation and thereby plays a pivotal role in accelerating the pace of economic development.

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Banks today are an important part of the payment mechanism of the economy, and it is through them that the monetary and fiscal policies of the government are concretized. By creating credit, banks are in a position to affect prices, nominal national income and other macro-economic variables. Banks are at the heart of the financial system. They are a class of financial institutions which the public views as safe and convenient outlets for its savings. The importance of a viable, sound and safe banking system cannot be overemphasized.

4.3 Brief History

Banking in its simplest form is as old as authenticated history. In India, references about banking habits and regulation exist in our scriptures and ancient texts. During the Vedic times (20001400 B.C.), money lending and 'Rna' or debt are repeatedly mentioned in the Vedic literature. During the smriti period, which followed the Vedic period and epic age, Manu the great law giver of that time spoke of vaishs earning money through interest. He observed that "a sensible man should deposit his money with person of good family, good conduct, well acquainted with the law, veracious, having money, many relatives, wealthy and honourable". He also talks about regulations governing credit interest on loan to bankers, usurers, renewal of commercial papers, etc2.

Chanakya's Arthshastra (about 300 B.C.) is full of facts to show that there were powerful guilds of merchant bankers in existence who received deposits, advanced loans and carried on the other banking functions3. B.K. Bhargava adds that bankers in the smriti period accepted deposits from the public, granted loans against pledges and personal security, granted simple loans, acted as bailee for his customers, subscribed to public loans by granting loans to king, acted as a treasurer and banker to the State and managed the currency of the country4.

A system of banks had also been devised as early as 2000 B.C. by the Babylonians. In ancient Greece and Rome, the practice of granting credit was widely prevalent. The Bank of Venice, which was established in 1157, is considered to be the most ancient bank. In Florence, 'Monte' was established in 1336, and a public bank was set up in 1401 in Barcelona5. For fulfilling the needs of merchants, the Bank of Amsterdam was set up in 1609 (and most European Banks at that time were formed on this model).

Early history apart modern banking began with the goldsmiths of London in the 17th century. At that time money was held in the form of gold and silver coins. As the goldsmiths had excellent strong rooms, people started keeping their money



with them for safe keeping in return fora fee. The goldsmiths used to issue receipts for the same which began to be transferred from one trader to another for settlement of debts. In this manner, the trader avoided the hassle of withdrawing their coins from the goldsmith to make the payment to their creditors. The creditors, in turn, were saved from the necessity of having to deposit the same with the goldsmith for safe keeping. To make such transactions simpler, the goldsmith started issuing receipts in convenient denominations and made them payable to bearer. The goldsmith soon observed that at a time only a small proportion of coin were needed for making payment, so they started lending the surplus money and charging certain interest for doing so. The goldsmith began entrusting reserves to the 'exchequer' under the sanction and care of the King. Unfortunately, King Charles II shut up the exchequer one day and that caused the ruin of the goldsmiths. However, this proved to be a turning point in the history of English banking with the growth of private banking and the Bank of England in 1694. At this point, it is pertinent to mention that apart from the goldsmiths, the moneylenders and merchants also had a strong role to play. Each of these was closely concerned in dealing of money which in those days was in the form of coins made of precious metals. Merchants were trustworthy people to whom people gave their monies for safe keeping. They also issued receipts acknowledging their liabilities and honoured them when the receipts were presented. Moneylenders in villages too lent money to people on interest. This money was usually their own, but sometimes, it also belonged to people with surplus money who gave it to them. Moneylenders, thus, became embryonic banks by serving as money borrowers as well as moneylenders. As these money changers transacted their business sitting on benches (equivalent of English 'Bench', German 'Bank', Italian 'Banck' and French 'Banqui'), they came to be known as 'banks'.

In India our historical, cultural, social and economic factors have resulted in the Indian money market being characterized by the existence of both the unorganized and the organized sectors.

Unorganized sector: The unorganized sector comprises moneylenders and indigenous bankers which cater to the needs of a large number of people especially in the rural areas. They have been meeting the financial requirements of the rural populace since times immemorial. Their importance can be gauged from the fact that Jagat Seths, hereditary bankers of the Nawab of Bengal, were recognized even by Aurangzeb and the East India Company who were compelled to borrow from them also publicly honoured them.



The indigenous bankers are different from the proper banks in a number of ways. For instance, they combine banking activities with trade whereas trading is strictly prohibited for banks in the organized sector. They do not believe in formalities or paper work for making deposits or withdrawing money. In fact, since a substantial percentage of their clientele is illiterate, they frequently take a thumb impression of their customers on a blank paper. Even if they use a 'Hundi' as a negotiable instrument yet it will not be indicated on its face whether the transaction - is supported by valuable consideration or it is merely as a result of mutual accommodation. The rate of interest charged by them fluctuates directly with the need of the borrower and may sometimes be as high as 300 per cent! They are insulated from all type of monetary and credit controls as they fall outside the purview of the RBI. Though they are still the major source of funds for small borrowers, but now their market has started shrinking because of the fast expansion of branches of banks in the unorganized sectors.

Organized sector: The organized sector of the money market comprises specialized banking institutions like Industrial Development Bank of India (IDBI), Small Industries Development Bank of Inya (SIDBI), National Bank for Agriculture and Rural Development (NABARD), Export-Import (EXIM) Bank and National Housing Bank (NHB) which are the apex institutions in their respective fields. The IDBI undertakes direct financing of big industrial projects and refinancing of term loans granted by other banks. SIDBI was set up to provide finance to the small-scale industries whereas NABARD looks after the needs of the agricultural and rural sector. The imports and exports of the country are looked after by EXIM which is the apex body for handling foreign trade. The commercial banks are the oldest institutions in the organized money market. They have a huge geographical network and enjoy tremendous public confidence. This sector also includes the public sector banks, private sector banks and foreign banks as well as cooperative banks.

Some of the main differences between the moneylenders (unorganized) and the banks (organized) sectors have been summarized below in Table 1.1.



Table 1.1Differences between Unorganized and Organized Sectors

Moneylenders (Unorganized sector) Banks (Organized sector)

Lend from own savings. Lend from deposits received from general public.

Frequently combine banking with trading activity.

Are prohibited from carrying on any trading activity.

Usually charge very high rate of interest, rates fluctuates with the needs of borrowers.

Rate of interest are comparatively lower.

Formalities/procedures for borrowing are bare minimal if at all.

Paper work, formalities, procedures are much more stringent.

Usually money has to be returned after a fixed period. No restrictions as to mode of demand (cheque, etc.) or time and place.

Money has to be returned on demand.Demand can be made only through cheques,draft,order,etc. during working hours in bank premises.

Does not provide other agency/general utility services.

They provide a number of agencies and general utility services.

Hardly use any procedure or any technology.

Usually all operations are computerized and use high technology for most purposes.

4.4 Business Of Banking

Banks are institutions that accept various types of deposits and use those funds for granting loans. The business of banking is that of an intermediary between the saving and investment units of the economy. It collects the surplus funds of millions of individual savers who are widely scattered and channelizes them to the investors. (See Figure 1.1).

Figure 1.1 Business of banking Money

In simple terms, banks serve as a middle man from the money surplus unit to be money deficit unit. They are intermediaries, who transfer funds from savers to investors through grants for business, commerce, education, housing and other purposes. They perform the basic purpose of intermediation through the following four transformation mechanisms:


Money surplus units Money deficit units

(Savers)(Intermediary (Banks)

(Investors)


Liability-asset transformation-The deposits of money, that banks accept from the public (which are liabilities for the bank) are converted by them into assets such as loans and investments.

Size transformation-By creating a reservoir of funds from the numerous small deposits collected from customers, banks provide large loans to investors.

Maturity transformation-The liquidity preferences of borrowers and lenders differ. Banks offer savers deposits according to their liability preferences (time or demand), and at the same time banks provide loans (short, medium or long-term) to the borrowers according to their preferences.

Risk transformation- The risks to which savers are exposed, are distributed by the bankers through diversification.

Meaning of Banking

According to section 5(b) of the Banking Regulation Act, 1949, "banking" means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise. Banking company means any company which transacts the business of banking in India. No company can carryon the business of banking in India unless it uses as part of its name at least one of the words bank, banker or banking.

Any company which is engaged in the manufacture of goods or carries on any trade and which accepts deposits of money from the public, merely for the purpose of financing its business, such manufacturer or trader shall not be deemed to transact the business of banking. The essence of a banking business is receiving money on current account as deposits from the public, which are repayable on demand and withdraw able by cheque, draft, order or otherwise.

Functions of Bank

According to section 6 of the Banking Regulation Act, 1949, the primary functions of a bank are:

The borrowing, raising or taking up of money; the lending or advancing of



money either upon or without security; and drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of exchange, hundies, promissory notes, coupons, drafts, bill of lading, railway receipts, warrants, debentures, certificates, scrips and other instruments, and securities whether transferable or negotiable or not. Besides the two main functions of lending and investment, a commercial bank performs a variety of other functions.

Other functions: Banks provide the following services: Carry out the standing instructions of customers for making

payments; including subscriptions, insurance premium, rent, electricity and telephone bills, etc.

Undertake government business like payment of pension, collection of direct tax (e.g., income tax) and indirect taxes (like excise duty).

Collect dividends, cheques, bills of exchange, promissory notes. Underwrite and deal in stock, funds, shares, debe:p.tures, etc. Act as agents for any government or local authority or any other

person or persons; also carryon agency business of any description including the clearing and forwarding of goods, giving of receipts and discharges, and otherwise acting as an attorney on behalf of customers, but excluding the business of a Managing Agent or Secretary and Treasurer of a company.

Contract for public and private loans and negotiating and issuing the same.

The effecting, insuring, guaranteeing, underwriting, participating in managing and carrying out of any issue, public or private, of State, municipal or other loans or of shares, stock, debentures or debenture stock of any company, corporation or association and the lending of money for the purpose of any such issue.

Many banks also act as trustees, executors and administrators to undertake the supervision of investments and distribution of income on behalf of their customers.

The issue of letters of credit, international money orders, travelers’ cheques (both in Indian Rupee and foreign currency), foreign currency, circular notes and bank drafts.

Safe custody services through provision of lockers and safe deposit vaults for safe keeping of documents, cash, jeweler, etc.

Remittance of funds through electronic funds transfer service, bank draft, etc.



It is pertinent to mention that services provided by banks have undergone a sea change in recent years. The use of internet technology has become a very powerful force changing the very core of traditional banking. Changing lifestyles and intense competition have further enlarged the range of services provided by banks. A brief summary of functions performed .by most commercial banks today are given in Table 1.2. For convenience, they have been grouped into primary, agency and general utility services.

Functions of Commercial BanksPrimary Agency General utility

Acceptance of deposits

Saving Fixed Demand

Advancing of loans Loans Overdraft Discounting of

bills

Collection of interest, dividend, salary, pensionBuying/selling of foreign exchangePayment of rent, insurance premium, electricity and telephone bills Collection of cheques, promissory notes, bills

Issue of letter of credit, travelers’ cheques, credit cards, debit cards, ATM cardsSafe custody of valuables and documents, lockersSpecialized advisory service to customers, electronic transfer of fundsInternet banking, mobile banking, bancassurance

Business Prohibited for Banking Company

According to section 8 of the said Act, no banking company shall directly or indirectly deal in the buying or selling or bartering of goods, except in connection with the realization of security given to or held by 'it, or engage in any trade, or buy, sell or barter goods for others otherwise than in connection with bills of exchange received for collection or negotiation. The banking system is integral to a country's financial stability and economic growth and also because banks deal largely in other people's money, banks are subject to numerous statutory regulations, e.g., the liquidity norms-since depositor's money is repayable on demand. Banks are also subject to priority



sector lending norms for lending to agricultural sector, small entrepreneurs,' artisans, etc., and the setting up of rural ‘branches’ for more balanced regional development, and so on.

Difference between Banking and Other Businesses

Though other businesses can also raise deposits from the public to finance their business or give loans, yet they cannot be called banks as they are very different. Some of the main differences between banking and other business have been summarized in Table 1.3.

Table 1.3 Difference between Banks and Other Businesses

Banking business Other businesses (Manufacturing, Trading/services)

Deal in money and financial products like deposits, loans, etc. Banks create credit and cannot deal in goods and services.

Deal in goods and services. Do not have the power to create credit, engage in manufacturing trading and providing other services.

Banking business is directly controlled/ regulated by RBI and other regulatory authorities to ensure trust and confidence of investors.

Business is not directly controlled by any statutory authority.

A substantial portion gets locked up to meet liquidity _ requirements like CRR/SLR.

There are no statutory restrictions regarding liquidity, almost the entire resources can be used.

Have to balance profitability with social justice and welfare.

Have comparatively far greater freedom to organize business.

Profit and loss statements, cash flow statements are prepared everyday.

Usually they are prepared once a year.

Banking operations need to be automated much more due to need for control and the routine/repetitive nature of business.

Business operations do not have a dire need for automation

Deposits with banks are liabilities of banks.

Deposits with bank are assets.

4.5 Banker Customer Relationship



The moment an individual opens an account with the banker, he becomes a customer of the bank. There exists a special relationship between the banker and its customer. To understand this relationship, it is important to know who is a banker and who is a customer.

Banker

A banker is one, who performs the business of banking. The term banking has already been defined earlier. Some of the salient features of this definition are as follows: A banking company must perform both of the essential functions, viz.

(a) accepting of deposits, (b) lending or investing the same. If the purpose of accepting of deposits is not to lend or invest, the business will not be called banking business. The explanation to section 5 (c) makes it clear that any company which is engaged in' the manufacture of goods or carries on any trade and which accepts deposits of money from the public, merely for the purpose of financing its business as such is not deemed to transact the business of banking .

The banker accepts deposits of money and not of anything else. The word public implies that banker accepts deposits from anyone who is capable of contracting and who offers his/her money for such purpose.

The definition also specifies the time and mode of withdrawal of deposits. The depositor must make a demand for withdrawing his/her money. The demand should be made in a proper manner and through an instrument in writing and not merely by verbal order or a telephonic message.

The banker is, thus, an intermediary and deals with money belonging to the public. A number of other institutions which also deal with money are not designated as banking institutions because they do not fulfil all the above-mentioned prerequisites.

Customer

There is no statutory definition of the term customer. However, the legal decisions on the matter throw some light on the meaning of the term. As such a customer is defined as a person who opens a deposit or current account or negotiates an advance on current or loan account. Accordingly, a person who goes to encash a bearer cheque in the bank, or visits a bank to deposit application money for allotment of shares of a company shall not be termed



as a customer. Dr. Hart defines a customer as "one who has an account with a banker or for whom a banker habitually undertakes to act as such". A person (whether an individual, firm, company, society or any legal entity including a government department and a corporation incorporated by, or under any law), is said to be a customer of the bank when his dealings with the bank relate to the business of banking, i.e., accepting of deposits and lending of money. So if a person goes to the bank for any other purpose like payment of income tax, utility bills, etc., he will not be considered a customer of the bank. To constitute a customer, a person must Open a bank account-saving, current or fixed deposit, in his name by

making necessary deposit of money, and The dealing between the banker and customer must be of the nature of

banking business.

Relationship between Banker and Customer

The general relationship between banker and customer is that of debtor and creditor. Sometimes, the banker acts as an agent or trustee also.

Relationship as debtor and creditor: The moment the customer opens an account with the banker, he becomes debtor of the customer and the customer becomes his creditor. The banker is then bound to return an equivalent amount of money, by paying a similar sum to the depositor when he is asked for it. The debtor creditor relationship between banker and customer is different from similar relationship in other commercial transactions in the following respects:

The creditor must demand payment. In case of ordinary commercial debt, the debtor repays the money on the specified date, or as per the terms of the contract. But in case of a deposit in the bank, the debtor/banker is not required to repay the amount on his own accord. The depositor/creditor must make a demand for the payment.

Demand must be made in the proper manner: The withdrawal should be effected through an order, cheque and draft or otherwise. These days bankers also make payments when requested through electronic cheques, ATMs, credit cards and debit cards.

Proper place and time of demand: If the payment is not being demanded through electronic mode, then the customer/creditor has to make the



demand at the proper place and proper time. In other words, he can demand payment only from that branch of the bank, where he has an account and that too during working hours on a working day. In ordinary commercial transaction, money can be demanded anytime and anywhere.

Banker as Trustee

Under certain circumstances, bankers enter into fiduciary relationship of a trustee with their customers. A trustee holds money or assets and performs certain functions for the benefit of some other person called the beneficiary. For instance, when a banker receives valuables for safe custody, he acts as a trustee.

This property does not pass on to the banker and it is not available for distribution amongst his general creditors in case of liquidation.

Banker as Agent

A banker acts as an agent of his customer in many ways, e.g., when he buys or sells securities or makes payment of various dues of his customers, or collects cheques on his behalf. In all these cases, the banker acts as an agent of his customer.

4.6 Bank Deposits

It is the taking of deposits and granting of loans that single out a bank. These are the core activities of a bank. Initially, all accounts are opened with a deposit of money by the customer and hence these accounts are called deposit accounts. A public deposit comprises the major proportion of a bank working funds which are used primarily to make loans and advances and to purchase securities. The size of deposits is a fair reflection of the confidence, reposed by the public in that bank. The growth and prosperity of a bank depends on how they are managed to maximize profits. The banker solicits deposits from the members of the public belonging to different walks of life, engaged in numerous economic activities. The nature of banking facility sought by them, therefore, varies widely, e.g., some want to earn interest, some want their money to be safe, others use banking facilities for conducting business. As a result, different types of accounts with various facilities and privileges are offered by banks to their customers. Banks accept various types of deposits, which are generally categorized as demand



or time deposits.

Demand deposits: Demand deposits are those where customers expect to be able to withdraw money at anytime. These include savings deposits and deposits in current accounts.

Time deposits: Any deposit which is not repayable on demand is a time deposit, e.g., a fixed deposit.

Fixed deposits: A fixed deposit is an account with the banker, which is repayable on the expiry of a specified period, that's why such deposits are also called term deposits. They are a genuine saving medium. The banker can utilize such amounts more profitably since he knows before hand when this money will be demanded. As a result, a much higher rate of interest is offered to the customer on such deposits. These deposits have different maturity periods and the rate of interest is proportionate to the maturity period. When a person deposits money with the banker on a fixed deposit, a 'deposit receipt' is given to him by way of acknowledgement for the amount deposited. This deposit receipt is not a negotiable instrument. However, it can be assigned provided due notice of assignment is given to the banker.

Saving bank accounts: Such accounts are usually maintained by people who wish to save a part of the current income to meet the future needs and also to earn some interest thereon. The need of keeping cash reserves against such deposits is comparatively more as compared to fixed deposits but smaller as against current deposits. The banker pays interest against these accounts to the customers though at a lower rate than in case of fixed deposits. Interest is allowed on minimum balance as at the close of any day between the tenth and the last day of each calendar month. The customer has to maintain a minimum balance in his account. There is a restriction as to the number of withdrawals he can make. A cheque book is issued to customer to withdraw money and records of the transactions are maintained in a passbook or through a monthly bank statement.

Current account: Such accounts are opened by businessmen! corporates who do not want any restriction on the operation of their account. It is running and active account and the banker is under an obligation to repay these deposits only when the customer demands payment through a cheque, card or otherwise, and that's why these are termed as demand liabilities.



Generally, a much higher level of minimum balance has to be maintained by the customer in this account. He is issued with a cheque book and a passbook, but no interest is paid to him on these deposits. In fact, he has to pay bank charges to the banker for maintaining this account for him. Clean or secured overdraft facilities are also granted against such accounts. Banks also extend free outstation cheque collection facility and, issue of demand drafts to such account holders.


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