20U1CBMC2 I B.

Com (BM) Banking Theory

DR. R. SARAVANAVEL

Unit - I
Banking - Origin - Banking System Components - Classification of Banks - Banking
Systems - Functions of Commercial Banks – Role of Banks in Economic Development.

Define Bank
“ Bank is such a financial institution which collects money in current, savings or fixed
deposit account; collects cheques as deposits and pays money from the depositors‟ account
through cheques.”- --Sir John Pagette.

What is the origin of the word ‘bank’?

The name bank is derived from the Italian word banco “desk/bench”, used during the
Renaissance by Florentine’s bankers. These bankers used to make their transactions above a
desk covered by a green tablecloth.

There are traces of banking activity even in ancient times. In fact, the word traces its origins
back to the ancient Roman Empire, where moneylenders would set up their stalls in the
middle of enclosed courtyards called macella on a long bench called a bancu. It is from here
that the words banco and bank are derived.

List out the objectives of bank

 To create propensity of savings amongst the people.
 To motivate people for investing money with a view to bringing solvency in them
 To create money against money as an alternative for enhancing supply of money.
 To build up capital through savings.
 To expedite investments.
 To extend services to the customers.
 To maintain economic stability by means of controlling money market.
 To extend co-operation and advices to the Govt. on economic issues.
 To assist the Govt. for trade& business and socio-economic development.
 To issue and control notes and currency as a central bank.
 To maintain and control exchange rates as a central bank.

State the characteristics of Indian banking system

 Dealing in Money: Bank is a business activity which deals with other people’s money i.e.
getting money from depositors and lending the same to borrowers.

 Banking Business: A bank is a financial institution which does banking activities of selling
financial services like home loans, business loans, lockers, fixed deposit etc. In order to
enable people to confirm that it is a bank and is dealing in money, for easy identification,
a bank should add the word “bank” as its last name.

 Acceptance of Deposit: A bank accepts money from the people in the form of deposits
where there is an obligation to refund deposits on demand or after the expiry of a fixed
tenure as they feel it is a safest place to deposit money.

 Lending Money: A bank provides advance money in the form of loans to needy persons for
promotion & development of business, purchase of home, car etc.
  Easy Payment and Withdrawal Facility: Payment & Withdrawal of money can be made
through issuance of cheques & drafts, ATM, Online Fund Transfer without the need for
carrying money in hand. A bank provides easy payment and withdrawal facility to its
customers in the form of cheques, drafts, ATM’s and ETF.

 Motive of Profit with Service Orientation: A Bank has a motive of employing funds
received as deposits from the public in a profitable manner with service oriented approach.

 Linking Bridge: Banks collect money from those who have surplus money and give the
same to those who are in need of money. It acts as a trust/custodian of funds of its
customers.

Banking System

 Branch banking
 Unit banking
 Correspondent banking
 Group banking
 Chain banking
 Deposit banking
 Investment banking
 Mixed banking
 Offshore banking.

Branch Banking
 Branch Banking implies a banking system wherein a banking organization, through
its wide network of branches provides banking services to its customers throughout
the country and even in abroad.

 Branch banking can be defined as a banking practice wherein a bank has several
branches that operate throughout the country and even in foreign countries, to provide
services to its customers.

Unit Banking
 Unit banking is a type of banking system adopted in many countries wherein there is
a single independent small bank that caters a particular locality.

 A unit bank has no branches at all and for the purpose of providing facilities
related to remittance and collection of funds, a unit bank takes recourse of the
correspondent banking system.
Correspondent Banking
Correspondent banking prevalent in over 200 countries is a profitable way of doing business
by banks in foreign countries in which they don’t have physical presence or limited
operational permissions. Correspondent banks thus act as banking agent for a home bank and
provides various banking services to customers where otherwise the home bank does not
operate.
 It helps customers to perform banking operations at ease even in places where their banks
don’t have physical presence. Customers stay loyal to such banks as they get excellent
customer service even in foreign lands.

Group banking
A plan offered by banks designed to be used by groups rather than individuals. A common
example is a company plan offered to employees. Group banking can also provide a more
personalized banking relationship for the members if the bank designates one representative, who is
generally more knowledgeable about the group’s needs, as the point of contact for all the members
of the group.

Chain Banking
Chain banking system refers to the type of banking when a group of persons come together to
own and control three or more independently chartered banks. Each of these banks could maintain
their independent existence despite common control and ownership. The banks in the chains were
assigned specific functions so there was no loss of profits and overlapping of interests.

Investment Banking
Investment Banking is about managing investments for a bank’s clients that offers such
services. These services can be availed by high net-worth individuals, corporations and even
governments to plan and manage large projects, saving them time and money by identifying risks
associated with the project before they move forward.

Mixed Banking
Mixed Banking is the system in which banks undertake activities of commercial and
investment banking together. These banks give short-term and long-term loans to industrial
concerns. The banks appoint experts which give valuable advice on various financial issues and also
help gauge the financial health of companies. Industries don’t have to run to different places for
differential financial needs. They thus promote rapid industrialization. They may however pose a
grave threat to liquidity of a bank and lead to bad debts.

Offshore bank
An offshore bank is a bank regulated under international banking license (often
called offshore license), which usually prohibits the bank from establishing any business activities in
the jurisdiction of establishment. An account held in a foreign offshore bank, is often described as
an offshore account.
Describe the advantages and disadvantages of branch banking
 Economies of Large Scale operations: Branch banking enjoys the advantages and economies of large
scale operations. Under branch banking system economies can maintained through large scale of
operations and wider geographical coverage increase public confidence in the banking system.

 Economy of Cash Reserves: Under branch banking system a particular branch can operate without
keeping large amounts of reserves. In time of need, resources can be transferred from one branch to
another. It is not easy for a .unit bank to draw on another unit bank.

 Proper use of capital: There is a proper use of capital under the branch banking system. Since the
resources are transferred from one branch to another. So the capital can be properly used by
investing in the profitable branches.

 Economy of Costs: Branch banking has the advantage of effecting remittances of funds from one
place to another with greater ease and at a lesser cost than unit banking, for inter-office indebtedness
can be far more easily adjusted.

 Risks-spreading Economy: The spreading of risks geographically is another major advantage of the
branch banking system. In branch banking, losses incurred one branch can be offset by profits
earned by the profit making branches which is not possible in case of unit banking.

 Easy and cheaper transfer of funds: Since the branches of bank under branch banking are spread all
over the country, it is easier and cheaper, for it to transfer funds from one place to another.

 Greater Safety and Liquidity: Branch banking also offers a wider scope for the selection of diverse
securities and varied investments, so that a higher degree of safety and liquidity can be maintained.

 Balanced economical growth: Under branch banking, the banking facilities can be made available to all
cities, towns, and even backward areas in the country. Thus, branch banking is very helpful in
achieving a balanced growth of the country's economy.

Disadvantages or Demerits of Branch Banking

 Danger of Mismanagement: Under the branch banking system a number of difficulties as regards
management, supervision and control, a number of branches undue expansions lead the danger of
mismanagement.

 Delays in Decision-making: The system of branch banking also suffers from red tape and delay on
account of the inadequate authority of branch managers. Usually, application for big credits has to be
referred to the head office by the branch manager. This causes delay and gives little initiative to
branch managers.

 Lack of Personal Contact: A large bank tends to become more and more impersonal in its dealings.
The general managers have hardly any personal contact with the local people or the staff of different
branches.

 High operating and maintenance expenses: Branch banking is very expensive, because with the
opening of too many branches, establishment and maintenance charges of the branches are bound
to be high and, as a result, profits may shrink.

 Concentration of Monopoly Power in the hands of few banker: Branch banking sometimes creates
monopoly power in the hands of few large bankers. Such a monopoly power in the hands of a few big
bankers is a source of danger to the community whose goal is a socialistic pattern of society.

 Lack of initiative: Branch banking lacks initiative. No branch office can take independent decisions
and also branch manager has limited powers.

 Regional imbalances: Branch banking encourages regional imbalances. The financial resources of
economically backward areas tend to get transferred to industrial and business centres. Due to which
backward areas continue to be neglected and remain over backward.
Differentiate branch banking and unit banking

 Unit banking is a type of banking system adopted in many countries wherein there is
a single independent small bank that caters a particular locality. On the other hand,
branch banking can be defined as a banking practice wherein a bank has several
branches that operate throughout the country and even in foreign countries, to
provide services to its customers.
 While unit banks are not influenced by ups and downs of the local economy, branch
banks remain unaffected by the ups and downs of the local economy, however, they
are hit by the changes in the national economy.
 A unit bank has more independence of operations, as compared to the branch bank.
 When it comes to supervision cost, it is higher in case of a unit bank than a branch
bank.
 A branch bank has a large pool of financial resources, at its disposal. Conversely, in a
unit banking system, the financial resources are limited to the particular unit only.
 If we talk about competition, there is a high level of competition between the bank
branches to sell its products and provide services to the customers. On the contrary,
in the unit banking system, the competition hardly exists within the bank.
 In the unit banking system, the rate of interest is not fixed as the unit bank has its
own policies and guidelines. As against, in a branch banking, the interest rate is
decided by the head office, as per the directions of the central bank.
 As a unit bank is an independent one, it does not need to rely on any other body for
taking important decisions. In contrast, in a branch banking system, the decision
making is time-consuming, as it has to rely on the head office.

Explain the classification of banks

1. Commercial Banks:
These are the most common and important type of banking institution. A commercial bank is
a monetary institution which serves the interest of its depositors by providing with security vaults for
the surplus resources and, on the other hand, makes profits by investing its resources in the
productive measures by extending loans.

2. Industrial Banks:
These banks have come up for the promotion of new industrial concerns. Industrial banks or
investment banks provide medium and long-term loans and also supply fixed capital to the industrial
concerns by subscribing to the shares and debentures of the industrial enterprises. Indian Finance
Corporation and Investment Corporation of India are the examples of industrial banks in India.
3. Exchange Banks:
Exchange banks are those banks which deal in foreign exchange, that is, to convert the rupee
into foreign currencies and vice versa. Dealings in foreign exchange are also handled by the
commercial banks. In our country, dealings in foreign exchange are conducted by the foreign
exchange banks as well as Indian commercial banks.

4. Co-Operative Banks:
Co-operative banks have been set up to meet the requirements of very poor farmers and small scale
industrial concerns.

These banks are classified in two groups, such as:

(i) Central Co-Operative Banks:
Members of these banks can be individual or the societies. These banks can get capital resources
from their shares, from public deposits and also get loans from the State Co-operative Banks.

(ii) State Co-Operative Banks:

These banks are also called ‘apex banks’. Their area of operation extends over a state. These
banks get short and medium- term loans from the Reserve Bank of India. The co-operative banks
play a very useful role in agriculture credit.

5. Land Mortgage Banks:

These banks provide long-term credit to farmers and agriculturists against the security of their land.
The loan is extended for the purchase of tools, implements, equipments and for financing permanent
improvements with a view to increase yield from land. These banks raise their resources in the form
of shares and by issuing of long-term debentures.

6. Central Bank:
At present there in no country in the world, which has not set up a Central Bank of its own. A
Central Bank is so-called because it occupies a central position in the monetary and banking system
of a country and is the highest financial authority. It is the apex bank and the statutory institution in
the money market of a country.

7. Saving Banks:
These institutions have been set up to promote the savings of the middle income group of the
society. In our country, postal saving banks arc a good example of such banks. These banks collect
the small savings of the public and operate savings accounts. Savings accounts are also operated by
the Indian commercial banks.
8. Indigenous Banks:
These banks have been called by different names in different parts of the country, such as, seths,
shroffs, mahajans, sahukars, chettis, etc. The indigenous bankers generally lend money and finance
the internal trade of our country. The rate of interest is comparatively higher.

9. Regional Rural Banks:

Rural banks, meant for the development of rural economies, have been established by the Central
Government at the request of commercial banks who have sponsored such proposal and are called
the Sponsor Banks.

What is Commercial Bank?

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

I Primary Functions

1. Accepting Deposits – Commercial banks accept deposits from their customers in the form of
saving, fixed, and current deposits.
 Savings Deposits – Savings deposits allow a customer to credit funds towards their
accounts for up to a certain limit. These deposits are preferred by individuals with a
fixed income, utilized to create savings over time.
 Fixed Deposits – Fixed deposits come with a predetermined lock-in period. Fixed
deposits are also referred to as time deposits as the funds are deposited for a specific
time frame.
 Current Deposits – Current deposits allow account holders to deposit and withdraw
money whenever necessary. In some cases, current accounts also offer overdrafts
until a pre-specified limit to individuals and businesses.

2. Providing Loans – One of the main functions of commercial banks is providing credit to
organizations and individuals, and profit from the earned interest. Usually, banks retain a
small reserve for their expenses while offering the remaining amount to customers as various
types of short and long-term credits.

 Cash Credit – Commercial Banks and its Functions include extending

advances to individuals and organizations against bonds, inventories, and
other types of securities. This facility, commonly known as cash credit,
provides a more substantial sum when compared to other forms of credits.
  Short-Term Credits – Short -term loans are usually pledged without any
security, offering a smaller loan amount and repayment tenor. These are also
referred to as personal loans.

3. Credit Creation – A unique function of commercial banks is credit creation. Instead of

offering liquid cash, banks create a line of credit and transfer the loan to a business or
commercial body all at once.

II Secondary Functions

 Providing locker Facilities – Commercial banks provide locker facilities to customers

who want to store valuables safely. Locker facilities eliminate the impending risk of theft
or loss, which prevail when kept at home.
 Dealing in Foreign Exchange – Commercial banks help provide foreign exchange to
individuals and organizations which export or import goods from overseas. However, only
certain banks which have the license to deal in foreign exchange are eligible for such
transactions.
 Exchange of Securities – Another function of commercial banks is to trade in bonds and
securities. Customers can purchase or sell the units from the financial institution itself,
which offers more convenience than alternate approaches.
 Discounting bills of exchange- Bill discounting is considered as a profitable investment
for banks. Bills create a steady flow of funds, while not becoming a risky venture during
payment as it is considered as a negotiable instrument. These also do not involve the
financial institution in any litigation.
 Bank as an Agent – Commercial Bank and its Function also requires them to provide
finance-related services to customers, fulfilling the role of an agent. These services usually
include –
o Acting as an administrator, trustee, or executor of a customer-owned estate.
o Assisting customers with tax returns, tax refunds, and other similar tasks.
o Serving as a platform to pay premiums, repay loan installments, etc.
o Offering a platform for electronic transaction of funds, processing of cheques, drafts,
bills, etc.
 Explain the role of banks in economic development
A proper financial sector is of special importance for the economic growth of developing and
underdeveloped countries. The commercial banking sector which forms one of the backbones of the
financial sector should be well organized and efficient for the growth dynamics of a growing
economy. No underdeveloped country can progress without first setting up a sound system of
commercial banking. The importance of a sound system of banking for a developing country may be
depicted as follows:
1. Capital Formation
The rate of saving is generally low in an underdeveloped economy due to the existence of deep-
rooted poverty among the people. Even the potential savings of the country cannot be realized due to
lack of adequate banking facilities in the country. To mobilize dormant savings and to make them
available to the entrepreneurs for productive purposes, the development of a sound system of
commercial banking is essential for a developing economy.
2. Monetization
An underdeveloped economy is characterized by the existence of a large non monetized sector,
particularly, in the backward and inaccessible areas of the country. The existence of this non
monetized sector is a hindrance in the economic development of the country. The banks, by opening
branches in rural and backward areas, can promote the process of monetization in the economy.

3. Innovations
Innovations are an essential prerequisite for economic progress. These innovations are mostly
financed by bank credit in the developed countries. But the entrepreneurs in underdeveloped
countries cannot bring about these innovations for lack of bank credit in an adequate measure. The
banks should, therefore, pay special attention to the financing of business innovations by providing
adequate and cheap credit to entrepreneurs.
4. Finance for Priority Sectors
The commercial banks in underdeveloped countries generally hesitate in extending financial
accommodation to such sectors as agriculture and small scale industries, on account of the risks
involved there in. They mostly extend credit to trade and commerce where the risk involved is far
less. But for the development of these countries it is essential that the banks take risk in extending
credit facilities to the priority sectors, such as agriculture and small scale industries.
5. Provision for Medium and Long term Finance
The commercial banks in under developed countries invariably give loans and advances for a short
period of time. They generally hesitate to extend medium and long term loans to businessmen. As is
well known, the new business need medium and long term loans for their proper establishment. The
commercial banks should, therefore, change their policies in favour of granting medium and long
term accommodation to business and industry.
 Unit I Assignment

Section – B

1. State the Characteristics of Indian banking system.

2. Distinguish between unit banking and branch banking
3. Briefly explain the role of banks in economic development

Section – C
4. Explain the functions of commercial banks

&&&&&&&&&