Financial Institutions: Commercial
Banking and Development
Financial Institutions (DFIs)
UNIT I
Commercial Bank
A commercial bank is a type of financial organisation
that handles all operations relating to money deposits
and withdrawals for the general public, as well as
investment loans and other similar activities. These
banks are profit-making enterprises that do business
only for the purpose of profit.
A commercial bank’s two fundamental qualities are
lending and borrowing. The bank accepts deposits and
distributes funds to various initiatives in order to
generate income (profit). The borrowing rate is the rate
of interest that a bank gives to depositors, while the
lending rate is the rate at which a bank lends money.
How Do Commercial Banks Work?
Functions of Commercial Bank
Commercial Banks perform various functions which
can be categorized into
Primary Functions
Secondary Functions
Agency Functions
General Utility Functions
Primary Functions
Accepting Deposits and Advancing of Loans are the
two primary functions performed by commercial
banks.
1. Accepting Deposits
One of the most essential functions of commercial
banks is accepting deposits. Commercial banks
accept deposits from their customers in different
forms based on the requirements of different
sections of society. The main types of deposits
include:
Accepting Deposit
1. Demand Deposits or Current Account Deposits: The deposits which are
repayable on demand by the banks are known as demand deposits or current
account deposits. In general, these kinds of deposits are maintained by
businessmen to make transactions with these deposits. One can get the amount
deposited as demand deposits by a cheque without any restriction. Besides,
commercial banks do not pay any interest to the depositors on these accounts;
instead, they charge some amount as a service charge for running these accounts.
2. Fixed Deposits or Time Deposits: The deposits in which the depositor,
deposits money with the bank for a fixed time period are known as fixed deposits
or time deposits. These deposits do not enjoy a cheque facility and carry a high
interest rate.
3. Saving Deposits: The deposits, which include combined features of demand
deposits and fixed deposits are known as saving deposits. The depositors have the
cheque facility to withdraw money from their accounts, but there are some
restrictions on the number and amount of withdrawals. The restrictions are
imposed to discourage the frequent use of saving deposits. Besides, the interest
rate on saving deposits is less than the interest rate on fixed deposits.
Advancing of Loans
The banks are not allowed to keep the amount
deposited with them, idle. Therefore, commercial
banks have to keep some amount of the total
deposits as cash reserves and lend the rest of the
balance to needy borrowers and charge interest from
them. The interest received by commercial banks
from advancing loans is the main source of their
income. Some of the different types of loans and
advances made by commercial banks are:
Advancing of Loans
Cash Credit: The loan given to the borrowers against their current
assets like stocks, bonds, shares, etc., is known as cash credit. For
this, a credit limit is sanctioned to the borrower, and money is
credited to this account. The borrower can now withdraw any
amount at any time within his credit limit. Interest is charged from
the borrower on the amount actually withdrawn by him.
Demand Loans: The loans given by the banks which they can
recall at any time on demand are known as demand loans. The
entire amount of the demand loan is credited to the borrower’s
account, and interest is charged on that amount.
Short-term Loans: Personal loans given to borrowers against
some collateral security are known as short-term loans. The amount
taken as a loan is credited to the account of the borrower, and he
can withdraw that money from his account. Interest is charged on
the entire sum of the loan granted.
Secondary Functions
Besides primary functions, commercial banks also perform some
secondary functions:
1. Overdraft Facility
A facility that allows the customer to overdraw from the amount of
his current account upto an agreed limit is known as an overdraft
facility. In general, an overdraft facility is given to respectable and
reliable customers for a short period. Besides, the customers have to
pay interest on the amount overdrawn by them.
2. Discounting Bills of Exchange
A facility in which the holder of a bill of exchange, before its
maturity date can get the bill discounted with the bank. The bank
pays the amount to the holder after deducting some amount as
commission. Now, on the date of maturity, the party which has
accepted the bill pays back the money to the bank.
Agency Functions
There are some agency functions performed by commercial banks
for which they charge some commission from their clients. Some of
these functions are:
Transfer of Funds: With the help of instruments like mail
transfers, demand drafts, etc., commercial banks provide their
customers with the facility of easy and economical remittance of
funds from one place to another.
Collection and Payment of Various Items: Commercial banks
provide their customers with the service of collecting bills, interest,
subscriptions, rents, and other periodical receipts on their behalf.
They also make payments for insurance premiums, taxes, etc., on
their customer’s standing instructions.
Purchase and Sale of Foreign Exchange: The central bank
gives authority to commercial banks to deal in foreign exchange.
Commercial banks, on the behalf of their customers, buy and sell
foreign exchange and also helps in promoting international trade.
Agency Functions
Purchase and Sale of the Securities: Commercial
banks on behalf of their customers, purchase and sell
government securities and stocks and shares of private
companies.
Income Tax Consultancy: Commercial banks provide
advice to their customers related to income tax. They also
help them in the preparation of their income tax returns.
Trustee and Executor: Commercial banks play the
role of a trustee and preserve the will of their customers
and as an executor, execute the will after their death.
Letters of Reference: Commercial banks provide
information about the economic position of their
customers to the traders and vice-versa.
General Utility Functions
Locker Facility: Commercial banks provide their customers with
the facility of lockers or safety vaults so they can keep their valuable
things in safe custody.
Traveller’s Cheques: To avoid the risk of taking cash on their
journey, commercial banks provide their customers with the facility
of traveller’s cheques.
Letter of Credit: Sometimes people need to show their
creditworthiness for various reasons. Commercial banks certify the
creditworthiness of their customers whenever required.
Underwriting Securities: Commercial banks also performs the
function of underwriting securities. And as the public has full faith
in the bank’s creditworthiness, they do not hesitate in purchasing
the securities which are underwritten by banks.
Collection of Statistics: Commercial banks advice their
customers on financial matters by collecting and publishing
statistics related to commerce, trade, and industry.
Importance of Commercial Banks
1. Help Consumers: Commercial banks help consumers in
purchasing durable consumer goods like Air Conditioners,
Refrigerators, T.V., etc., which are out of their paying capacity limit,
by advancing credit to them. By doing so, commercial banks create
demand for these consumer goods.
2. Provision of Finance and Credit: Commercial banks play an
essential role as a source of finance and credit for industry and
trade. These banks not only perform activities that are confined to
domestic trade and commerce but are also extended to foreign
trade.
3. Accelerating the Rate of Capital Formation: Commercial
banks encourage people’s habit of thrifting and mobilise their
savings which are then allocated effectively among the ultimate
users of funds; i.e., the investors for productive investment.
Therefore, savings made by people result in capital formation
forming the basis of economic development.
Importance of Commercial Bank
4. Promoting Balanced Regional
Development: Commercial banks play an essential role by
providing credit facilities to rural people by opening up their
branches in backward areas. These banks use the funds
collected in the developed regions to channelise investment in
the under developed regions of the country. By doing so,
commercial banks bring out more balanced regional
development.
5. Developing Entrepreneurship: Commercial banks
promote entrepreneurship by way of underwriting shares of
new and existing companies and also, grant assistance for the
promotion of new ventures or for financing promotional
activities. These banks provide finance to the loss-
making/sick industries to make them viable units.
Role of Commercial Banks
They aid in the successful implementation of monetary policies.
They boost the industrial sector by offering short, medium, and long-term
finance.
They accelerate trade by offering agency services, overdraft facilities, and
other solutions to wholesale and retail businesses.
These financial institutions help lower and middle-class customers in
procuring consumer products on loans—easy repayment options.
Banks also operate on rural and regional fronts.
The agricultural sector receives strong financial backing from commercial
institutions facilitating crop cultivation, irrigation facilities, dairy farming,
poultry farming, horticulture, and pisciculture.
They adopt innovative ways to facilitate easy banking—automation,
digitalization, and artificial intelligence.
They ensure a superior level of data security for their clients.
Types of Commercial Banks
They are further classified into the following categories:
Private Sector Banks: The majority stake is owned by
private shareholders (individuals or corporates). They
accept deposits and distribute loans to individual customers,
small businesses, and medium-sized businesses.
Public Sector Banks: For public banks, majority equity lies
in the hands of the government. Nationalized banks provide
financial services to mass customers at affordable rates.
Foreign Banks: As the name suggests, these financial
institutions operate in foreign countries but have head offices
in the parent country. The bank’s foreign branches take
deposits, extend loans, engage in securities trading, and
facilitate foreign exchange functions.
Development Financial Institutions
The development finance institutions or development
finance companies are organizations owned by the
government or charitable institution to provide funds for
low-capital projects or where their borrowers are unable
to get it from commercial lenders. Development finance
institutions (DFIs) occupy an intermediary space
between public aid and private investment, facilitating
international capital flows.
Types of Finance provided are –
Medium (1 – 5 years) and
Long term ( >5 years).
Objectives of Development Finance
Institutions
The prime objective of DFI is the economic development of the
country
These banks provide financial as well as the technical support to
various sectors
DFIs do not accept deposits from people
They raise funds by borrowing funds from governments and by
selling their bonds to the general public
It also provides a guarantee to banks on behalf of companies and
subscriptions to shares, debentures, etc.
Underwriting enables firms to raise funds from the public.
Underwriting a financial institution guarantees to purchase a
certain percentage of shares of a company that is issuing IPO if it is
not subscribed by the Public.
They also provide technical assistance like Project Report, Viability
study, and consultancy services.
Some Important DFIs (Sector Specific)
Industry
IFCI – 1st DFI in India. Industrial Corporation of India was
established in 1948.
ICICI – Industrial Credit and Investment Corporation of India
Limited established in 1955 by an initiative of the World Bank.
It established its subsidiary company ICICI Bank limited in
1994.
In 2002, ICICI limited was merged into ICICI Bank Limited
making it the first universal bank of the country.
Universal Bank – Any Financial institution performing the
function of Commercial Bank + DFI
It was established in the private sector and is still the Only DFI
in the private sector.
Some Important DFIs (Sector Specific)
IDBI – Industrial Development Bank of India was set
up in 1964 under RBI and was granted autonomy in
1976
It is responsible for ensuring adequate flow of credit to
various sectors
It was converted into a Universal Bank in 2003
IRCI – Industrial Reconstruction Corporation of India
was set up in 1971.
It was set up to revive weak units and provide financial
& technical assistance.
Some Important DFIs (Sector Specific)
SIDBI – Small Industries development bank of India
was established in 1989.
Was established as a subsidiary of IDBI
It was granted autonomy in 1998
Some Important DFIs (Sector Specific)
Foreign Trade
EXIM Bank – Export-Import Bank was established in January 1982
and is the apex institution in the area of foreign trade investment.
Provides technical assistance and loan to exporters
Agriculture Sector
NABARD – National Bank for agriculture and rural development was
established in July 1982
It was established on the recommendation of the Shivraman
Committee
It is the apex institution in the area of agriculture and rural sectors
It functions as a refinancing institution
Housing
NHB- National Housing Bank was established in 1988.
It is the apex institution in Housing Finance
Role of DFIs
DFI provide long-term credit for capital-intensive investments
spread over a long period and low yielding rates of return,
such as urban infrastructure, mining and heavy industry, and
irrigation systems.
They act as critical intermediaries for channelling long-term
finance required for infrastructure and realising higher
economic growth.
In India, after the 1991 reforms, major DFIs were converted
into commercial banks. However, after these there were few
institutions in the country which could take care of industrial
or infrastructure development.
Therefore, in order to plug the infrastructure deficit, the
government has taken a positive step by making a proposal to
re-establish the DFIs in India.
DFI: Background & Present Status
Development banks are different from commercial
banks, which mobilize short- to medium-term deposits
and lend for similar maturities to avoid a maturity
mismatch.
In India, the first DFI was operationalized in 1948 with
the setting up of the Industrial Finance Corporation
(IFC).
DFIs in India like Industrial Development Bank of India
(IDBI), Industrial Credit and Investment Corporation of
India (ICICI) and IFCI did play a significant role in
aiding industrial development in the past with the best of
the resources made available to them.
DFI: Background & Present Status
However, after 1991 reforms, the concessional funding they
were getting from Reserve Bank of India (RBI) and the
government was no longer available in the subsequent years.
As a consequence, IDBI and ICICI had to convert themselves into
universal banks.
While these DFIs disappeared, a new set of institutions like
IDFC (1997), IIFCL (2006) and more recently, National
Investment and Infrastructure Fund (NIIF) (2015) emerged to
focus on funding infrastructure.
In budget 2021, with the initial capital base of ₹20,000 crore
as committed by the government, the new DFI, assuming a
leverage of around 7 times, can lend up to ₹1.4 trillion.
Need/Significance of DFI
Infrastructure Building: Inadequate and inefficient
infrastructure leads to high transaction costs, which in
turn stunts an economy’s growth potential.
Therefore, DFIs makes sense as the Centre government envisages
mobilizing nearly ₹100 lakh crore for the ambitious National
Infrastructure Pipeline.
International Precedent: Irrespective of the level of
development, countries across the world have set up
development banks to finance key infrastructure and
manufacturing projects.
For instance, the European Investment Bank (EIB) acts like a DFI for
Europe.
Need/Significance of DFI
Lack of Finance for Infrastructure: Although
India has a long-term debt market for the
government securities and corporate bonds cut, it is
still out of reach of retail investors and unable to
meet the large infrastructure financing needs.
Economic Crisis Triggered By Covid-19
Pandemic: The Covid-19 pandemic has exacerbated
inequality, the poverty gap, unemployment, and the
economy’s slowing down.
Thus, infrastructure building through DFIs can help in quick
economic recovery.
Challenges for DFIs
Mobilizing Capital For DFI: To lend for the long
term, DFI requires correspondingly long-term sources of
finance.
In this context, the government may allow equity investment by
institutions having a long term horizon like insurance companies,
pension funds to augment the capital.
Further, DFI can be adequately capitalized by the sovereign-backed
funds, alternative routes such as capital gains/tax-free bond issues,
external borrowings, and loans from multilateral agencies.
Administration of DFI: The ownership and
organisation structure are critical and require greater
clarity as this would have bearing on the functioning,
flexibility, governance of the institution and its long-term
sustainability.
Challenges for DFIs
Functionality of DFI: It is critical to hire experts with
a good understanding of infrastructure, policies,
financing and risk management to work with the
institution by offering market-driven lending packages.
Reaching Out Retail Investors: The government
needs to set up institutions and network platforms to
reach retail investors and incentivise and structure the
bonds/instruments so that they are attracted to invest
long-term in those instruments.
Periodic Review of DFI: Periodic reviews are
necessary to ensure that the DFI remains relevant by
taking into account changing priorities of the economy
and making consequential adjustments in the role.
Thank You
