Basic Concepts and Need of Banking

Definition of a Bank
An organization that accepts deposits of money from the public for lending or
investment, repayable on demand or otherwise and withdrawal by cheque draft or
order or otherwise.

Banks are the financial institution, authorised by the government to conduct banking
activity like accepting deposits, granting credit, managing withdrawals pay interest,
clearing cheques and providing general utility services to the customers. Banks are
the apex organisation, which dominates the entire financial system of the country. It
acts as a financial intermediary, between the depositors and borrowers, that ensures
smooth functioning of the economy.

Banks can be public sector banks, private sector banks or foreign banks. They are
responsible for making loans, creating credit, mobilisation of deposits, safe and time
bound transfer of money and providing public utility services. Ownership of a
commercial bank lies with the shareholder and they are operated with the profit motive.

Types of Deposits
1) CASA ie current account and savings account
2) Time deposits: ie fixed deposits, recurring deposits etc.
CASA stands for Current Account and Savings Account which is mostly used in West
Asia and South-east Asia. CASA deposit is the amount of money that gets deposited
in the current and savings accounts of bank customers. It is the cheapest and major
source of funds for banks. The savings accounts portion pays more interest compared
to current accounts.

Banks offer mainly two types of accounts. These could be term deposits- like fixed or
recurring deposits or non-term deposits - like current or savings accounts.

A term deposit is valid for a fixed period of time and in return the bank pays interest at
a fixed rate with the condition that you do not touch the money in the interim. For
example, you put in Rs 10,000 in a fixed deposit for a period of seven years and the
bank pays you an interest at the rate of 12 per cent per annum.

On the other hand, current and savings accounts are used for daily operations and are
valid as long as the customer wants them to be. They have lower interest rates than
term deposits depending on the bank’s terms and conditions. For example, in an urban
area ICICI Bank pays 3.0 per cent interest on a savings account with cheque book on
a minimum balance of Rs 10,000.

Since interest rates are lower than term deposits, CASA is a cheaper source of funds
for banks. For this reason, financial experts also look at CASA ratio to understand a
bank’s financial health, as the same reflects the bank’s capacity to raise money with
lower borrowing costs.

Net Demand and Time Liabilities

Definition: The Net Demand and Time Liabilities or NDTL shows the difference
between the sum of demand and time liabilities (deposits) of a bank (with the public or
the other bank) and the deposits in the form of assets held by the other bank.

In other words, the net demand and time liabilities of a bank can be calculated by using
the following formula:

Bank’s NDTL = Demand and time liabilities (deposits) – deposits with other
banks

Suppose a bank has deposited 5000 with the other bank and its total demand and time
liabilities (including the other bank deposit) is 10,000. Then the net demand and time
liabilities will be 5,000 (10,000-5,000).

Thus, the deposits of a bank are its liabilities that can be in the form of demand liability,
time liability and other demand and time liabilities. Let’s discuss these in detail:

Demand Liabilities: The demand liabilities include all those liabilities of a bank which
are payable on demand. Such as current deposits, cash certificates and
cumulative/recurring deposits, outstanding telegraphic transfers, Demand drafts,
margins against the letter of credit/guarantees, credit balance in cash credit account,
etc., all are paid on demand.

Time Liabilities: Time liabilities are those liabilities of a bank which are payable
otherwise on demand. These include fixed deposits, cash certificates, staff security
deposits, time liabilities portion of saving deposits account, margin held against the
letter of credit (if not payable on demand), gold deposits, etc.

Other Demand and Time Liabilities: These include all those miscellaneous liabilities
which are not covered in above two types of liabilities. Such as interest accrued on
deposits, unpaid dividend, suspense account balances showing the amount due to
other banks or public, participation certificates issued to other banks, cash collaterals,
etc.

Definition of NBFC
A Non-Banking Financial Company (NBFC) is a company registered under the
Companies Act, 1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or
other marketable securities of a like nature, leasing, hire-purchase, insurance
business, chit business but does not include any institution whose principal business
is that of agriculture activity, industrial activity, purchase or sale of any goods (other
than securities) or providing any services and sale/purchase/construction of
immovable property. A non-banking institution which is a company and has principal
business of receiving deposits under any scheme or arrangement in one lump sum or
in installments by way of contributions or in any other manner, is also a non-banking
financial company (Residuary non-banking company).

These entities are not banks, but they are engaged in lending and other activities, akin
to that of banks like providing loans and advances, credit facility, savings and
investment products, trading in the money market, managing portfolios of stocks,
transfer of money and so on.

It is indulged in the activities of hire purchasing, leasing, infrastructure finance, venture

capital finance, housing finance, etc. An NBFC accepts deposits, but only term
deposits and deposits repayable on demand are not accepted by it.

A company incorporated under the Companies Act, 1956 and desirous of commencing
business of non-banking financial institution as defined under Section 45 I(a) of the
RBI Act, 1934 should comply with the following:

i. it should be a company registered under Section 3 of the companies Act, 1956

ii. It should have a minimum net owned fund of ₹ 200 lakh.

It is not legally permissible for other entities to accept public deposits. Unincorporated
bodies like individuals, partnership firms, and other association of individuals are
prohibited from carrying on the business of acceptance of deposits as their principal
business. Such unincorporated bodies are prohibited from even accepting deposits if
they are carrying on financial business.

All NBFCs are not entitled to accept public deposits. Only those NBFCs to which the
Bank had given a specific authorisation and have an investment grade rating are
allowed to accept/ hold public deposits to a limit of 1.5 times of its Net Owned Funds.

Presently, the maximum rate of interest an NBFC can offer is 12.5%. The interest may
be paid or compounded at rests not shorter than monthly rests. The NBFCs are
allowed to accept/renew public deposits for a minimum period of 12 months and
maximum period of 60 months. They cannot accept deposits repayable on demand.

The list of registered NBFCs is available on the web site of Reserve Bank of India and
can be viewed at www.rbi.org.in

In India, these companies emerged in the mid-1980’s. Kotak Mahindra Finance, SBI
Factors, Sundaram Finance, ICICI Ventures are examples of popular NBFC’s.

Difference between NBFC and Bank (refer to class notes)

Calculation of Minimum Average Balance

In 2017-18, as many as 21 public sector banks and three major private sector lenders
collected a whopping Rs 5,000 crore from customers for non-maintenance of minimum
balance in their accounts. Maintaining minimum average balance (MAB) in a savings
account is important yet neglected by many. You must maintain the minimum balance
in your account to avoid penalties.

MAB is the average of all the closing-day balances in a given month. To calculate the
MAB, you need to add each day's end-of-the-day balance and divide it by the number
of days in that month.

MAB = (Sum of all the EOD closing balances)/ (number of days in a month)
Illustration was discussed in the class

Calculation of Interest on savings account

According to the guidelines rolled out by the Reserve Bank of India in 2010, the
interest on savings account is calculated on daily outstanding balance. It means
that you earn interest on the bank balance you have at the end of each day.

The formula for the same is as follows,

Interest on savings account= Daily balance*Rate of interest* (No. of days/365)

Illustration was discussed in the class

Premature withdrawal of FD
Fixed deposits generally pays higher interest than savings account. But it comes
with a lock-in period. If you withdraw before the fixed tenure then a penalty is levied
on the withdrawal, i.e. you will receive the amount after deduction of a small
percentage of it, which generally ranges from 0.5%-1%.

Let’s understand this better with an example,

Mr X has invested Rs. 100,000 in fixed deposit for a period of 1 year, earning an
interest of 5.50% p.a. . The 6 month interest rate is 4%. Premature withdrawal
penalty is 0.5%.

Initially, when he had made the deposit, he had promised to keep the deposit for a
period of 1 year for which the bank had offered 5.50% interest. But now that he is
withdrawing earlier, the bank will pay her the revised interest which is applicable
for a 6 month fixed deposit. In our case, it is 4%.

The point to note here is that because of premature withdrawal, the bank will not
pay him interest at the rate of 5.5% for a period of 6 months. It will pay him interest
applicable for a six month deposit period.
Along with it, the bank will also charge a penalty for breaking the promise, i.e.
premature withdrawal, which is 0.5% in our example. Therefore, the effective
interest that MR X will receive is, 4% – 0.5% = 3.5%.

Illustration was discussed in the class

Refer to the Article on Bank Moratorium discussed in the class

https://economictimes.indiatimes.com/news/economy/policy/rbi-ends-loan-moratorium-
unveils-restructuring-plan/articleshow/77403803.cms