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Principles and Practices of Banking

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© Amity University Press

All Rights Reserved

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No parts of this publication may be reproduced, stored in a retrieval system or transmitted
in any form or by any means, electronic, mechanical, photocopying, recording or otherwise
without the prior permission of the publisher.

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Advisory Committee

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Chairman : Prof. Abhinash Kumar
Members : Prof. Arun Bisaria

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Dr. Priya Mary Mathew
Mr. Alok Awtans
Dr. Coral J Barboza
Dr. Monica Rose
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Mr. Sachit Paliwal
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Subject Matter Expert

Mr. Sachit Paliwal
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Published by Amity University Press for exclusive use of Amity Directorate of Distance and Online Education,
Amity University, Noida-201313
 Contents

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Page No.

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Module - I: Introduction to Indian Financial Systems and Regulation 01
1.1 Indian Financial System
1.1.1 Introduction

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1.1.2 Recent Developments
1.1.3 Market Structure

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1.1.4 Financial Innovation
1.2 Regulatory Bodies
1.2.1 RBI Roles and Functions

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1.2.2 SEBI Roles and Functions
1.2.3 IRDA Roles and Functions
1.3 Banks

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1.3.1 Roles and Functions
1.3.2 Regulatory Provisions
1.3.3 Banking Regulation Act 1949
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1.3.4 RBI Act 1935
1.4 Banking Concept
1.4.1 Retail Banking
1.4.2 Wholesale Banking
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1.4.3 International Banking

1.5 Money Market
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1.5.1 Commercial Papers

1.5.2 Bancassurance
1.6 Risk Management
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1.6.1 Credit Risk

1.6.2 Market Risk
1.6.3 Liquidity Risk
1.6.4 Operational Risk
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1.6.5 Interest Rate Risk

1.7 Others
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1.7.1 VaR Analysis

1.7.2 Banking Codes
1.7.3 Basel I
1.7.4 Basel II
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1.7.5 Basel III

1.7.6 Capital Adequacy Ratio
 Module - II: Introduction to Banking and Its Regulations 122
2.1 Functions of Banks

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2.1.1 Deposits

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2.1.2 Services (Locker)
2.1.3 Ancillary Services
2.1.4 Mandate and Power of Attorney

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2.1.5 Paying and Collecting Banker
2.1.6 Remittance

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2.2 Relationship
2.2.1 Banker - Customer
2.2.2 KYC

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2.3 Negotiable Instrument
2.3.1 Protection Available
2.4 Others

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2.4.1 Endorsement
2.4.2 Forged Instruments
2.4.3 Bouncing of Cheque
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Module - III: Asset Products and Different Committee Recommendations 172
3.1 Credit Recommendation
3.1.1 Tandon Committee
3.1.2 Chore Committee
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3.1.3 Nayak Committee

3.2 Principles of Lending
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3.2.1 Introduction
3.2.2 Working Capital and Term Loans
3.2.3 Appraisal Techniques
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3.3 Credit Monitoring

3.3.1 Introduction
3.4 NPA Management
3.4.1 Introduction
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3.4.2 DRT/DRAT
3.4.3 SARF AESI Act 2002
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3.4.4 Competition Act 2005

3.5 Priority Sector Lending
3.5.1 Credit Appraisal Mechanism
3.6 Financial Inclusions
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3.6.1 PMJDY Agriculture

3.6.2 SMEs
 3.6.3 SHGs
3.6.4 SSIs

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3.6.5 Microfinancing

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3.7 New Product and Services
3.7.1 Credit Cards
3.7.2 Personal Loans

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3.7.3 Consumer Loans
3.8 Others

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3.8.1 Nachiket Mor Committee Report
3.8.2 Payment Banks and Small Banks
3.8.3 Business Correspondence

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3.9 Base Rate
3.9.1 Introduction and Calculations
3.9.2 Prime Lending Rate

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3.10 Treasury Management
3.10.1 Introduction

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Module - IV: Other Banking Products and Technology 244
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4.1 Banking Technology
4.1.1 CBS
4.1.2 Electronic Products
4.1.3 Distribution Channels
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4.1.4 Teller Machines

4.1.5 Cash Dispenser
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4.1.6 ATM
4.1.7 Home Banking
4.1.8 Electronic Payment System
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4.1.9 Global Development and Banking Technology

4.2 Online Banking
4.2.1 PINs
4.2.2 Smart Cards
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4.2.3 Signature Storage and Display

4.2.4 Cheque Truncation
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4.2.5 Microfiche
4.2.6 Note and Coin Counting Devices
4.3 Electronic Funds Transfer
4.3.1 SWIFTS
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4.3.2 RTGS
4.4 Information Technology
 4.4.1 RBI NET
4.4.2 DATANET

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4.4.3 NICNET

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4.4.4 I-NET
4.4.5 Email
4.5 Cyber Security

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4.5.1 Protecting the Confidentiality and Data
4.5.2 Phishing Attack

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4.6 Others
4.6.1 Cloud Computing
4.6.2 Mobile Banking

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Module - V: Support Services and Different Channels in Banking 281
5.1 Support Services
5.1.1 Marketing of Banking Services

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5.1.2 Marketing of Banking Products
5.1.3 Product Research and Development
5.1.4 Test Marketing r
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5.1.5 Cross Selling
5.1.6 Upselling
5.1.7 PLC
5.1.8 Product Modification
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5.1.9 Packing and Branding

5.1.10 Diversification
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5.2 Factors Influencing the Products

5.2.1 Direct Channels
5.2.2 Indirect Channels
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5.2.3 Physical Distribution

5.3 Promotion
5.3.1 Promotion Mix
5.3.2 Role of Promotion
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5.4 Information System in Marketing

5.4.1 DSA/DMA
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5.4.2 Channel Management

5.5 Selling Function
5.5.1 Wealth Management
5.5.2 Portfolio Management
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5.5.3 Telemarketing
 Principles and Practices of Banking 1

Module - I: Introduction to Indian Financial Systems

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and Regulation

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Learning Objectives:
●● Recent Developments, Market Structure and Financial Innovation

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●● Roles and Functions of RBI, SEBI and IRDA
●● Regulatory Provisions - Banking Regulation Act 1949 and RBI Act 1935

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●● Retail and Wholesale Banking
●● International Banking, Commercial Papers and Bancassurance
●● Risks - Credit, Market, Liquidity, Operational and Interest Rate

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●● VaR Analysis
●● Banking Codes - Basel I, Basel II and Basel III

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●● Capital Adequacy Ratio

Introduction
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The post-independence economic scene has seen a sea change, with the end
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result being that the economy has made enormous progress in a variety of fields. There
has been both quantitative expansion and diversification of economic activities. The
lessons of the 1980s have led to the conclusion that for India to reap the full benefits
of increased reliance on voluntary, market-based decision-making, efficient financial
systems are required.
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The financial system is likely to be the most important institutional and functional
vehicle for economic transformation. Finance serves as a link between the present
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and the future, and whether it is the mobilisation of savings or their efficient, effective,
and equitable allocation for investment, the success with which the financial system
performs its functions sets the tone for the achievement of broader national goals.

The term financial system refers to a collection of interconnected activities/

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services that work together to achieve a predetermined purpose or goal. It includes

various markets, institutions, instruments, services, and mechanisms that influence the
generation of savings, the formation of investment capital, and growth.

The Financial System’s Concept - Financial institutions, markets, instruments,

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and services are all involved in the savings, finance, and investment process. Above
all, supervision, control, and regulation are crucial. As a result, financial management is
an essential component of the financial system. Goldsmith stated, based on empirical
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evidence, that “... a case for the hypothesis that the separation of the functions of
savings and investment made possible by the introduction of financial instruments,
as well as the expansion of the range of financial assets that results from the
establishment of financial institutions, increase the efficiency of investments and raise
the ratio of capital formation to national production and financial activities and through
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these two channels increase the rate of growth.”

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 2 Principles and Practices of Banking

Interdependence in the Financial System - A financial system provides essential

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services in a modern economy. The use of a stable, widely accepted medium of
exchange lowers transaction costs. It facilitates trade and, as a result, production
specialisation. Financial assets with appealing yield, liquidity, and risk characteristics

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encourage financial savings. Financial intermediaries improve resource efficiency by
evaluating alternative investments and monitoring borrowers’ activities. An economic
agent with access to a variety of financial instruments can pool, price, and exchange

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risks in the markets.

A growing economy is built on trade, efficient resource use, saving, and risk
taking. In fact, with the active support of the financial system, the country could make

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this a reality. The financial system has been identified as the most powerful catalyst for
economic growth, making it one of the most important development inputs.

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1.1 Indian Financial System
The financial system facilitates the exchange of funds between lenders and
borrowers. In India, the financial system is governed by independent regulators in the

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insurance, banking, capital markets, and various service sectors. Thus, a financial
system can be said to play an important role in a country’s economic growth by
mobilising surplus funds and effectively utilising them for productive purposes.
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1.1.1 Introduction
A financial system is a collection of institutions, instruments, and markets that
encourage savings and channel them to their most efficient use. It is made up of
individuals (savers), intermediaries, markets, and savers (investors).
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Financial System Definition by Authors

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According to Prasanna Chandra:

“financial system consists of a variety of institutions, markets, and instruments
related in a systematic manner and provide the principal means by which savings are
transformed into investments”.
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According to Van Horne:

“financial system allocates savings efficiently in an economy to ultimate users
either for investment in real assets or for consumption”.
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Five Parts to the Financial System

1. Money
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2. Financial Instruments
3. Financial Markets
4. Financial Institutions
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5. Central Nanks
1. Money: Money is used as a medium of exchange to purchase goods and services.

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 Principles and Practices of Banking 3

It also serves as a standard unit of measurement and a store of value. Money, on the
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other hand, may not be a good store of value because it depreciates with inflation.
2. Financial Instruments: Financial instruments are formal obligations that entitle one

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party to receive payments or a portion of another party’s assets. Loans, stocks, and
bonds are examples of tradable financial instruments.
3. Financial Markets: A financial market is a location or network where financial

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instruments can be purchased and sold quickly and cheaply.
4. Financial Institutions: Financial institutions are companies that connect borrowers
and lenders, as well as give savers and borrowers access to financial instruments

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and markets. The primary market and the secondary market are the two types of
financial markets.
5. Central Banks: Central banks are large financial institutions that manage government

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finances, regulate the supply of money, and act as commercial banks’ counterparts.

Introduction to Indian Financial System:

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The financial system of a country is an important tool for the country’s economic
development because it aids in the creation of wealth by linking savings with
investments. It facilitates the flow of funds from households (savers) to businesses
(investors) to aid in the creation of wealth and the development of both parties.
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A country’s financial system is concerned with the following:

◌◌ Allocation and mobilisation of savings

◌◌ Provision of funds
◌◌ Facilitation of financial transactions
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◌◌ Development of financial markets

◌◌ Provision of legal financial framework
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◌◌ Provision of financial and advisory services

The primary function of a financial system, according to Robinson, is “to provide a
link between savings and investment for the creation of wealth and to permit portfolio
adjustment in the composition of existing wealth.” A financial system is made up
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of different financial institutions, financial markets, financial transactions, rules and

regulations, liabilities and claims, and so on. Financial System Characteristics:

It is critical to a country’s economic development. It promotes both saving and

investing. It connects savers and investors. It aids in capital formation; it aids in risk
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allocation; and it aids in the expansion of financial markets. It contributes to financial

deepening and broadening.
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Structure of Indian Financial System/Components of Indian Financial System:

(1) Financial Institutions – Financial institutions act as financial market intermediaries,
facilitating financial transactions between individuals and financial customers.
It simply refers to a for-profit or non-profit organisation that collects money from
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individuals and invests it in financial assets such as stocks, bonds, bank deposits,
loans, and so on.

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 4 Principles and Practices of Banking

Financial institutions can be classified into two types:

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◌◌ Banking Institutions or Depository institutions – These are banks and credit
unions that collect money from the general public in exchange for interest on

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deposits and then use that money to make loans to financial customers.
◌◌ Non- Banking Institutions or Non-Depository institutions – These are
brokerage firms, insurance companies, and mutual funds that cannot accept

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money deposits but can sell financial products to financial customers.

Financial institutions can be divided into three types:

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◌◌ Regulatory – It includes institutions such as SEBI, RBI, and IRDA, among
others, that regulate financial markets and protect investors’ interests.
◌◌ Intermediaries – It includes commercial banks such as SBI, PNB, and others
that offer short-term loans and other financial services to individuals and

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businesses.
◌◌ Non – Intermediaries – It includes financial institutions such as NABARD,
IDBI, and others that make long-term loans to corporate customers.

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(2) Financial Markets – It refers to any marketplace in which buyers and sellers trade
assets such as stocks, bonds, currencies, and other financial instruments. A financial
market can be further subdivided into two parts: the capital market and the money
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market. The capital market deals in long-term securities with maturities of more
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than one year, whereas the money market deals in short-term debt instruments with
maturities of less than one year.
(3) Financial Assets/Instruments – Cash deposits, checks, loans, accounts receivable,
letters of credit, bank notes, and all other financial instruments that provide a claim
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against a person/financial institution to pay either a specific amount on a specific

future date or the principal amount plus interest are examples of financial assets.
(4) Financial Services – Financial services are concerned with the development and
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provision of financial instruments and advisory services to individuals and businesses

in the areas of banking and related institutions, personal financial planning, leasing,
investment, assets, insurance, and so on. It entails the provision of a wide range of
fund/asset-based and non-fund/advisory services, as well as all types of institutions
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that provide intermediary financial assistance and facilitate financial transactions

between individuals and corporate customers.

Importance of Indian Financial System

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It increases the rate and volume of savings by providing various financial

instruments and efficient savings mobilisation. It contributes to the country’s national
output by providing funds to corporate customers to help them expand their respective
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businesses. It protects investors’ interests and ensures smooth financial transactions

through regulatory bodies such as the RBI, SEBI, and others. It promotes economic
development and raises people’s standard of living. It contributes to the development
of the poorer sections of society through rural development banks and co-operative
societies. It assists corporate clients in making better financial decisions by providing
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effective financial and advisory services.

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 Principles and Practices of Banking 5

Functions of Financial System in India

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Liquidity Function: A financial system’s primary function is to provide money and
monetary assets for the production of goods and services. Monetary assets are those

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that can be easily converted into cash or money without losing value. All activities in
a financial system involve liquidity—either the provision of liquidity or the trading of
liquidity.

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Payment Function: The financial system provides an extremely convenient method
of paying for goods and services. The cheque and credit card systems are the most
convenient modes of payment in the economy. Transaction costs and times are

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significantly reduced.

Saving Function: A financial system’s ability to mobilise savings and channel

them into productive activities is an important function. Savings are converted into
investments through the financial system. r
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Risk Function: The financial markets offer protection against risks to one’s life,
health, and income. These assurances are provided through the sale of life, health, and
property insurance policies.
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Transfer Function: A financial system facilitates the transfer of resources across

geographical boundaries.

Reformatory Functions: A financial system that develops, introduces innovative

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financial assets/instruments, services, and practises, and restructures existing assets,

services, and so on to meet the emerging needs of borrowers and investors.

Objectives of Financial System

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Facilitate Payment: Payment is made possible by the financial system via banks
and other financial institutions. Anything we buy or sell necessitates the exchange of
money. The financial system is in charge of this.

Link between Saver and Investor: The financial system serves as a meeting place
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for savers and investors. A saver saves money, and an investor invests it in various
types of stocks in order to profit from it.
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Helps in Capital Formation: A good financial system that provides finance on time
and in an appropriate amount is required for capital formation.

To Ensure Safety on Investment: For proper supervision of the financial market,

the financial system has various institutions that control the market. As a result, the
investment can be made safe.
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 6 Principles and Practices of Banking

Helps in the Growth of Economy: Proper fund mobilisation and control in the
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financial market aids business growth and encourages investors to invest. This
contributes to economic growth.

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1.1.2 Recent Developments
The banking sector, capital market, money market, regulatory bodies, financial

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institutions, and financial instruments comprise the Indian Financial System. The
financial sector has undergone timely reforms to make it more accessible to the general
public. Reforms enable the Indian economy to improve its resource utilisation and

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availability. The financial sector reforms in India began in 1991, when various sectors
of the economy were opened to Foreign Financial Institutions. These modifications
were regarded as privatisation. Various reforms have been implemented in the financial
system. Over the last few decades, India has made significant economic progress. The

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world has made significant progress in reducing extreme poverty, and India has played
an important role in that progress. Within a generation, India cut extreme poverty in half
and is transforming itself into one of the world’s fastest-growing economies.

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The Indian government has implemented significant market-oriented reforms in
recent years. India is in the top ten in terms of progress for the third year in a row.
During that time, it rose from 142nd to 63rd in the Doing Business rankings. According
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to the new report, it is now easier than a year ago to start a new business, obtain a
building permit, and trade goods across the border.
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Key developments in for the financial sector:
The year 2021 began with a lot of uncertainty for the financial sector, particularly
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commercial banks, who were unsure how the loan moratorium and restructuring
enacted in the aftermath of the Covid-19 pandemic would play out. There were also
concerns about the monetary policy framework, with no one knowing how long the
ultra-loose policy would be maintained. From cryptocurrency concerns to policy
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normalisation, here are the key developments in the financial sector since 1991.

1. Reduction in Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR): The
reduction of the Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) has
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been a significant financial reform, allowing more bank credit to be made available to
industry, trade, and agriculture. The statutory liquidity ratio (SLR), which was as high
as 39% of deposits with banks, has been gradually reduced to 25%.
It should be noted that under statutory liquidity ratios, banks are required to keep at
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least 25% of their total liabilities in liquid assets such as government securities and
gold reserves. The RBI reduced the statutory liquidity ratio to 24% in 2008.
Similarly, the cash reserve ratio (CRR) was reduced from 15% to 4.5% in stages
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beginning in June 2003. It should be noted that the reduction in CRR has been made
possible by reducing the government’s monetized budget deficit and eliminating the
automatic system of financing the government’s budget deficit through the practise
of issuing ad hoc treasury bills to the Central Government.
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On the other hand, a reduction in the Statutory Liquidity Ratio (SLR) has been
possible as a result of the government’s efforts to reduce the fiscal deficit and thus
its borrowing requirements. Furthermore, a reduction in SLR has become possible

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 Principles and Practices of Banking 7

as a result of a shift to the payment of market-related interest rates on government

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securities.
Because government securities are risk-free and now have market-related interest

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rates, banks may be tempted to invest their excess funds in these securities,
especially when demand for credit from industry and trade is insufficient.
The reduction in CRR and SLR has made more lendable resources available to

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industry, trade, and agriculture. Reduced CRR and SLR allowed the Reserve Bank
of India to use open market operations and changes in bank rates as monetary
policy tools to achieve the goals of economic growth, price stability, and exchange

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rate stability.
According to Dr. C. Rangarajan, former Governor of the Reserve Bank of India,
“as we move away from automatic monetisation of deficits, monetary policy will
come into its own.” The overall perception of the Central Monetary Authority on what

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appropriate level of expansion of money and credit should be based on how the
real factors in the economy are evolving will determine the regulation of money and
credit.”

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2. End of Administered Interest Rate Regime: The fact that interest rates were managed
by the Reserve Bank/Government was a fundamental flaw in the Indian financial
system. In the case of commercial banks, the Reserve Bank of India regulated both
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deposit and lending rates. Prior to 1993, low interest rates on government securities
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could be maintained by maintaining a high Statutory Liquidity Ratio (SLR).
Commercial banks and certain other financial institutions were required by law
to invest a large portion of their liabilities in government securities under SLR
regulation. The goal of the administered interest-rate structure was to allow certain
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priority sectors to obtain funds at low interest rates. Thus, the administered interest
rate system involved cross-subsidization: concessional rates charged by primary
sectors were offset by higher rates charged by non-concessional borrowers.
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In a phased approach, the structure of administered rates has been almost completely
eliminated. The RBI no longer sets interest rates on fixed or time deposits paid by
banks to depositors. Banks have also been relieved of any prescribed conditions for
depositors’ premature withdrawal. Individual banks are free to set their own terms
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for early withdrawal. Savings bank accounts currently have a prescribed rate of 3.5
percent.
Individuals use Savings Bank Accounts as current accounts, even when they have
a cheque-book facility. Because the banks’ cost of servicing these accounts is high,
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the interest rate on them must be low. Furthermore, lower interest rate ceilings
are prescribed for foreign currency denominated deposits made by non-resident
Indians (NRI). Such a lower prescribed ceiling is required for managing external
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capital flows, particularly short-term capital flows, until capital account liberalisation
is implemented.
Previously regulated lending rates of interest for various categories have been
gradually deregulated. However, the RBI insists on transparency in this matter.
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Each bank must publish its prime lending rates (PLRs) and the maximum spread it
charges. The maximum spread is the difference between the lending rate and the
cost of funds at the bank.

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 8 Principles and Practices of Banking

Interest rates on smaller loans up to Rs. 2,000,000 are regulated at concessional

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rates. Currently, the interest rate on these smaller loans should not be higher than
the prime lending rate. Furthermore, lending interest rates for exports are prescribed
and tied to the period of availment. Changes in prescribed interest rates for exports

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have frequently been used as a tool to influence export proceeds repatriation.
Thus, with the exception of prescribed lending rates for exports and small loans up to

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Rs. 2, 00,000, lending rates are no longer under control. Banks can now set lending
rates based on borrowers’ risk-reward perceptions and the purposes for which bank
loans are sought.

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3. Prudential Norms: High Capital Adequacy Ratio: Prudential norms, particularly
the capital-adequacy ratio, have been gradually introduced to meet international
standards in order to ensure that the financial system operates on a sound and
competitive basis. The capital adequacy norm refers to the ratio of a bank’s paid-up

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capital and reserves to deposits. Indian banks’ capital bases have been significantly
lower by international standards, and have actually declined over time.
In India, as part of financial sector reforms, a capital adequacy norm of 8% based

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on a risk-weighted asset ratio system has been implemented. Indian banks with
overseas branches were required to meet this capital-adequacy standard by March
31, 1994. Foreign banks operating in India were required to meet this standard by
March 31, 1993. r
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Other Indian banks were required to meet the 8% capital adequacy standard by
March 31, 1996. The RBI advised banks to review their current level of capital funds
in comparison to the prescribed capital adequacy norm and take phased steps to
increase their capital base to meet the prescribed norm by the deadline.
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It should be noted that Global Trust Bank (GTB), a private sector bank whose
operations were halted by the RBI on July 24, 2004, had a capital adequacy ratio
that was significantly lower than the prescribed prudent capital adequacy ratio norm.
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In this regard, it is worth noting the relationship between capital adequacy and
provisioning. After ensuring that adequate capital provisions have been made, banks
can meet the capital adequacy norm.
To meet this capital adequacy standard, the government intervened by providing
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capital funds to some nationalised banks. Some of the larger public sector banks
raised capital from the capital market by selling equity. A law was passed to allow
public sector banks to raise funds in the capital markets in order to strengthen their
capital base. Banks can also use a portion of their annual profits to strengthen their
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capital base (that is, ploughing back of retained earnings into investment).
4. Competitive Financial System: After the nationalisation of 14 large banks in 1969,
no new banks were permitted to be established in the private sector. While the
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importance and role of public sector banks in the Indian financial system were
emphasised, it was recognised that there was an urgent need to introduce greater
competition in the Indian money market, which could lead to higher financial system
efficiency.
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As a result, private sector banks like HDFC, Corporation Bank, ICICI Bank, UTI
Bank, IDBI Bank, and others have been established. The establishment of these
banks has made a significant contribution to housing finance, automobile loans, and

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 Principles and Practices of Banking 9

retail credit via the credit card system. They have enabled the widespread use of
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what is commonly referred to as plastic money, namely, ITM cards, Debit Cards, and
Credit Cards.

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In addition to the establishment of private sector Indian banks, competition has been
encouraged by allowing liberal entry of branches of foreign banks; as a result, CITI
Bank, Standard Chartered Bank, Bank of America, American Express, and HSBC

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Bank have opened more branches in India, particularly in metropolitan cities.
The recent liberalisation of foreign direct investment in banks is a significant step
forward. In the budget for 2003-04, the limit on foreign direct investment in banking

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companies was raised from 49% to a maximum of 74% of the banks’ paid-up capital.
This did not, however, apply to foreign banks’ wholly owned subsidiaries.
A foreign bank may operate in India through one of three channels:

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(1) as a branch of a foreign bank
(2) as a wholly owned subsidiary of a foreign bank
(3) as a subsidiary with aggregate foreign investment of up to 74% of the paid-up

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capital.
The aforementioned measures are expected to make it easier for foreign banks to

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establish subsidiaries. In addition to encouraging competition among banks, they
have increased transparency and disclosure standards in order to meet international
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standards. Banks are required to submit to the RBI and SEBI the maturity pattern of
their assets and liabilities, changes in the provision account, and information about
non-performing assets (NPA).
The RBI’s annual publication ‘Trends and Progress of Banking in India’ provides
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detailed information on individual banks’ financial positions, such as losses, assets,

liabilities, NPA, and so on, allowing the public to assess the banks’ performance.
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5. Non-Performing Assets (NPA) and Income Recognition Norm: Bank non-performing

assets have been a major issue for commercial banks. Non-performing assets denote
bad loans, or loans that are difficult to recover. A large number of non-performing
assets reduces a bank’s profitability. In this regard, the RBI’s income recognition
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norm is worth mentioning. This rule states that a bank’s income on assets is not
recognised if it is not received within two quarters of the last date.
Recovery management has been greatly strengthened in recent years in order to
improve the performance of commercial banks. Restructuring at the bank level,
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recovery of bad debt through Lok Adalats, Civil Courts, the establishment of
Recovery Tribunals, and compromise settlements are all measures taken to reduce
non-performing assets. The enactment of the ‘Securitization and Reconstruction of
Financial Assets and Enforcement of Security Interest’ Act provided a significant
)A

boost to the recovery of bad debt (SARFAESI). Debt Recovery Tribunals have been
established under this Act to aid banks in the recovery of bad debts.
As a result of the aforementioned measures, gross NPA fell from Rs. 70,861 crores
in 2001-02 to Rs. 68,715 crores in 2002-03. However, there are still significant
(c

amounts of non-performing assets that must be recovered. Furthermore, as a result

of the RBI’s implementation of risk-based supervision, the ratio of gross NPA to gross

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 10 Principles and Practices of Banking

advances of scheduled commercial banks fell from 12.7% in 1999-2000 to 8.8% in

Notes

e
2002-03.
6. Elimination of Direct Credit Controls: The elimination of direct or selective credit

in
controls is another significant financial sector reform. Selective credit controls have
been eliminated. Under selective credit controls, the RBI used to control the provision
of bank credit to traders against stocks of sensitive commodities and to stock brokers

nl
against shares through a system of changes in margin. As a result, credit is now
more freely available to both banks and borrowers.
However, it is worth noting that banks are required to follow the RBI’s guidelines

O
for lending to priority sectors such as small scale industries and agriculture. At
deregulated interest rates, the advances eligible for priority sector lending have been
increased.
This is consistent with the recognition that the main issue is credit availability rather

ty
than credit cost. In June 2004, the UPA government announced that farmers would
be able to obtain agricultural credit at a rate that was 2% lower than the banks’ prime
lending rate. Furthermore, agricultural credit will be doubled in three years.

si
7. Promoting Micro-Finance to Increase Financial Inclusion: The government has
launched a microfinance scheme to promote financial inclusion. The RBI provides
banks with guidelines for mainstreaming microcredit providers and expanding their
r
reach. It was also stated that micro-credit extended by banks to individual borrowers
ve
directly or through any intermediary would be counted as part of their priority-sector
lending going forward. However, no specific model for micro-finance has been
prescribed, and banks have been given the freedom to develop their own model(s)
or choose any conduit/intermediary for extending micro-credit.
ni

Though there are various models for pursuing microfinance, the Self-Help Group
(SHG)-Bank Linkage Programme has emerged as the country’s major microfinance
programme. Commercial banks, regional rural banks (RRBs), and cooperative banks
U

are implementing it.

Extension of Swabhimaan Scheme: By March 2012, over 74,000 habitations with
populations in excess of 2,000 had been provided with banking facilities under
the Swabhimaan financial inclusion campaign, using a variety of models and
ity

technologies, including branchless banking via business correspondents (BCs).

According to Census 2001, the Finance Minister announced in his Budget Speech
for 2012-13 that Swabhimaan would be extended to habitations with a population of
more than 1,000 in the north-eastern and hilly states, and a population of more than
m

1,600 in the plains areas.

As a result, approximately 45,000 such habitations were identified for coverage under
the expanded Swabhimaan campaign. According to the progress reported by the
)A

conveners of the State Level Bankers’ Committee (SLBC), 10,450 of the identified
habitations had banking facilities by the end of December, 2012. Banks will be able
to reach all habitations above a certain population threshold as a result of this.
8. Setting up of Rural Infrastructure Development Fund (RIDF): The Government of
(c

India established the RIDF in 1995 with contributions from commercial banks up
to the amount of their shortfall in priority sector lending by banks, with the goal
of providing low-cost fund support to states and state-owned corporations for the
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 Principles and Practices of Banking 11

expeditious completion of ongoing projects relating to medium and minor irrigation,

Notes

e
soil conservation, watershed management, and other forms of rural infrastructure.
The Fund has continued, with its corpus being announced in the Budget each year.

in
Coverage under the RIDF has become more broad-based over time, with each
tranche now funding a diverse range of 31 activities across multiple sectors.
The Government of India has decided to implement a Direct Benefit Transfer

nl
(DBT) scheme on January 1, 2013. To begin, benefits under 26 schemes will be
directly transferred into beneficiaries’ bank accounts in 43 identified districts across
respective states and union territories (UT).

O
Banks will make certain that all beneficiaries in these districts have access to a bank
account. All PSBs and RRBs have made provisions for the data collected by the
relevant Departments/Ministries/Implementing Agencies to be used for seeding bank
account details in banks’ core banking systems (CBS) with Aadhaar. All PSBs have

ty
also joined the National Payment Corporation of India’s Adhaar Payment Bridge to
ensure the smooth transfer of benefits.

si
Key Trends
Trend 1: Accelerating Digital Transformation: The industry is seeing a continued
and aggressive focus on digitization and the adoption of new and emerging
r
technologies to improve operational efficiencies, accelerate time-to-market, and provide
ve
superior customer experiences.

As mobile and online banking become more popular among customers, banks are
reducing their spending on branches3 in order to invest in self-service digital channels.
Digital wearable devices with the power of smartphones are making it easier for banks
ni

to provide targeted services to customers.

Trend 2: Emergence of FinTech Firms: Many banks are attempting to capitalise on

the opportunities presented by digital, either by leveraging the technologies in-house
U

or by partnering with FinTech firms. Initially, these firms were viewed as competitors
exploiting the void left by the BFS industry’s inability to keep up with technological
advances.
ity

However, bank-FinTech collaborations are becoming more common, with the latter
providing marketing, administration, loan servicing, or other services that enable banks
to offer tech-enabled banking products. Banks are also discovering some additional
benefits of bank-FinTech collaborations, such as access to assets and customers. 4 As
a result, these collaborations are starting to reshape the financial services landscape.
m

Trend 3: Building a Cognitive Side to the Business: While customer needs and
competitive forces require banks to embrace full-fledged digitization, performance
)A

pressures force lenders to cut costs and maintain healthy operating margins. As new
regulatory requirements and data protection laws place additional strain on already-
strained resources, emerging technologies such as AI and robotics are assisting banks
in efficiently addressing these constraints.

Indeed, many forerunners in the BFS industry are already experimenting with
(c

various AI use cases in their operations. From using AI to power chatbots and provide
round-the-clock, agile customer service to utilising the technology for critical functions

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 12 Principles and Practices of Banking

such as anti-fraud and regulatory compliance, banks are realising the dual benefits
Notes

e
of cost optimization and operational improvement. Furthermore, robotic process
automation and machine learning are assisting banks in replacing labor-intensive,
manual workflows with highly reliable, cost-efficient, and fast robotic operations.

in
These technologies are also sparking industry innovation, such as biometric-based
authentication, voice commerce, and the robo advisors introduced earlier, Nao, Pepper,

nl
and Lakshmi.

5 Of course, the impact on the industry’s employees is also a factor in this

equation. While banks will require an increasing number of people with techno-

O
functional skill sets, many of their existing roles may be eliminated.

Trend 4: Rethinking Money: Technologies such as blockchain are already

heralding a quiet revolution, calling into question the conventional economic value

ty
provided by the BFS industry. With peer-to-peer lending, smart contracts, and digital
payments, blockchain is shaking up the very foundations of traditional business
models, eliminating intermediaries and speeding up underlying processes. Blockchain
is expected to save the BFS industry up to USD 20 billion in annual operating costs,

si
prompting an increasing number of banks7 to implement the technology in commercial
production.

r
Aside from blockchain, cryptocurrencies such as Bitcoin, Ethereum, and Ripple
are slowly gaining traction, calling into question the need for physical cash itself. In
ve
this scenario, where once-core assets are no longer considered core, and controls that
once served to protect are now giving rise to new regulations — such as Open APIs
and PSD II — the industry appears to be on the verge of rebirth.
ni

Desired Financial Reforms

Prime Minister Narendra Modi has set the lofty goal of transforming India into a $5
trillion economy by 2025. Achieving that goal would be beneficial to the people of India
U

as well as the rest of the world. It will necessitate even more tax, trade, infrastructure,
and government structure reforms. And it will necessitate a strong, stable financial
sector as well as significant progress on financial reforms.
ity

Some of the desired financial reforms are as follows:

Boosting Growth through Financial Strength: The Indian banking system is at a fork
in the road. Nonetheless, the financial sector is confronted with a number of challenges.
While there are signs that commercial banks are making progress in clearing non-
m

performing loans, much more work remains to be done.

State-owned banks account for nearly 70% of the nation’s banking assets. This
)A

heavy reliance on the public sector distorts markets, making it difficult for India to
address funding gaps in critical areas of development such as infrastructure, small and
medium-sized businesses, and housing. Non-banking financial companies, also known
as shadow banks, have emerged as a significant new source of credit for businesses
and consumers. However, their expansion has resulted in new risks as a result of links
(c

with the traditional banking sector.

The financial sector is grappling with these issues at a critical juncture in the global
economy. Global growth is slowing as a result of sluggish investment and deteriorating
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 Principles and Practices of Banking 13

trade. India’s economy, like that of many other countries, is facing challenges, with
Notes

e
consumption softening and investment slowing. Bond yields have fallen into low or
negative territory for several top bond issuers globally, benefiting an increasingly narrow
group while under-funding productive investments needed for broad-based growth,

in
including in India. This creates a difficult environment for reform. At the same time, it
emphasises the importance of taking decisive action to allow for faster growth.

nl
The potential is enormous. If the current challenges are addressed, India has
the potential to build one of the largest domestic banking sectors in the world. Faster
private-sector credit growth would boost GDP, employment, and median income.

O
Involving the Private Sector: In developing countries, state banks typically account
for a minority rather than a majority of market share: closer to 20% versus 70%.

In comparison to other countries, the financial sector in this country generates

ty
a low level of credit. The credit-to-GDP ratio in India is 51 percent. In comparison,
Malaysia has a rate of 136 percent and Brazil has a rate of 70 percent. Despite the fact
that India’s gross domestic savings rate, at nearly 30 percent of GDP, is comparable
to peer countries, this trend has taken hold. The savings are sufficient, but the system

si
does not make effective use of them.

To achieve the goal of a $5 trillion economy, credit must expand at a much faster

r
rate while maintaining good credit quality and avoiding excessive risk taking.
ve
More credit would assist India in meeting its needs in areas such as housing,
SMEs, and infrastructure. Through 2035, India’s annual infrastructure finance gap is
expected to average 0.7 percent of GDP, more than double the global average of 0.3
percent.
ni

Productive credit growth would benefit the underprivileged. Hundreds of millions

of Indian citizens, as well as millions of businesses and entrepreneurs, work in the
informal economy, with little access to financial services. Many of them could effectively
U

use credit to start a business or buy a motorcycle to commute to work.

The experience of other emerging markets and developing countries can teach
us a few things. A wave of developing countries liberalised their financial sectors in
ity

the 1980s and 1990s. In the early 1990s, countries in Central and Eastern Europe
privatised large parts of their financial systems as they restructured their previously
centrally planned economies. Following the debt crisis of the 1980s, countries in Latin
America, including Mexico, liberalised their banking sectors.
m

The majority, but not all, financial liberalizations were successful. One thing we can
learn from this is that it is critical to have strong, independent regulatory authorities in
place to oversee the transition. The global experience also suggests that transitions
should be carried out during times of strength, when macroeconomic conditions are
)A

balanced and the country is on solid economic and fiscal footing.

The Reserve Bank of India has made significant efforts to monitor asset quality.
The government’s plan to consolidate public-sector banks provides an opportunity to
improve governance, oversight, efficiency, and risk management.
(c

All of these steps will serve as the foundation for a broader strategy to reduce
the role of the government in the financial system. A combination of private-capital

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 14 Principles and Practices of Banking

injections and full privatisations would improve the sector’s ability to support credit,
Notes

e
facilitate effective financial intermediation, and reduce moral hazard and fiscal
exposures.

in
It would also be beneficial to gradually reduce the statutory requirement for state
banks to provide liquidity, as well as the priority-sector lending policy. These policies
end up distorting markets rather than expanding them. India is well positioned to

nl
benefit from recent advancements in financial technology. India has already laid a solid
foundation for fostering Fintech, including the RBI’s “regulatory sandbox,” which was
created with assistance from the World Bank Group. Last year, three of the top Fintech
deals in Asia were based in India, and 80 percent of Indians have bank accounts. India

O
is in a good position to share what it has learned with other countries. India can also
maintain its entrepreneurial spirit by allowing the private sector to innovate in this area,
such as in the mortgage market.

ty
Deepening Capital Markets: India’s capital markets have the potential to play a
critical role in assisting the country in achieving its economic goals. The equity market
capitalization is now over $2.2 trillion, up more than 6% year on year. The debt market,

si
on the other hand, is still in its infancy.

Government securities continue to dominate the debt market, while top-rated

financial and public-sector issuers dominate the corporate bond market. Corporate
r
bond issuance accounts for approximately 3.94 percent of GDP, which is significantly
ve
lower than in other emerging markets. Corporate bond proceeds increased from about
$52 billion in fiscal 2012-3 to $101 billion in fiscal 2016-7. Corporate bond issuance has
remained roughly flat since then.

Deepening India’s capital markets could supplement bank financing in promoting

ni

growth by assisting in the creation of new market niches and attracting interest from
domestic and foreign institutional investors.

Deeper capital markets can be an important way to increase the flow of long-term
U

finance, especially given the banking sector’s asset-liability mismatches. Long-term

financing is increasingly important to institutional investors such as pension funds,
insurance companies, mutual funds, and sovereign wealth funds around the world.
ity

Strengthening Non-Bank Financial Companies: The expansion of non-bank

financial companies (NBFCs) has been critical in channelling credit to underserved
markets via new products. The World Bank Group’s private-sector arm, IFC, has been
a supporter of the NBFC sector, assisting in the distribution of credit to underserved
m

markets. NBFCs have been a valuable complement to commercial banks, assisting in

meeting the nation’s infrastructure financing needs as well as those of entrepreneurs
and consumers.
)A

The sector has recently experienced a downturn, which has resulted in liquidity
issues for some NBFCs. Many of these non-bank banks are dealing with asset-liability
mismatches, borrowing in the short term and lending in the long term. They are heavily
reliant on commercial banks and market funds for funding. As a result, some banks are
vulnerable to NBFC weakness. Resolving the “twin balance sheet” issue of NBFC and
(c

related bank weakness will be a significant step toward strengthening India’s financial
system and reviving economic growth.

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 Principles and Practices of Banking 15

The recent softening in the NBFC sector provides an opportunity for the
Notes

e
government and regulators to reconsider these institutions’ role in India’s financial
system. We would appreciate the RBI’s efforts to strengthen its regulatory and oversight
framework to include all licenced financial institutions, including all systemically

in
important NBFCs.

When properly regulated, NBFCs will play an important role in fostering Fintech

nl
innovation. This is why, as their role in the financial system evolves, policymakers must
ensure that NBFCs are properly regulated and adequately capitalised.

Toward A Stronger India

O
Allowing greater private sector participation in the financial system, making it easier
for funds to flow into capital markets, and properly regulating systemically important
NBFCs are all ways for the financial sector to evolve in a way that will position India

ty
for rapid, broad-based growth. It cannot be delivered without a modernised financial
system.

In recent decades, India has made significant progress in developing a financial

si
sector that meets the country’s specific development needs. However, in a world where
payments can be sent with the click of a button from the most basic cell phone, it is
critical that countries have financial sectors that ensure stability while providing deep,
r
well-regulated markets and being agile enough to respond to rapid industry innovation.
ve
Transformation: Key to the Industry’s Future
While it is clear that increased technological use is the way forward for banks, there
are several uncertainties about execution. Banks and financial institutions should re-
ni

define themselves as agile technology companies in the financial services industry, not
the other way around, to be most effective. This implies that BFS firms should divest
non-core operations, retaining only those businesses that offer true differentiation to
customers. As customer preferences, demographics, and lifestyles change, banks will
U

need to revisit the fundamentals that underpin their core operations.

As banks continue to deal with existing developments, their ability to transform

themselves quickly and agilely, as well as their future strategies for surviving the next
ity

revolution, will determine who wins and who loses in this technologically advanced
future.

1.1.3 Market Structure

m

The Indian Financial Market can be defined as a place where financial products
and services are regularly bought and sold. It is involved in the purchase and sale of
various types of investments, financial services, loans, and so on. The Indian financial
)A

market is divided into two parts: the money market and the capital market.

Any marketplace where securities are traded is referred to as a financial market.

There are various types of financial markets, including (but not limited to) forex, bond
markets, stock markets, money markets, and so on. Securities or assets traded in
(c

financial markets may be listed on regulated exchanges or traded over-the-counter

(OTC). The country’s economic development is based on financial markets. If the
markets fail, it can lead to a recession and job losses.

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 16 Principles and Practices of Banking

Financial Market in India – Meaning & Overview

Notes

e
The financial market, like any other market, involves trading, or the buying
and selling of only financial products and services. As a result, the financial markets

in
primarily deal with the sale and purchase of various types of investments, financial
services, loans, and so on. Financial instruments have a dynamic demand and supply
because their prices are determined by the financial instruments.

nl
Financial markets serve as a link between borrowers and lenders. They bring
together individuals who have excess funds and those who are in need of funds in order
to facilitate the transfer of funds between them. The transfer of funds occurs through the

O
use of various financial instruments that operate in the financial markets.

Structure of Financial Market in India

The Indian financial market is divided into two major components: the money

ty
market and the capital market. The capital market is further classified as primary and
secondary markets.

r si
ve
ni
U
ity
m
)A

Money Market
The money market serves as a venue for short-term borrowing and lending. It
(c

involves high-volume transactions between traders and institutions at the wholesale

level. At the retail level, the money market consists of mutual funds purchased by
individual investors and bank accounts opened by customers. The assets traded in the

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 Principles and Practices of Banking 17

money market are both risk-free and extremely liquid. Because the maturity period is
Notes

e
shorter, the risk of volatility is lower, as are the returns.

Treasury bills, commercial papers, certificates of deposit, bankers’ acceptance, and

in
other common money market instruments include treasury bills, commercial papers,
certificates of deposit, bankers’ acceptance, and so on.

nl
Capital Market
Capital markets, as opposed to the money market, deal in long-term securities.
Securities with maturities of more than a year are traded in the capital market.

O
As a result, the market trades in both debt and equity-oriented securities. Foreign
Institutional Investors (FIIs), financial institutions, non-resident Indians (NRIs), and
individuals are among those who participate in the capital market.

The capital market is further subdivided into two parts: the primary market and the

ty
secondary market.

Primary Market –

si
●● Also known as the New Issue Market (NIM)
●● Functions include origination, underwriting, and distribution
●● Here, stocks are issued for the first time r
ve
●● Here, intermediaries include Investment Banks
●● Here, companies sell securities directly to investors
●● Prices of shares are fixed at par value
ni

●● Some examples are IPO (Initial Public Offering), bonus and right share issues,
private placement, preferential allotment, and so on.
U

Secondary Market
●● Also known as the After Issue Market (AIM)
●● Functions include the buying and selling of securities between investors without
ity

the involvement of the issuing company

●● Stocks are traded here once they are issued
●● Intermediaries include Brokers
●● Here, investors and traders buy and sell securities
m

●● Here, prices fluctuate based on supply and demand for shares

●● Examples include stocks, bonds, derivatives, and so on.
)A

Other types of Financial Markets in India

Commodity Market, Derivatives Market, OTC (Over-the-Counter) Market, Foreign
Exchange Market, Bond Market, and Banking Market are the other types of financial
markets in India. The following is a more detailed explanation of the same.
(c

Commodity Market: It trades commodities such as pulses, gold, metals, silver, oil,
grains, and so on.

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 18 Principles and Practices of Banking

Derivatives Market: A market for trading futures and options.

Notes

e
OTC Market: Deals with companies that are typically small and can be traded at a
low cost without regard for regulations.

in
Foreign Exchange Market: It deals in the exchange of currencies from various
countries. It is regarded as the most liquid financial market because currencies can
be easily sold and purchased. Currency fluctuations benefit traders who want to make

nl
money by selling at a higher rate and buying at a lower rate.

Bond Market: It facilitates the trading of government and corporate bonds issued
by corporations and governments to raise capital. These bonds are debt instruments

O
with a predetermined rate of return. They also have a set tenure, so the bond market is
depleted of liquidity.

Banking Market: It is made up of banks and non-banking financial institutions that

ty
offer a variety of banking services such as deposit collection, loan offerings, and so on.

1.1.4 Financial Innovation

si
The modern economy cannot exist without an efficient financial system, which is
defined as the collection of markets, institutions, instruments, and regulations that allow
financial securities to be traded, interest rates to be determined, and financial services
r
to be produced and delivered globally. The financial system is regarded as one of
ve
modern society’s most important creations, and it is described as an integrated part of
the economic system, and thus a significant part of the social system.

The financial system, as an integrated part of the global economic system,

determines the cost and quantity of funds available in the economy to pay for everyday
ni

purchases. It establishes a mechanism for the exchange of funds among various

economic entities such as households, businesses, governments, and financial
institutions.
U

Role of Innovations
The demand theory states that innovations are created in response to the demand
ity

of business entities seeking a competitive advantage in their business environment

(this type of new developments are called the demand-driven innovations). This
demand, however, can be influenced by either the internal needs of the business entity
aiming to improve its activity or by changes in its environment necessitating the proper
adjustment in its business strategy.
m

The second approach emphasises the role of the supply side, as innovations
are created first by innovation providers and then implemented in business entities
(the end-users of innovations). This type of new solution is known as supply-driven
)A

innovation, and it is achieved as a result of a three-step process:

(1) The creative stage (invention)

(2) The phase of innovation
(c

(3) The phase of diffusion (realized either by imitation or by commercialization of

innovative solutions)

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 Principles and Practices of Banking 19

The approaches presented to the theory of technological innovations can be

Notes

e
applied to the theory of financial innovations; however, the latter’s unique characteristics
must be considered.

in
Financial innovations are not a new phenomenon; they have been accompanying
technological innovations since their inception (Michalopoulos, Leaven and Levine,
2009, p. 2-5). It is well understood that financial and technological innovations

nl
are inextricably linked and evolve in tandem over time. On the one hand, financial
innovations provide a mechanism for financing innovative technological projects when
traditional sources of funding are inaccessible due to high investment risk.

O
On the other hand, technological and economic progress, which results in
increased complexity of business processes and new types of risk, forces the financial
system and financial markets to adapt to the changes, to be modernised in response
to the new requirements of business entities and the modern world’s challenges. This

ty
leads to the conclusion that, in the absence of financial innovations, technological and
economic development would be slowed, and national wealth would be lower. At the
same time, without the demand generated by technological progress, the application of

si
financial innovations would be limited.

Financial Innovations

r
The emergence of New Industrial Policy in the late 1990s paved the way for many
ve
financial innovations and technologies. These innovations have proven their worth over
time and are an important part of today’s financial landscape.

The following are some of the innovations that have changed the way we do
business:
ni

Venture Capital: Venture capital is a fund or initial capital provided to businesses

at the start-up stage for new ideas and small businesses with high growth potential.
Venture capital is regarded as a significant source of funding for startups that are
U

unable to obtain sufficient funding from reliable sources. Because the risk of funding
venture capital is high, the returns on investment in startups can be rewarding.

The company’s growth prospects are one of the most important factors influencing
ity

venture capitalists’ returns. Aside from good returns, venture capitalists gain the ability
to influence the decisions of the companies in which they have invested their money.
Furthermore, the venture capitalist who is investing his money may have no prior
business experience in the industry.
m

A group of wealthy investors, investment banks, and other financial institutions can
provide venture capital. Venture capital is becoming increasingly popular among small
start-up businesses and companies that cannot raise funds by issuing debt.
)A

Microfinance: “Microfinance typically refers to a variety of financial services such

as credit, savings, insurance, money transfers, and other financial products offered by
various service providers to the poor and low-income population.” Microfinance is the
provision of financial services to low-income clients, including individuals and groups,
who have historically been denied access to banking and related services due to low
(c

earning and growth potential.

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 20 Principles and Practices of Banking

Microfinance reduces poverty, empowers women, and promotes economic growth

Notes

e
and development. Microfinance is extremely important in women’s empowerment.
Women have traditionally been unable to actively participate in the economic activity of
households, particularly those in developing countries. Microfinance, on the other hand,

in
aims to provide financial services to women in order for them to start businesses and
actively participate in economic activities.

nl
Microfinance has given them confidence, raised their status, and increased their
participation in decision-making, reducing gender inequality. It is emerging as a potent
tool for poverty alleviation in the new economy, particularly for women. In India, the
microfinance industry is dominated by Self Help Groups (SHGs), which aim to provide a

O
cost-effective mechanism for providing financial services to individuals and groups who
lack access to financial services due to low business incomes.

NEFT: National Electronic Funds Transfer (NEFT), according to the Reserve Bank

ty
of India, is a nationwide payment system that facilitates one-to-one funds transfers.
Individuals, firms, and corporations can use NEFT to electronically transfer funds
from any bank branch to any other bank branch in the country that participates in the

si
Scheme.

Individuals, firms, and corporations with accounts at a bank branch can transfer
funds using NEFT. Individuals who do not have a bank account can deposit cash at
r
NEFT-enabled branches and instruct the bank to transfer funds via NEFT. Such cash
ve
remittances, however, will be limited to a maximum of Rs.50,000/- per transaction. Such
walk-in customers must provide complete information, such as their full address, phone
number, and so on. As a result, NEFT can assist in the transfer of funds even if you do
not have a bank account. This is a simple, secure, safe, fast, and cost-effective method
ni

of transferring funds, particularly for retail remittances.

ATM: The automatic teller machine (ATM) is a computerised telecommunications

device that allows bank customers to conduct financial transactions without having to
U

visit the bank using ATM machines and plastic cards. Customers can use ATMs to gain
access to their bank accounts in order to make cash withdrawals or check account
balances. ATMs are widely available in cities, providing customers with easier access to
their accounts. Using your bank’s ATM is usually free, but using an ATM operated by a
ity

competing bank may incur a small fee.

Mobile Banking: Mobile banking is a system that enables a variety of financial

transactions to be carried out using a mobile device such as a phone. With the
increased use of smartphones, mobile banking is becoming increasingly popular, and it
m

is becoming very successful over time.

Key Drivers For Financial Innovations To Be Successful In Long Run

)A

Once implemented, financial innovations are not guaranteed to be successful in the

long run. There should be some key drivers to keep it going in the long run. To make a
financial innovation successful in the long run, five factors must be considered:

◌◌ Human capital that is well-trained.

(c

◌◌ A steady flow of investments into the market to facilitate future innovation

efforts.

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 Principles and Practices of Banking 21

◌◌ The development of technological leadership.

Notes

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◌◌ The ability to adapt to changes in financial market innovation projects.
◌◌ Faced with dynamism in public innovation support systems.

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To begin, high skilled manpower or human capital with expertise knowledge of
the specific financial innovation should be available to deal with day-to-day technical
problems.

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Second, investments that could be made now but are not made may have a
negative impact in the future because the pool of opportunities will be reduced due to
limited investments. As a result, investors should have tacit knowledge in order to avoid

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such losses and negative effects, and proper R&D should be done with future prospects
in mind.

Third, technological leadership should be maintained because key businesses

ty
located abroad may respond to low demand in local markets and may face financing
difficulties. Partial company relocations should be avoided in order to prevent the
unequal distribution of demand and industrial growth.

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Fourth, many businesses have been impacted by the recent financial crisis, and
they may continue to pay their debts in the near future. To avoid this, they should have
a self-sustaining financial system and risk management plans in place to deal with such
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a crisis. v) Fifth, companies must be adaptable enough to deal with any dynamism
displayed by public support systems, which may halt or slow their growth by imposing
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various regulations.

Issues that make financial innovations challenging

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1) The Indian financial system is vast and intricately interconnected, with both
positive and negative consequences for the system. As a result, it will have an
impact on the economy’s social welfare.
U

2) The nature of financial innovations is highly dynamic. Changes in the

structure of financial innovations are determined by how the innovations are
disseminated from early adopters to general users through various marketing
and promotional strategies.
ity

3) Government rules and regulations impose financial innovations in the

liquor industry, just as they do on other types of innovations such as
pharmaceuticals. The impact of such financial reforms on the direction and
speed of financial innovation is highly uncertain.
m

Impact of Financial Innovations on Social Welfare of the Economy

The positive effects of an innovation can be measured as an increase or rise
)A

in social welfare when comparing the new set of options to those that are already
available. Such a framework would aid in determining whether the innovations are likely
to improve social welfare or are a waste of monetary resources. In the context of a
discrete choice model, economists estimate the underlying demand and utility functions
of the representative consumer using data on actual attributes, prices, and sales.
(c

For example, texting and driving has resulted in an increase in automobile

accidents caused by distracted drivers—and has resulted in the formation of regulations

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 22 Principles and Practices of Banking

that discourage the use of such innovations. The main difficulty in assessing the impact
Notes

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of financial innovations on the social economy is that the majority of their consequences
are negative. Many financial innovations, on the other hand, address broad social
needs. For example, venture capitalists provide financial resources as well as expertise

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to assist new businesses in growing in the market; credit cards not only extend credit
but also simplify the process of purchasing goods and services.

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Effects and Scope of Financial Innovations
Many financial technologies and innovations, such as NEFT, mobile banking,
and e-banking, have emerged in the last decade. However, there is much room for

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improvement in financial innovations and technologies, as India has been attempting
to adapt to the turbulent financial market following the liberalisation and globalisation of
the Indian economy, but there has been no innovation in this area.

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India also lacks financial innovation drivers and technologies such as the Internet
and computers, which impede the growth of adoption of these financial innovations as
part of the current way of doing business. Countries should begin spending more on

si
financial innovation in order to improve growth opportunities and reap the benefits of
these financial innovations. The future of these innovations may be brighter if countries
begin to invest more in them.

r
In our country, there is a wide range of financial innovations. It has been observed
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that as time passes, people become more familiar with new technologies such as the
Internet, which is a critical component of these financial innovations and technologies,
and thus the scope of these innovations broadens. Still, there is a lot of room for
improvement in all areas.
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1.2 Regulatory Bodies

Financial Regulatory Bodies are public authorities or government agencies that
U

have autonomous authority over specific areas. Individuals who are involved in any
activity, supervisory, or regulatory capacity. As a result, Financial Regulatory Bodies is
an important topic for general banking awareness preparation for various competitive
exams. The regulatory framework of the Indian financial system is established by
ity

various financial regulatory agencies. They are tasked with ensuring equality and
responsibility among the participants in that specific financial domain. Each financial
regulator plays an important role in ensuring that the interests of investors and other
stakeholders are not jeopardised and that the country’s financial system is fair. The
m

Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI),
the Insurance Regulatory and Development Authority (IRDA), the Pension Funds
Regulatory and Development Authority (PFRDA), and the Ministry of Corporate Affairs
are the major financial regulators of banks and financial institutions in India (MCA)
)A

A financial regulatory body is established by legislative act to establish standards

in a specific field of activity or operations in the private sector of the economy, and
then to put those standards into effect. Regulatory interventions take place outside of
the executive’s purview. In layman’s terms, financial regulation is a type of regulation
(c

or supervision that subjects financial institutions to specific requirements, guidelines,

and restrictions. Financial regulatory bodies have been established to help with this.

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 Principles and Practices of Banking 23

They can be either governmental or non-governmental in nature. The primary goal

Notes

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of financial regulators is to maintain the country’s financial system’s stability and
integrity. Financial regulation also has an impact on the structure of banking sectors by
broadening the range of financial products available. One of the three legal categories

in
that comprise the content of financial law is financial regulation, with the other two being
case law and market practises.

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1.2.1 RBI Roles and Functions
The Reserve Bank of India (RBI) regulates India’s banking system and is thus the

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most prominent bank in our country. It is also the central bank of India and plays an
important role in the Indian economy.

Roles & Functions of RBI – Introduction

ty
With a population of over 1.2 billion people, India is one of the world’s fastest-
growing economies, and it has become a global investment hub. The RBI is one of
the many factors that manage and influence the Indian economy. It is one of the oldest

si
institutions that has contributed to the success of the Indian economy. In addition, the
RBI is also known as the Banker’s Bank. The RBI protects the Indian economy and is
responsible for growth in FOREX, exports, capital markets, and a variety of other areas.

r
Furthermore, these sectors are expanding at a healthy rate. It is critical to the country’s
economic and financial structure’s strengthening, development, and diversification. It is
ve
the most powerful bank in the Indian banking system.

Structure of The Indian Banking System

●● Reserve banks of India.
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●● Indian Scheduled Commercial Banks

●● State Bank of India and its associate banks
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●● Twenty nationalized banks

●● Regional rural banks
●● Other scheduled commercial banks
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●● Foreign Banks Non-scheduled banks

●● Co-operative banks
The Reserve Bank of India (RBI) is India’s central banking institution. It is in charge
m

of the Indian rupee’s monetary policy. It was founded on April 1, 1935, in accordance
with the provisions of the Reserve Bank of India Act, 1934. The Reserve Bank was
initially privately owned and managed, but since its nationalisation in 1949, it has been
)A

wholly owned by the Government of India.

Preamble of RBI
The Reserve Bank of India’s Preamble states that the Reserve Bank of India’s
basic functions are “to regulate the issue of Banknotes and the keeping of reserves
(c

with a view to securing monetary stability in India and generally to operate the currency
and credit system of the country to its advantage; to have a modern monetary policy

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 24 Principles and Practices of Banking

framework to meet the challenge of an increasingly complex economy, to maintain price

Notes

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stability while keeping the goal of growth in mind.”

The RBI has four regional offices located throughout the country:

in
◌◌ Chennai
◌◌ Delhi

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◌◌ Kolkata
◌◌ Mumbai
It consists of 20 regional offices and 11 sub-offices.

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Organizational Structure of RBI:
●● The RBI’s operations are overseen by a central board of directors. The
Government of India appoints this board for a four-year term.

ty
●● Four Deputy Governors are full-time officials. Mr. Shaktikanta Das is the current
Governor of the Reserve Bank of India.

si
●● Mr B.P. Kanungo, N. S. Vishwanathan, and M. K. Jain are the four Deputy
Governors.
●● Nominated by the government: There are ten directors from various fields, as well
r
as two government officials.
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Functions of RBI in Indian Banking System
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U
ity
m
)A
(c

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 Principles and Practices of Banking 25

Notes

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in
nl
O
ty
r si
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Monetary Authority: It determines the amount of money that must be delivered to
the economy in order to improve the exchange rate, maintain a good expense balance,
achieve financial stability, control inflation, and strengthen and support the basic
banking system.
ni

The issuer of the currency: It is India’s sole authority for the production of currency.
It also takes steps to control the circulation of counterfeit money.
U

The issuer of Banking Permit: According to Section 22 of the Banking Regulation

Act, a bank is not permitted to begin operations without first obtaining a licence from the
RBI.
ity

Banker’s to the Government: It serves as a financier for both the state and federal
governments. It provides access to short-term credit. It governs all new matters of
government lending, keeping the government debt unresolved, and overseeing the
market for government securities. It advises the government on banking and monetary
issues.
m

Banker’s Bank: It is the bank of all banks in the country because it provides loans
to bankers/banks, rediscounts bank invoices, and receives bank payments.
)A

Financier of last resort: In times of crisis or need, all other banks can borrow from
the Reserve Bank of India by keeping qualified securities as a deposit.

Banker and debt controller of government: It holds government credits without

charging interest, accepts and pays compensation, makes exchange payments,
and helps to float new loans and control public debt. It also serves as a guide to
(c

governments.

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 26 Principles and Practices of Banking

Money supply and Regulator of Credit: To manage the demand and supply of cash
Notes

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in the economy through open market actions, credit ceilings, and other means. It must
meet the remaining banking system’s credit requirements. It necessitates maintaining
price stability and a high rate of economic growth.

in
Act as clearinghouse: The RBI oversees 14 clearing houses to aid in the settlement
of banking transactions. It allows for the exchange of devices as well as the processing

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of fee instructions.

Controller of foreign exchange: The RBI serves as FOREX’s guardian. It is in

charge of supervising and implementing the Foreign Exchange Management Act

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(FEMA) of 1999. It buys and sells foreign currency in order to keep the Indian rupee’s
exchange rate against other currencies stable.

Regulator of Economy: The RBI manages the system’s money supply and monitors

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various vital indicators such as inflation, GDP, and so on.

Managing Government securities: It directs investments in organisations that invest

a specified percentage of their total liabilities/assets in government securities.

si
Regulator and Supervisor of Expense and Settlement structures: The Payment and
Clearing Methods/structures Act of 2007 (PSS Act) gives the Reserve Bank of India
oversight authority over the country’s expense and clearing systems. It focuses on the
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creation and operation of secure, protected, and efficient payment and reimbursement
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mechanisms.

Developmental Role: This section focuses on raising the standard of India’s

banking system and ensuring that credit is available to the productive sectors of the
economy. It performs a wide range of public relations functions to support national
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goals. Similarly, it entails establishing organisations aimed at shaping the country’s

financial structure. It also advocates for increased access to low-cost financial services,
as well as financial education and literacy.
U

Publisher of economic data and additional data: The Reserve Bank of India
preserves and disseminates all critical banking and additional economic data,
articulating and critically assessing India’s economic policies. It gathers, combines, and
ity

publishes information on a regular basis.

Exchange manager and regulator: The Reserve Bank of India represents India
as an associate member of the International Monetary Fund (IFM). The majority of
commercial banks are RBI-certified traders.
m

Banking Ombudsman Scheme: In 1995, the Reserve Bank of India introduced

the Banking Ombudsman Scheme. Accusers can file their objections in any format,
including online, and can also file a petition to the RBI against the grants and other
)A

verdicts of the Banking Ombudsman.

Standards Board of India and Banking Codes: The Reserve Bank of India
establishes the Standards Board of India (BCSBI) and Banking Codes to calculate the
presentation of banks in comparison to Codes and standards based on recognised
global practises.
(c

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 Principles and Practices of Banking 27

Impartial Practices Codes For Investors:- The RBI developed the Fair Practices
Notes

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Code for Investors, which was communicated to banks in order to protect the interests
of debtors. All banks are expected to follow the codes developed by the RBI.

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Miscellaneous Functions: The Reserve Bank of India collects, collates, and
publishes all monetary and banking information in its weekly statements, the RBI Notice
(monthly), and the Report on Cash and Finance on a regular basis.

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The endowment of Industrial Finance: Rapid industrial growth is critical to
economic growth. It is critical to provide satisfactory and timely acknowledgement
to small, medium, and large businesses. The RBI plays an important role in the

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establishment of distinct financial institutions such as ICICI, IDBI Ltd, and EXIM BANK,
among others.

Provisions of Training: It has always worked hard to provide critical training to the

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banking industry’s workforce. The RBI has established training institutions for bankers
in a number of locations. Few examples include BSC (Bankers Staff College), NIBM
(National Institute of Bank Management), and CAB (College of Agriculture Banking).

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The RBI’s Role in the Current Scenario
The RBI’s role in the Indian economy has evolved in response to the country’s
circumstances. In April 2019, the Reserve Bank of India issued a monetary policy
r
decision to reduce its borrowing rate to 6%. This was the second rate cut of the
ve
year, and it is expected to have a more significant positive impact on borrowing rates
through the credit market. Prior to April, credit rates in India had remained persistently
high, despite the central bank’s position, which had been limiting borrowing across the
economy. The central bank must contend with a slightly volatile inflation rate of 2.4
ni

percent in 2019, 2.9 percent to 3 percent in the first half of 2020, and 3.5 percent to 3.8
percent in the second half of 2020.
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RBI’s Role in Economic Development

●● Dovelopment of banking System
●● Development of Financial Institutions
ity

●● Development of Impovershed Regions

●● Economic Stability
●● Economic Growth
m

●● Appropriate Interest rate structure

●● miscelianeous
The Reserve Bank of India plays a critical role in the Indian economy, as it can
)A

make or break it. The following are the areas in which the RBI has a significant role.

●● Development of the banking system

●● Development of financial institutions
(c

●● Development of backward areas

●● Bringing Economic stability

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 28 Principles and Practices of Banking

●● Facilitating Economic growth

Notes

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●● Preparing Proper interest rate structure

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RBI’s Role in Promoting Schemes and Policies
One of the main functions of the RBI is to announce schemes and policies that
benefit both the community and the government.

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The segments chosen by the RBI for economic development are listed below.

◌◌ Promotion of commercial banking

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◌◌ Promotion of cooperative banking
◌◌ Promotion of industrial finance
◌◌ Promotion of export finance

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◌◌ Promotion of credit guarantees
◌◌ Promotion of differential rate of interest scheme
◌◌ Promotion of credit to priority sections including rural & agricultural sector

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◌◌ Promotion of credit to weaker sections

Supervisory Functions of RBI

●● r
Authorization of banks and management of the number of new branches
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●● Banks must be inspected on a regular basis.
Monitoring Non-Bank Financial Organizations: Non-bank financial institutions are
unconcerned about the operation of monetary policy. The RBI has the authority to issue
orders to NBFIs regarding their operations. Deposit Insurance Scheme Implementation:
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In the event of a bank failure, the RBI is working to develop the Deposit Insurance
Scheme to protect the deposits of small depositors. (For bank credits of less than one
lakh rupees.)
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Prohibitory Functions of RBI

It cannot provide direct financial assistance to any trade, industry, or business. It is
ity

unable to purchase its own share. It is not permitted to purchase stock in any industrial
or commercial enterprise. It is unable to acquire any movable property. It cannot make
loans based on the security of shares or real estate.

RBI Functions – General Terms

m

Monetary policy refers to the use of monitoring tools by the RBI’s regulator in order
to control the availability, cost, and use of cash and credit.
)A

Cash Reserve Ratio (CRR): The RBI determines CRR, and the percentage
changes each year. Banks are required to keep a certain amount of their credits
in cash with the Reserve Bank of India. CRR is followed by the RBI either to drain
additional liquidity from the economy or to discharge additional reserves required for the
economy’s progression.
(c

Statutory Liquidity Ratio (SLR): It is the amount that commercial banks are required
to keep in the form of gold or government-approved securities before issuing credit to
customers.
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 Principles and Practices of Banking 29

Repo Rate: The Repo Rate is the rate at which the Reserve Bank of India credits
Notes

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cash to commercial banks. Every time banks face a resource constraint, they can take
resources from the RBI in exchange for safeties. If the RBI raises the repo rate, banks
will find it difficult to borrow, and vice versa. As a tool to control inflation, the RBI raises

in
the repo rate, making it more expensive for banks to borrow from the RBI, with the goal
of limiting the availability of cash. Similarly, in a deflationary environment, the RBI will
do the exact opposite.

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Reverse Repo Rate: The reverse repo rate is the rate at which the Reserve Bank
of India is willing to borrow from commercial banks. If the RBI raises the reverse repo
rate, it indicates that the RBI is eager to give banks a good interest rate for depositing

O
money with the RBI. This reduces the amount of cash available to bank customers
because banks prefer to credit their money with the RBI because it provides greater
security. This obviously leads to a higher level of interest that banks will demand from

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their clients in exchange for lending them money.

The Repo Rate and Reverse Repo Rate are important tools that the Reserve Bank
of India can use to control the availability and supply of cash in the economy.

si
Fiscal Policy: It is linked to direct taxes and government spending. When direct
taxes rise and government spending rises, non-refundable income of the general public
falls, and thus demand falls.
r
At its meeting today, the MPC (Monetary Policy Committee) decided to keep the
ve
policy repo rate below the liquidity adjustment facility (LAF) unchanged at 5.15 percent,
based on a calculation of the current and growing macroeconomic conditions. As a
result, the reverse repo rate below the LAF has remained at 4.90 percent, while the
Bank Rate and marginal standing facility (MSF) rate have remained at 5.40 percent.
ni

The MPC’s decision is dependable, with an impartial stance of the monetary plan in
agreement with the goal of achieving the medium-term target for consumer price index
(CPI) inflation of 4% within a range of +/-2% while supporting growth.
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Policy Repo Rate 5.45%

Reverse Repo Rate 4.90%
Marginal Standing Facility Rate 5.40%
ity

Bank Rate 5.40%

CRR 4%
SLR 19.50%
m

Base Rate 8.95%- 9.45%

MCLR 7.70%- 8.05%
Savings Deposit Rate 3.50% – 4.00%
)A

Term Deposit Rates > 1 year 6.00%- 6.75%

1.2.2 SEBI Roles and Functions

SEBI is a statutory regulatory body that was established on April 12, 1992.
(c

It monitors and regulates the Indian capital and securities markets, ensuring that
investors’ interests are protected by developing regulations and guidelines. SEBI’s
headquarters are in Mumbai’s Bandra Kurla Complex.

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 30 Principles and Practices of Banking

SEBI has a corporate framework that is made up of various departments,

Notes

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each of which is led by a department head. SEBI is comprised of approximately 20
departments. Corporation finance, economic and policy analysis, debt and hybrid
securities, enforcement, human resources, investment management, commodity

in
derivatives market regulation, legal affairs, and other departments are among them.

SEBI’s hierarchical structure includes the following members:

nl
◌◌ The chairman of SEBI is appointed by the Union Government of India.
◌◌ This structure will include two officers from the Union Finance Ministry.
◌◌ The Reserve Bank of India will appoint one member.

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◌◌ The Union Government of India will nominate five additional members.

Authority and Power of SEBI

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The SEBI has three main powers:

i. Quasi-Judicial: SEBI has the authority to issue judgments relating to securities

market fraud and other unethical practises. This contributes to the securities market’s

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fairness, transparency, and accountability.
ii. Quasi-Executive: SEBI has the authority to carry out the regulations and judgments
that have been issued, as well as to take legal action against those who violate them.
r
It also has the authority to inspect books of accounts and other documents if there is
ve
a violation of the regulations.
iii. Quasi-Legislative: SEBI reserves the right to enact rules and regulations to protect
investors’ interests. Insider trading regulations, listing obligations, and disclosure
requirements are among its regulations. These have been designed to prevent
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malpractice. Despite the powers, the outcomes of SEBI’s functions must still be
reviewed by the Securities Appellate Tribunal and the Supreme Court of India.
U

Functions of SEBI
●● SEBI was established primarily to protect the interests of investors in the securities
market.
ity

●● It promotes the growth of the securities market and regulates the industry.
●● SEBI provides a platform for stockbrokers, sub-brokers, portfolio managers,
investment advisers, share transfer agents, bankers, merchant bankers, trustees
of trust deeds, registrars, underwriters, and other related individuals to register and
m

regulate their work.

●● It governs the activities of depositories, participants, securities custodians, foreign
portfolio investors, and credit rating agencies.
)A

●● It forbids insider trading, which is defined as fraudulent and unfair trade practises
in the securities market.
●● It ensures that investors are educated on the securities market intermediaries.
●● It keeps track of large stock acquisitions and corporate takeovers.
(c

●● SEBI is in charge of research and development to ensure that the securities

market is always efficient.

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 Principles and Practices of Banking 31

Mutual Fund Regulations by SEBI

Notes

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●● SEBI’s mutual fund regulations include the following:
●● A sponsor of a mutual fund, an associate or a group company, which includes a

in
fund’s asset management company, cannot hold the following positions through
the schemes of the mutual fund in any form:
o o (a) 10% or more of the asset management company’s or any other mutual

nl
fund’s shareholding and voting rights.
o o (b) An asset management company may not serve on the board of any other

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mutual fund.
●● A shareholder cannot own 10% or more of a mutual fund’s asset management
company, either directly or indirectly.

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●● For a sectoral or thematic index, no single stock can have more than a 35% weight
in the index; for other indices, the cap is 25%.
●● The cumulative weight of the index’s top three constituents cannot exceed 65

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percent.
●● An individual index constituent should have a trading frequency of at least 80%.
●● At the end of each calendar quarter, AMCs must evaluate and ensure compliance
r
with the norms. The indices’ constituents must be made public by publishing them
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on their website.
●● Before launching a new fund, it must notify SEBI of its compliance status.
●● All liquid schemes must have at least 20% of their assets in liquid assets such as
government securities (G-Secs), repo on G-Secs, cash, and treasury bills.
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●● A debt mutual fund can only invest up to 20% of its assets in one sector;
previously, the limit was 25%. The additional exposure to housing finance
U

companies (HFCs) has been increased from 10% to 15%, with a 5% exposure on
securitised debt based on retail and affordable housing loan portfolios.
●● According to SEBI, amortisation is not the only method for valuing debt and money
market instruments. The mark-to-market method is also employed.
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●● An exit penalty will be imposed on liquid scheme investors who leave the scheme
within seven days.
●● Mutual fund schemes may only invest in listed non-convertible debentures (NCD).
m

According to the regulator’s guidelines, any new investment in commercial papers

(CPs) and equity shares in listed securities is permitted.
●● Short-term deposits, debt, and money market instruments with structured
)A

obligations or credit enhancements are no longer permitted in liquid and overnight

schemes. • When investing in debt securities with credit enhancements, a
minimum of four times security cover is required for mutual funds schemes. A
prudential limit of 10% is imposed on such schemes’ total investment in debt and
money market instruments.
(c

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 32 Principles and Practices of Banking

1.2.3 IRDA Roles and Functions

Notes

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The Insurance Regulatory and Development Authority of India (IRDAI) is an
independent regulatory body that protects policyholder interests. They oversee the

in
development of the insurance sector in India, the requirements that various types of
insurance policies project, and assist in maintaining rapid growth. The IRDAI was
established in 1999 by the IRDAI Act, with various functions and responsibilities

nl
bestowed upon it.

The IRDAI has established a number of rules and regulations governing the
operation of the insurance industry. Its sole purpose is to protect the interests of

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policyholders while also ensuring the overall growth and evolution of the insurance
industry. If there are any changes to the rules and regulations, IRDAI sends out notices
to insurance companies on a regular basis. It encourages insurance companies to be
more efficient in their operations and to keep insurance rates and other charges under

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control.

Objective of IRDAI

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The IRDAI’s primary goal is to carry out the provisions of the Insurance Act.
IRDAI’s mission statement is:

●● To protect the policyholder’s interests and ensure fair treatment.

●●
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To govern the insurance industry impartially and to ensure the industry’s financial
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sanity.
●● Creating regulations on a regular basis to ensure that the insurance industry runs
smoothly.
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IRDAI Act
The IRDAI Act regulates the insurance industry in India completely (all the
U

insurance business in India is regulated by IRDAI). The IRDAI is an important player

in the development of insurance regulatory mechanisms in the insurance sector. The
Government of India established a committee to examine the structure of the insurance
sector and advocate for revisions to the rules and regulations to make it more effective
ity

and efficient. In 1999, IRDAI was introduced in parliament. The bill was debated and
discussed before becoming the Insurance Regulatory and Development Authority of
India (IRDAI) Act of 1999.

Functions of IRDA
m

The authority must ensure the regulation, development, and promotion of the
insurance business, according to Section 14 of the IRDA Act 1999.
)A

Among the essential functions of IRDA are the following:

◌◌ To issue the registration certificate to the applicant, as well as to renew,
modify, withdraw, suspend, or cancel such registration.
◌◌ To protect policyholders’ interests when assigning and nominating
(c

policyholders, understanding insurance claims, insurable interests,

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 Principles and Practices of Banking 33

surrendering the policy’s value, and other insurance contract terms and
Notes

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conditions.
◌◌ Specify the qualifications, code of conduct, and practical training required of

in
intermediary/insurance intermediaries and agents.
◌◌ To explain the code of conduct that applies to both surveyors and assessors.
◌◌ Ensure the efficiency and proficiency with which the insurance business is

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conducted.
◌◌ To promote and regulate the relationship between professional organisations
and the insurance and reinsurance industries.

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◌◌ To levy the charge in order to carry out the Act’s purpose.
◌◌ To request information, conduct inspections, inquiries, and investigations,
including audits of insurers, intermediaries, insurance intermediaries, and

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other organisations involved in the insurance business.
◌◌ To regulate and control the insurer’s rates, benefits, terms, and conditions
pertaining to general insurance business that is not controlled and regulated
by the Tariff Advisory Committee under Section 64U of the Insurance Act of

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1938.
◌◌ To specify how the books should be kept and how the statement of accounts

◌◌
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should be prepared by insurers and other insurance companies.
To keep insurance companies’ investment funds afloat.
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◌◌ Control over the maintenance of margin solvency.
◌◌ To resolve disputes between insurers and intermediaries of insurance
intermediaries.
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◌◌ To oversee the tariff advisory committee’s operations.

◌◌ Determining the percentage premium income of the insurer of finance
schemes in order to promote and regulate professional organisations.
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◌◌ To protect policyholders’ interests in the event of policyholder assignment and

nomination.
◌◌ Specifying the percentage of life insurance and general insurance business
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that will be handled by the insurer in the rural or social sector.

◌◌ To regulate the insurance industry in such a way that the applicable laws and
regulations are financially sound.
◌◌ To draught laws on a regular basis to eliminate any ambiguity in the insurance
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sector.
◌◌ To take action when appropriate standards are insufficient or are not
effectively enforced.
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◌◌ To grant, modify, or suspend insurance company licences.

◌◌ To carry out any other IRDA functions that may be assigned to them.

Types of Insurance Policies Regulated by IRDAI

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The insurance industry is divided into two major groups.

1. Life insurance: Life insurance, as the name implies, governs the plans that protect your

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 34 Principles and Practices of Banking

life. It is a contract between an insurance policyholder and an insurance company in

Notes

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which the insurer agrees to pay a sum of money in exchange for premium payments
if the insured person dies or reaches the specified maturity period.

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Furthermore, there are two types of life insurance: term life insurance and whole life
insurance.
2. Non-life insurance (also commonly known as general insurance): Everything else

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that isn’t covered by life insurance is referred to as non-life or general insurance. This
includes health insurance, auto insurance, motorcycle insurance, home insurance,
business insurance, travel insurance, and so on.

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Roles of the IRDAI in the insurance sector:
◌◌ IRDAI issues the life insurance company with a certificate of registration and
also renews, modifies, withdraws, suspends, and cancels the registration.

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◌◌ The regulatory body protects policyholders’ interests in areas such as policy
assignment, policyholder nomination, insurable interest, insurance claim
settlement, policy surrender value, and other terms and conditions applicable

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to an insurance contract.
◌◌ It specifies the qualifications, code of conduct, and practical training that
insurance intermediaries and agents must have.
◌◌ r
IRDAI ensures that surveyors and loss assessors follow the code of conduct.
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◌◌ The autonomous body promotes efficiency in the insurance business and
promotes and regulates professional organisations associated with the
insurance and reinsurance industries.
◌◌ It levies fees and other charges to carry out the purposes of the IRDAI Act.
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◌◌ IRDAI performs functions such as inspection, conducting inquiries and

investigations, and auditing insurers, insurance intermediaries, and other
organisations involved in the insurance business.
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◌◌ The regulatory body also controls and regulates the rates, benefits, terms, and
conditions that insurers may offer in the general insurance business.
◌◌ It also specifies the form and manner in which books of account and
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statements of accounts should be maintained by insurers and insurance

intermediaries. • IRDAI monitors insurance companies’ investment of funds
and governs the maintenance of the margin of solvency.
◌◌ It also hears disputes between insurers and intermediaries or insurance
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intermediaries, and it oversees the Tariff Advisory Committee’s operations.

◌◌ The IRDAI specifies the percentage of the insurer’s premium income that
will be used to fund the schemes for promoting and regulating professional
)A

organisations referred to in clause (f).

◌◌ It specifies the percentage of life and general insurance business that the
insurer will conduct in the rural or social sector.
◌◌ With so many roles, the IRDAI upholds industry standards and works to
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eliminate insurance fraud.

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 Principles and Practices of Banking 35

1.3 Banks
Notes

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A bank is a financial institution that is permitted to accept deposits and make loans.
Banks can also offer financial services like wealth management, currency exchange,

in
and safe deposit boxes. Banks are classified into three types: retail banks, commercial
or corporate banks, and investment banks. Banks are regulated by the national
government or central bank in the majority of countries.

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Banks are vital to the economy because they provide essential services to both
consumers and businesses. They provide you with a secure location to store your cash
as a financial services provider. You can conduct routine banking transactions such as

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deposits, withdrawals, check writing, and bill payments using a variety of account types
such as checking and savings accounts and certificates of deposit (CDs).

Banks also provide credit to individuals and businesses. The money you deposit

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at the bank—short-term cash—is lent to others for long-term debt, such as car loans,
credit cards, mortgages, and other debt vehicles. This process contributes to market
liquidity, which generates money and maintains supply.

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A bank’s goal, like any other business, is to make a profit for its owners. The
majority of banks’ owners are their shareholders. Banks accomplish this by charging
borrowers higher interest rates on loans and other debt than they do on savings
accounts.
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The Department of Financial Services is responsible for the operation of banks,
financial institutions, insurance companies, and the National Pension System. The
Secretary (Financial Services) leads the Department, which is supported by five
Additional Secretaries (AS), three Joint Secretaries (JS), two Economic Advisers (EA),
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and a Deputy Director General (DDG).

1.3.1 Roles and Functions

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In common parlance, the term “bank” refers to a commercial bank and its
operations. The Central Bank is a distinct entity with distinct roles. A bank’s function is
to collect public deposits and lend those deposits for the development of agriculture,
industry, trade, and commerce.
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The bank pays lower interest rates to depositors while receiving higher interest
rates on loans and advances from them. In modern banking, the bank performs a
variety of other functions, such as the creation of debts and money, the transmission
of money from one country to another, the expansion of foreign trade, the safekeeping
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of valuables, and so on. Thus, the bank generates profits by engaging in a variety of
activities.
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Commercial Bank:
Historically, commercial banks were formed for the purpose of conducting
business. Commercial banks resulted in the birth of modern banking. According to
Professor Roger, “a commercial bank is one that deals with money and money’s worth
in order to make a profit.”
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 36 Principles and Practices of Banking

A commercial bank’s goals are as follows:

Notes

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1. To establish as a profit-maximizing institution and to conduct overall economic
activities.

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2. To collect public savings or idle money at a lower rate of interest and lend it at
a higher rate of interest.
3. To instil in people a desire to save money.

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4. To encourage people to invest money in order to achieve financial stability.
5. To create money against money as a means of increasing the supply of

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money.
6 Savings are used to build capital.
7 To accelerate investment.

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8 To provide additional services to customers.
9 To keep the money market under control in order to maintain economic
stability.

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10 To provide economic assistance and advice to the government.
11 Assist the government with trade and business development, as well as
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socioeconomic development
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The Functions of Commercial Bank

A: General Functions:
1. Receiving Deposits: The primary function of a commercial bank is to receive
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or collect deposits from the general public in various forms of accounts, such as
current, savings, and term deposits. The current account earns no interest, the
savings account earns a lower rate of interest, and fixed deposits earn a higher rate
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of interest. As a result, the commercial bank expands its customer base.

2. Accommodation of loans and advances: Commercial banks place a high value on
providing loans and advances at rates higher than deposit rates in order to profit
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from them. Working capital is provided to the borrower in order for the business to
expand and run smoothly. Similarly, commercial banks provide financial assistance
for agricultural and industrial development. According to government directives,
credit facilities are made available to entrepreneurs in order to revitalise sick and
dying industries. As a result, commercial banks also provide welfare services to the
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general public.
3. Creation of Loan Deposits: Commercial banks not only accept public deposits and
make loans to the public, but they also create loan deposits. For example, when
)A

loans are disbursed in accordance with the terms of the sanction, the loan amount
is credited to the borrower’s account. The borrower is not permitted to withdraw the
entire amount at once. The residual amount, or balance remaining in the account,
generates loan deposits.
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4. Creation of medium of exchange: The Central Bank has sole authority to issue notes.
Commercial banks, on the other hand, create mediums of exchange by issuing

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 Principles and Practices of Banking 37

cheques. Cheques, like notes, are transferable and are widely used in banking
Notes

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transactions.
5. Contribution in foreign trade: Commercial banks play an important role in facilitating

in
foreign exchange and foreign trade transactions such as imports and exports. It
makes significant contributions to the economy through import and export finance,
earning foreign exchange for the country.

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6. Formation of capital: Commercial banks provide financial assistance for the formation
of capital in the country’s trade, commerce, and industry, thereby accelerating its
economic development.

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7. Creation of Investment Environment: Commercial banks play an important role in
creating favourable investment environments in the country.

Public Utility Functions

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Commercial banks provide public utility services in modern banking:

1. Remittance of Money: One of the functions of a commercial bank is to transfer

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money from one location to another. Remittances are made in the form of demand
draughts, telegraphic transfers, and other methods through various branches and
correspondents both at home and abroad.
2. r
Help in trade and commerce: Commercial banks aid in the expansion of trade and
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commerce. Customers in inland and foreign trade are given credit facilities in the
form of letters of credit, bills purchased and discounted, and so on.
3. Safe custody of valuables: Commercial banks offer customers “locker services” for
the safe custody of valuables such as documents, shares, securities, and so on.
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4. Help in Foreign Exchange business: When a letter of credit is opened, the commercial
bank obtains a credit report on the supplier, which helps to expedite import and
export business.
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5. Act as a Referee: Commercial Bank acts as a third-party arbitrator for and on behalf
of its customers.
6. Act as an Adviser: Commercial banks offer valuable advice to customers on a variety
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of products, business growth and development, and the viability of businesses and
industries.
7. Collect utility service bills: As part of its social responsibility, Commercial Bank
collects utility service bills from the general public, such as water, electricity, gas,
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telephone, and so on.

8. Purchase and sale of prize bonds, sanchaya patra, shares etc.: As part of its social
responsibility, Commercial Bank agrees to buy and sell prize bonds, sanchaya patra,
)A

and shares, among other things.

9. Help people travel abroad: Commercial banks assist customers in travelling abroad
by issuing travellers cheques, draughts, cash, and other items in their favour.

Agency Functions:
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Aside from the aforementioned functions, a commercial bank serves as a customer

representative.

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 38 Principles and Practices of Banking

1. Collection and payment: On behalf of its clients, commercial banks collect and pay
Notes

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cheques, bills of exchange, promissory notes, pensions, dividends, subscriptions,
insurance premiums, interest, and so on.

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2. Purchase and sale of shares and securities: Commercial banks are tasked with the
purchase and sale of shares and securities on behalf of their customers.
3. Maintenance of secrecy: One of the most important functions of a commercial bank

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is the preservation of secrecy.
4. Act as a trustee: Commercial Bank acts as a trustee on the customer’s behalf.

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5. Economic Development and Welfare activities: Commercial banks make significant
contributions to the country’s welfare and economic development.

Central Bank:

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The Central Bank is the institution in charge of the banking system and the money
market. A central bank’s primary function is to assist the government in formulating
economic policy, controlling and conducting the money market, and controlling bank

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credit. Different definitions have been provided by specialised bankers, economists, and
thinkers:

“A central bank is a bank whose primary responsibility is to maintain monetary

stability.” r
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“The central bank is a banking system in which a single bank has either a complete
or a residuary monopoly of note issue,” according to Decock.

According to Professor Hatley, “the central bank is the lender of last resort.”
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Functions of Central Bank:

The functions of the central bank differ from those of other banks. The central
bank’s functions are listed below:
U
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(c

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 Principles and Practices of Banking 39

Notes

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O
ty
r si
ve
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U
ity
m
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A. Traditional or general functions:

1. Issue of notes and coins: The central bank’s primary function is to issue notes
and coins in response to public demand as well as the needs of business
and commerce. Notes are issued against gold, silver, and foreign currency in
(c

accordance with the rules.

The following are the arguments in its favour:

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 40 Principles and Practices of Banking

(a) To maintain equilibrium in the quality of notes and currency issued

Notes

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(b) To maintain equilibrium in the size, types, and values of notes and currency
(c) To maintain stability in both inland and foreign exchange rates (d) To instil

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confidence in the people
(d) To control the money market.

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2. Government Bank: The Central Bank serves as the government’s banker and
economic adviser. The central bank conducts and keeps track of all government
receipts and payments.

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3. Banker’s Bank: The Central Bank serves as a bank for bankers. As a general
rule, all scheduled and commercial banks must maintain an 18 percent Statutory
Liquidity Reserve (SLR) with the Central Bank.

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4. Lender of the last Resort: In the event of a commercial bank’s financial crisis,
the central bank acts as a lender of last resort by lending gainst first-class
securities, bills of exchange, and so on.

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5. Reservoir of foreign currency: The Central Bank keeps a Foreign Currency
Reserve. The following factors are responsible for foreign currency control:
(a) The issuance of notes
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(b) The payment of liabilities
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(c) The payment of debts.
6. Clearing House: The Central Bank serves as a clearing house for interbank
transactions.
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7. Credit Control: Credit control is one of the central bank’s primary functions.
Credit can be controlled in the following ways:
(a) Change in bank rates
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(b) Open market operation

C. Change (increase or decrease) in reserve- ratio
(d) Selective credit
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(e) Direct influence

(f) Moral suasion
(g) propaganda.
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B. Purposeful functions:
(a) Control Currency Market: The Central Bank serves as the currency market’s
)A

controller and guardian. The central bank is the forerunner in the formation,
control, and maintenance of the currency market, as well as its overall
development.
(b) Stabilize Exchange Rate: The Central Bank maintains the stability of foreign
(c

currency exchange rates by controlling credit. The position of stable exchange

rates contributes to a favourable balance of trade, and the acceptability of stable
currency gains traction in the international market.

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 Principles and Practices of Banking 41

(c) Maintain Gold Standard: The central bank is in charge of maintaining and
Notes

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controlling the gold reserves.
(d) Stabilize Price-Level: Price fluctuations and frequent price changes have an

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impact on economic growth. To compensate for economic imbalances and crisis
situations, the central bank implements price-level stabilisation measures.
(e) Stabilize business activities: The central bank formulates credit policy, and in

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that spirit, the central bank takes the necessary steps to protect the economy
and stabilise business activities.
(f) Employment opportunities: Through its credit-control mechanism, the Central

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Bank takes steps to create job opportunities.

C. Expansion and Development Functions:

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(a) Development of Agriculture and Industry Sector: The Central Bank develops
policies to expand the agricultural sector in order to boost the country’s economy.
(b) Development of natural resources: The role of the central bank is critical in

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gaining access to natural resources that can lead to economic growth.

D. Other Functions:

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(a) Adviser and Representative of Government: The Central Bank advises the
government on economic issues and occasionally acts as the government’s
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representative.
(b) Economic Research: The Central Bank conducts various economic research
projects and develops economic policies. The Central Bank conducts surveys
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on various economic issues for the benefit of the general public in the country.

1.3.2 Regulatory Provisions

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The Reserve Bank of India (RBI) regulates the Indian banking system through the
provisions of the Banking Regulation Act, 1949. Some key aspects of the regulations
that govern banking in this country, as well as RBI circulars relating to banking in India,
will be discussed below.
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Exposure Limits
Lending to a single borrower is limited to 15% of the bank’s capital funds (tier 1
and tier 2 capital), which can be increased to 20% for infrastructure projects. Lending
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to group borrowers is limited to 30 percent of the bank’s capital funds, with the option
of increasing it to 40 percent for infrastructure projects. With the approval of the bank’s
board of directors, the lending limits can be increased by another 5%. Lending includes
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exposure to both funds and non-funds.

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

Banks in India are required to keep at least 4% of their net demand and time
liabilities (NDTL) in cash with the RBI. These are currently not earning any interest. The
(c

CRR must be maintained every two weeks, and daily maintenance must be at least
95 percent of the required reserves. In the event of a daily maintenance default, the

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 42 Principles and Practices of Banking

penalty is 3% above the bank rate multiplied by the number of days of default multiplied
Notes

e
by the amount that falls short of the prescribed level.

In addition to the CRR, a minimum of 22% and a maximum of 40% of the NDTL,

in
known as the SLR, must be kept in the form of gold, cash, or certain approved
securities. Excess SLR holdings can be used to borrow overnight from the RBI under
the Marginal Standing Facility (MSF). The interest rate charged under MSF is 100 basis

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points higher than the repo rate, and the amount that can be borrowed is limited to 2%
of NDTL. (Read more about who determines interest rates to learn more about how
interest rates are determined, particularly in the United States.)

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Provisioning
Non-performing assets (NPA) are divided into three types: substandard, doubtful,
and loss. In the case of a term loan, an asset becomes non-performing if there have

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been no interest or principal payments for more than 90 days. Substandard assets are
those that have had NPA status for less than 12 months, after which they are classified
as doubtful assets. A loss asset is one that the bank or auditor does not expect to be

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repaid or recovered and is generally written off the books.

A provision of 15% of the outstanding loan amount for secured loans and 25% of
the outstanding loan amount for unsecured loans is required for substandard assets.
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For doubtful assets, provisioning for the secured portion of the loan ranges from 25%
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of the outstanding loan for NPAs that have been in existence for less than one year,
to 40% for NPAs that have been in existence for one to three years, to 100% for NPAs
that have been in existence for more than three years, and to 100% for NPAs that have
been in existence for more than three years.
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Standard assets must also be provisioned. Provisioning for agriculture and small
and medium-sized businesses is 0.25 percent, commercial real estate is 1 percent
(0.75 percent for housing), and the remaining sectors are 0.4 percent. To arrive at
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net NPAs, provisioning for standard assets cannot be subtracted from gross NPAs.
For loans made to companies with unhedged foreign exchange exposure, additional
provisioning is required in addition to the standard provisioning.
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Priority Sector Lending

The priority sector consists primarily of micro and small businesses, as well
as initiatives related to agriculture, education, housing, and lending to low-income or
underprivileged groups (classified as “weaker sections”). For domestic commercial
m

banks and foreign banks with more than 20 branches, the lending target is 40% of
adjusted net bank credit (ANBC) (outstanding bank credit minus certain bills and non-
SLR bonds), or the credit equivalent amount of off-balance-sheet exposure (sum
of current credit exposure + potential future credit exposure calculated using a credit
)A

conversion factor), whichever is higher.

The amount disbursed as loans to the agriculture sector should be the credit
equivalent of off-balance-sheet exposure or 18 percent of ANBC, whichever is greater.
Of the total amount lent to micro-enterprises and small businesses, 40% should be
(c

advanced to enterprises with equipment valued at a maximum of 200,000 rupees and

plant and machinery valued at a maximum of half a million rupees, while 20% should

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 Principles and Practices of Banking 43

be advanced to micro-enterprises with plant and machinery valued at a maximum of a

Notes

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million rupees and equipment valued at more than 2 million rupees.

The total value of loans made to weaker sections should be 10% of ANBC or the

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credit equivalent amount of off-balance-sheet exposure, whichever is greater. Weaker
sections include specific castes and tribes that have been labelled as such, as well as
small farmers. There are no specific goals in place for foreign banks with fewer than 20

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branches.

Until now, private banks in India have been hesitant to lend directly to farmers and
other vulnerable groups. One of the main reasons is that priority sector loans have a

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disproportionately higher number of NPAs, with some estimates indicating that they
account for 60% of total NPAs. To meet their quota, they buy loans and securitized
portfolios from other non-banking finance corporations (NBFCs) and invest in the Rural
Infrastructure Development Fund (RIDF).

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New Bank License Norms
According to the new guidelines, groups applying for a licence must have a

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successful track record of at least ten years, and the bank must be operated through
a non-operative financial holding company (NOFHC) that is wholly owned by the
promoters. The minimum paid-up voting equity capital must be five billion rupees,
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with the NOFHC holding at least 40% and gradually reducing it to 15% over a 12-year
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period. The shares must be listed within three years of the bank’s inception.

For the first five years of operation, foreign shareholding is limited to 49 percent,
after which RBI approval is required to increase the stake to a maximum of 74 percent.
The bank’s board of directors should be made up of a majority of independent directors,
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and it must adhere to the previously discussed priority sector lending targets. The
NOFHC and the bank are not permitted to hold any securities issued by the promoter
group, and the bank is not permitted to hold any financial securities held by the
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NOFHC. The new regulations also require that 25% of the branches be opened in
previously unbanked rural areas.

Wilful Defaulters
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Willful default occurs when a loan is not repaid despite the availability of resources,
or when the money lent is used for purposes other than the intended purpose, or when
a property secured for a loan is sold without the bank’s knowledge or approval. If a
company within a group defaults and the other companies in the group that have given
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guarantees fail to honour their guarantees, the entire group is considered a willful
defaulter.

Willful defaulters (including the directors) are barred from receiving funding,
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and criminal charges may be brought against them. The RBI recently amended the
regulations to include non-group companies in the category of willful defaulter if they fail
to honour a guarantee given to another company outside the group.

In some ways, how a country regulates its financial and banking sectors reflects
(c

its priorities, goals, and the type of financial landscape and society it wishes to create.
In the case of India, the regulations enacted by its central bank provide insight into its

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 44 Principles and Practices of Banking

approaches to financial governance and demonstrate the extent to which it prioritises

Notes

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stability within its banking sector as well as economic inclusiveness.

Though the regulatory structure of India’s banking system appears conservative,

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this must be viewed in the context of the country’s relative underbanking. Excessive
capital requirements are required to build trust in the banking sector, while priority
lending targets are required to provide financial inclusion to those to whom the banking

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sector would not normally lend due to the high level of NPAs and small transaction
sizes.

Because private banks do not directly lend to priority sectors, public banks have

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been left with the burden. A case could also be made for redefining the priority sector
in light of agriculture’s high priority, despite the fact that its share of GDP has been
declining.

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1.3.3 Banking Regulation Act 1949
The Banking Companies Act 1949 was another name for the Banking Regulations
Act 1949. Since it was first passed in 1949 under the name Banking Companies Act.

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However, after some time, its name was changed to the Banking Regulation Act 1949
on 1 March 1966, and its regulations went into effect on 16 March 1949. Aside from
that, all banking firms established in India are regulated and controlled by Indian
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legislation. Since 1956, the banking laws and acts have also been implemented in the
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Indian state of Jammu and Kashmir. Commercial banks’ functions include advances,
receiving deposits, credit, endowing loans, cash, bill discounting, overdraft, and so on.

It regulates and supervises the banks that have been established in India. In
India, the Banking Regulation Act 1949 is a legislative act. It is normally in charge of
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regulating and managing the operations of all banking corporations in India. Aside from
that, it was first enacted in India as the Banking Companies Act, 1949, and it went into
effect on March 16, 1949. Following its passage, too many causes arise, and some
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changes are made up in this act again. On March 1, 1966, its name was changed to
Banking Regulation Act 1949. Furthermore, the Banking Regulation Act has been in
effect in the Indian state of Jammu and Kashmir since 1956. Originally, the Banking
Law only applied to banking institutions. However, it was amended in 1965 to make it
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suitable for cooperative banks and to familiarise further modifications.

History
The following is a timeline of the Banking Regulations Act of 1949.
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The Banking Companies Act 1949 was the first time a banking act was enacted.
It essentially regulates the business. This act went into effect on March 16, 1949,
under the name Banking Companies Act 1949, which was later changed to Banking
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Regulation Act 1949. It took full power on March 1, 1966. Following that, the banking
laws are applied to all Indian banks, including those in Jammu and Kashmir.

The Banking Regulation Act of 1949 has a territorial scope that extends throughout
India. Aside from that, the Indian Parliament passed the Banking Regulation Act
(c

in 1949. Because it is India’s legislative body, it essentially regulates all banks in the
country. It became law on March 10, 1949.

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 Principles and Practices of Banking 45

Features
Notes

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The following features of the Banking Regulation Act are explained further below.

●● A comprehensive depiction of banking in order to obtain within the scope of

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statutory regulations into all institutions that obtain repayable on demand,
deposits, lending, or investment.
●● Another feature is the prohibition on non-banking assets or companies receiving

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deposits money again payable on demand.
●● Prohibiting trading in order to eliminate the numerous risks associated with non-

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banking sectors.
●● Lowest capital averages as a remedy
●● Defining the ideal compensation and dividend payments.

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●● Inclusion of the scope of bank legislation enlisted beyond the various sections of
India.
●● The foreword to a comprehensive system of authorising banks and their

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constituents.
●● Requirement for a specific type of balance sheet. Aside from that, it gave the
Reserve Bank several banks of powers and controls, including the ability to call for
a specific time recovery. r
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●● The Reserve Bank of India examines a bank’s books and reports.

Pivotal Provisions
The following are the main provisions of the banking regulatory acts.
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●● Title, size, and conception are the first provisions of the BR Act.
●● Another example is the Banks’ Restricted Functions.
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●● Aside from that, another provision of the BR act is the administration of a bank.
●● Also included are the Capital and Reserves.
●● Regulations and laws governing the settlement of bonus and dividend provisions.
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●● Limitation on the nature of subsidiary companies

●● Restrictions on a variety of loans and advances.
●● Authorization of financial institutions
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●● Opening new branches and relocating existing ones.

●● Assets, recoveries, specifics, accounts, audits, and so on.
)A

The Banking Regulation Act of 1949 is divided into 56 sections. The crucial
sections of the Banking Regulation Act, 1949 are Restrictions on the power to remit
debts under Section 20A, the Reserve Bank’s power to manage advances by banking
companies under Section 21 and Section 21A, etc.
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1.3.4 RBI Act 1935

The Reserve Bank of India (RBI), established on April 1, 1935 under the RBI Act
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 46 Principles and Practices of Banking

1934 (on the recommendations of the John Hilton Young Commission 1926 - known as
Notes

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the Royal Commission on Indian Currency and Finance), is the country’s central bank
and was nationalised on January 1, 1949. Prior to its establishment, the Central Bank’s
functions were handled by the Imperial Bank of India, a subsidiary of SBI. Originally a

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shareholders’ bank, it was taken over by the Central Government in 1948 under the
Reserve Bank (Transfer of Public Ownership) Act (paid up capital Rs.5cr). The RBI’s
headquarters are in Mumbai.

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The RBI is managed by a Central Board of Directors, with four local boards in
Mumbai, Delhi, Calcutta, and Chennai. It has one Governor, four Deputy Governors,
and IS other directors.

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Functions of RBI:
Issuance of currency: Except for one rupee note or coins, RBI is the sole agency/

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authority in India to issue currency notes (called bank notes) under the signatures of the
Governor, according to Section 22 of the RBI Act 1934. (which is issued by the. Central
Govt - signed by Finance Secretary).

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The Issue Department is in charge of issuing new notes in exchange for gold coins,
bullion, rupee coins, foreign securities, eligible promissory notes, and other approved
securities (the aggregate value of gold and foreign exchange reserves should not be
r
less than Rs.200 crore, of which gold (coins and bullion) should not be less than Rs.ll
ve
crore). The Banking Department is in charge of all banking activities and keeps a stock
of currency, which is distributed through currency chests located throughout the country.

Banker to the Government: Central Bank transacts government business and

manages public debt under Section 20 for the Central Government and Section 21-A for
ni

the State Government. Where it does not have an office, SBI or another public sector
bank is designated as its Agent. It advises the government on all monetary issues and
also provides Ways and Means advances (Section 17).
U

Bankers’ bank: It holds commercial banks’ deposits and serves as a lender of

last resort, providing financial assistance in a variety of ways. Sections 17 (2) and (3)
allow banks to approach the RBI for rediscounting, refinancing, and other services. It
offers export refinance to the extent of IS percent of outstanding export credit eligible
ity

for refinance as of the end of the previous fortnight (wef May OS, 200 I) as well as a
Liquidity Adjustment Facility as of June 5, 2000.

Controller of Banks: Every bank that wishes to conduct banking operations in India
must obtain a licence from the RBI. The RBI also acts as a bank controller by including
m

Indian banks in the Act’s 2nd Schedule (such banks which are incorporated under
Companies Act or under any other .law in force in India or outside including State Coop
Banks and which are included in 2nd Schedule of RBI Act 1934 are called scheduled
)A

banks). It issues licences to conduct banking operations. It issues directives, conducts

inspections (both on-site and off-site), and exercises management control.

Controller of credit: Under Sections 21 and 3SA, the RBI has the authority to fix
interest rates (including the Bank Rate) as well as exercise selective credit controls in
(c

order to control inflation and money supply in order to ensure economic growth and
price stability. For this purpose, various methods such as changing the cash reserve
ratio, stipulating margin on securities, directed credit guidelines, and so on are used.

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 Principles and Practices of Banking 47

These are referred to as quantitative and qualitative methods, respectively. It also

Notes

e
conducts open market operations, which are the sale and purchase of securities.

Statutory Reserves: Banks must also keep a certain percentage of their assets in

in
liquid/cash form in order to meet SLR/CRR requirements.

Collection of information: The RBI collects credit information (U/s 4S-C information
on borrowers with credit limits of up to Rs.1 0 lac on a secured basis and Rs.5 lac on an

nl
unsecured basis) and can share it with other banks (See 45- D). Furthermore, the RBI
obtains information on suitably filed accounts and BSR returns.

Maintenance of external value: The RBI is also in charge of maintaining both the

O
external and internal value of Indian currency. The RBI holds foreign exchange reserves
and has broad authority to regulate foreign exchange transactions under the Foreign
Exchange Management Act (FEMA).

ty
Reserve Bank of India Act 1934 Important Provisions
The Act, which was originally passed in 1934, was amended in 1997 to include

si
NBFCs as well.

Section Summary of Provision in the Section

2(e) Scheduled bank means a bank shose name is included in the 2nd schedule
of RBI Act 1934 r
ve
17 Defines various types of business which RBI may transact, which incluede
acceptatnce of deposit without interest from Central/Stete government,
any other person/Institution. purchase/sell foreign exchange, securities,
rediscount the bill/spromissory notes, grant loans etc.
ni

18 RBI provides emergency loans tgo banks on liberal terms.

19 Describes business which RBI may not transact.
U

20 Banker to Govt. It performs various functions for the Govt. It transacts Govt.
Business and managers public debt of the Central Govt.
21 RBI has the right to transact Govt. business in India i.e. remittance, exchange,
keep it deposit free of int. etc.
ity

22 Sole right to issue bank notes.

23 Bank notes shall be issued by issue deptt.
24 Denomination of notes (2, 5, 10, 20, 50, 100, 500, 1000, 5000, 10000)
Cental Govt.
m

May direct discontinuance or non-issue of bank note of any denomination

(2 &5 aiready discontinued).
26 Bank notes issued by RBI shall be legal tender and shall be guaranteed by
)A

Central Govt.
28 RBI can frame rules for refunding value of mutilated, soiled or imperfect
notes as a matter of grace. Rupee coin and one rupee note shall not be a
currency note for any of the purposes of this Act.
(c

29 Bank note shall be exempted fro stamp duty under Indian Stamp Act.

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 48 Principles and Practices of Banking

31 Prohibits issue of note payable to bearer. No person in India other than RBI
Notes

e
or Central Govt. shall draw. accept make or issue any bill of Exchange, hindi
or promissory note for the payment of money payable to bearer on demand.

in
33 Assets of issue deptt. of RBI shall consist of gold coins, gold billion and
ofreign securities not a anytime be less than INR 200 cr, of which gold coin
and gold bullion not less than INR 115cr.

nl
42 Cash Reserve Ratio (CRR) of scheduled ba nks to be kept with RBI on an
average daily balance
42(c) Empowers RBI to add or delete the name of any bank in 2nd schedule of

O
RBI Act 1934
43 RBI to publish every fortnight a consolidated statement showing aggregate
liablities and assets of all SCBs.

ty
45A to F Empowers RBI to collect credit information. (Sec. 45C Return as onlast
Friday of April & October every year gibving information on borrowers
enjoying secured credit limits of INR1, lac and above and unsecured limits
of INR5lac and above) RI also collects details (1/2 yearly March/Sectp) of

si
all doubtful, loss and suit filed accounts with aggregate outstanding of INR 1
lac and above and circulatede the information amongts banks and financial
institutions, Besides, banks submit basic statistical Returns i.e. BSR-1
r
(details regarding borrowl accounts of above INR 2lac and BSR 2 (information
ve
about deposits with break-up in to current; saving and term deposits).
45H-45T Regulations reiating to non-bank finance companies. Section 45-S puts
bank on acceptance of depostis from public by individualor unincorporated
body, as per an amendment in 1997.
ni

48 Exemption to RBI from paying income tax or super tax.

49 Announce/publish bank rate. (bank rate as per this section is the standard
rate a which RBI is prepared to buy or rediscount bills of exchange or other
U

commercial papers eligible for purchase under this act.)

1.4 Banking Concept

ity

A bank is a financial institution that accepts deposits and lends money. A bank
allows a person with extra money (a saver) to deposit it in the bank and earn interest on
it. Similarly, a bank lends money to a person in need (investor/borrower) at an interest
rate. As a result, banks serve as a go-between for savers and borrowers.
m

The bank typically accepts deposits from the public at a much lower interest rate
known as the deposit rate and lends the money to the borrower at a higher interest
rate known as the lending rate. The difference between the deposit and lending rates is
known as the ‘net interest spread,’ and the interest spread is the bank’s profit.
)A

1.4.1 Retail Banking

Banks are an important and vital part of India’s financial system. They are one of
the most important contributors to the country’s economic growth and development.
(c

Retail banking is a critical component of the commercial banking system and is

extremely important to the general public. It is a growing trend that is regarded as a

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 Principles and Practices of Banking 49

brilliant innovation in the banking sector. Emerging economies such as India have
Notes

e
benefited greatly from this new retail lending trend. One of the primary reasons for the
growth of this sector is the ever-changing technology.

in
Retail Banking
Consumer banking is another name for retail banking. It is, as the name implies,
a component of the commercial banking system that deals with the general public

nl
and individual customers. Retail banking systems aim to provide citizens with banking
services such as checking accounts, opening accounts, savings accounts, loans, debit
cards, and more. This system is aimed at members of the general public and their

O
personal financial needs. It does not include companies, businesses, or corporations
that may require more complex banking solutions.

Most people associate banks with retail banking services such as savings,

ty
transactions, mortgages, debit cards, credit cards, and so on. This is not a new
phenomenon in India, but changes in customer demographics and technological
advancements have made it an integral part of day-to-day operations. Retail banking is

si
done at commercial banks’ local branches. It should be noted that it could simply be a
branch of a bank that handles people’s general needs for saving and spending money.

Functions of Retail Banking

r
While retail banking has existed in various forms for a long time, it is a relatively
ve
new concept. It has evolved over time to become an important component of both
traditional and modern banking systems, as well as a significant market segment.
Simply put, retail banking handles all of the banking needs of individual customers.
ni

Consumer banking has three primary functions

◌◌ First, banks accept deposits for savings accounts, recurring deposit accounts,
fixed deposit accounts, and other financial services in order to safely secure
U

the general public’s capital.

◌◌ Second, banks provide credit in the form of interest earned on savings as well
as loans and mortgages.
ity

◌◌ Finally, retail banks assist customers in handling and managing their money
through a variety of retail banking solutions and services. These services
assist customers with their financial matters and day-to-day transactions.

Types of Retail Banks

m

Because they serve the general public, these banks are often referred to as
“people’s banks.” Personal banking and mass-market banking are other terms for
it. Large commercial banks frequently have local branches to meet the various retail
)A

banking objectives.

Retail banks come with a variety of formation goals.

Commercial Banks: Also referred to as banks in general. However, investment

(c

banks and financial institutions are not included in this category. They assist their clients
by providing personal banking, business banking, online banking, financial services,
and lending and borrowing.

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 50 Principles and Practices of Banking

Regional Rural Banks: RRBs, also known as Gramin Banks, are regionally
Notes

e
established banks in various Indian states to serve low-income groups or people living
in rural areas. These banks provide regular retail banking services as well as loans and
mortgages.

in
Private Banks: These are typically urban banks that serve people with moderate to
high income levels.

nl
Post Offices: The National Postal System provided basic banking services such as
account opening, savings, recurring deposits, and more in areas where people did not
have access to regular banks. This is a convenient and secure mode of banking for

O
developing countries in areas where underdeveloped sections of society cannot reach
the bank.

Retail Banking Services Offered by Banks

ty
The introduction of banking technology has resulted in a dramatic change in the
functioning and operations of retail banking in India. Banks have embraced cutting-
edge technology to reach out to customers, meet their needs and expectations, learn

si
customer behaviour, increase productivity, staff efficiency, increase sales, and manage
money. Banks offer a variety of retail banking services, including a variety of financial
products classified as retail deposit products, loan services, and payment services.
r
The following are a few retail banking solutions and services that banks provide to
ve
their customers. Savings Bank Accounts: This is a type of bank account that customers
can open at a bank that offers retail banking services in order to deposit funds and earn
interest on them.

Current Account: Checking account, transaction account, and demand deposit

ni

account are some other terms for this type of bank account at a retail bank. It is made
available to account holders based on their request. It can also be used for frequent
transactions by the account holder.
U

Debit Card: It is a plastic payment card that can be used to make payments at
ATMs and other locations instead of cash. Most banks issue this card with each current
or savings account.
ity

Credit Card: This is a plastic card that, like debit cards, can be used to make
payments instead of cash. Banks permit cardholders to make payments on credit in
exchange for a promise to pay the bank the amount spent plus agreed-upon additional
charges.
m

ATM Cards: These cards can only be used to withdraw money and perform other
transactions at ATMs.
)A

Other products offered by retail banks to individuals include term deposit accounts,
fixed deposit accounts, recurring deposit accounts, zero balance salary accounts, and
savings accounts with higher interest rates for senior citizens.

Loans: Banks make loans to their customers for a variety of reasons. Home loans,
auto loans for new/used vehicles, consumer loans, education loans, crop loans to
(c

farmers, and business loans for small businesses are all available through retail banks
in India.

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 Principles and Practices of Banking 51

Aside from the aforementioned retail banking features, banks offer their customers
Notes

e
safe deposit boxes for the safekeeping of their valuables for an annual fee. Other
important services provided by retail banks include funds transfer, NEFT, RTGS, Core
Banking Solutions, Internet banking, mobile banking, information system, electronic

in
clearings service, cheque clearance, remittances, payment settlement, and others.
Retail banking is a prime example of a technological revolution that has altered the
banking system.

nl
Advantages of Retail Banking
Retail banking is an option for both banks and individual customers. The

O
significance of retail banking emphasises the benefits of bank services. Retail banking,
as opposed to corporate banking, focuses on small businesses and individuals for
profit. It has proven to increase earnings and business for banks over the years. It has
reduced operational costs and aided banks in establishing a market-wide brand image

ty
among the general public. Furthermore, banks have established customer relationships
with their customers. The customer base has grown and been strengthened as a result
of this.

si
The retail sector contributes significantly to bank revenue as well as economic
development. It reduces the risk for banks that rely on loans for income. Furthermore, it
provides a secure way to keep your savings and capital safe.
r
ve
Retail Banking Trends in India
The banking industry has undergone significant change in the last ten years. Banks
have been forced to adopt new strategies and techniques as a result of increased
competition, the IT revolution, the emergence of Fintech and non-financial services,
ni

and changing customer demographics and expectations. Banks are embracing digital
transformation, which provides a better customer experience, lowers operating costs,
and lowers the cost of banking transactions.
U

Meanwhile, internet banking and mobile banking are the two most rapidly emerging
retail banking trends. Banking has become more simple and convenient as a result of
technological advancement. This trend is expected to result in a significant decrease
ity

in bank visits in the coming years. Artificial intelligence and voice assistants used to
deliver personalised and contextualised services are technologically advanced
innovations that are expected to change banking systems. Adoption of biometric
authentication and KYC systems are two emerging trends that are expected to reduce
the risk of fraud and fraudulent activity.
m

The Scope of Retail Banking in India

As previously stated, retail banking has numerous advantages. This is one of the
)A

reasons it has been such a huge success for banks and customers alike. Today, it is a
lucrative banking segment that has piqued the interest of investors and accelerators.
Because technology is constantly evolving, the future of retail banking in India is
uncertain. The digital transformation is only the beginning; there is much more in the
works that will change the money business forever.
(c

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 52 Principles and Practices of Banking

1.4.2 Wholesale Banking

Notes

e
Wholesale banking is a complete banking solution provided by merchant banks to
large scale business organisations and government agencies or institutions. Companies

in
that want to use wholesale banking must have a strong financial statement and operate
on a large scale. Clients of wholesale banking are typically multinational corporations.

Wholesale banking provides an opportunity for businesses to grow, even if they

nl
lack the necessary capital.

Features

O
The wholesale banking market is divided into three major segments. Commercial
banks (for smaller corporate clients), corporate banks (for upper-midmarket corporate
clients), and investment banks are the three types (for large multinational corporate
clients and financial-institution groups). Wholesale banking exists to serve large-scale

ty
business goals.

Some of its characteristics are as follows:

si
Large Scale Operations: Wholesale banking primarily meets the enormous
financial needs of large corporations and the government.

r
Low Operational Cost: Due to a small customer base and a low volume of
transactions, the cost of carrying out transactions and other banking operations is quite
ve
low.

High Risk Involved: Wholesale banking carries a high level of risk. The failure of
the borrower company may result in the failure of all parties associated with it.
ni

Control Over Financial Transaction Monitoring and Recovery: Due to the limited
number of customers, banks find it easier to monitor financial transactions and recover
loans and advances.
U

Huge Impact on Non-Performing Asset: If there is a delay or default in the

repayment of wholesale banking loans and advances, the bank’s non-performing assets
increase.
ity

High Cost of Deposit: The interest rates paid by banks on deposits made by large
business entities are high.

Functions
m

Wholesale banking is a completely different concept that does not cater to small
businesses or individual clients. Its functions are as follows:
)A

Primary Functions –
The following are some of the major services provided by wholesale banks:

Making Advances: The primary goal of wholesale banks is to provide large-scale

business entities with high-value loans and advances.
(c

Accepting Deposits: These banks also accept deposits from large corporations and
pay high interest on the funds deposited.

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 Principles and Practices of Banking 53

Credit Creation: The wholesale banks stimulate the flow of funds in the economy
Notes

e
by initiating loans and deposits from the government and large corporations.

Secondary Functions –

in
Banks also have some additional responsibilities, which are listed below:

Underwriting: The wholesale bank raises capital for large business organisations’

nl
projects by issuing debt or equity shares to investors on their behalf.

Mergers and Acquisitions: These banks facilitate the merger of two or more
companies around the world, as well as the acquisition of one business unit by another

O
organisation, through operations such as currency conversion.

Trust and Consultancy Services: Other services provided by merchant banks to

their clients include investment advice and trust building.

ty
Fund Management: The merchant banks work tirelessly to manage and handle the
funds deposited by their clients wisely.

si
Response of Wholesale Banks to Market Conditions
Wholesale banks play an important role in the economy, and they must adapt to
changing market conditions.
r
The following are the various adjustments and updates made by merchant banks in
ve
this context:

Global Expansion: Wholesale banks are expanding to locations where multinational

client companies have branches.
ni

Wholesale Credit Transformation: A wholesale bank focuses on providing a

consistent client experience, processes, roles, and technology in credit products and
bank operations.
U

Client Onboarding: The primary goal is to improve the client companies’

information, transparency, service speed, and experience.

Data Management: Banks maintain and improve the security, governance, and
quality of confidential data.
ity

Monetize Mobile Capabilities: Through mobile channels, these banks provide

customers with self-service operations and information about various products and
services.
m

Platform Modernization, Simplification and Migration: By accepting deposits and

making loans and advances, wholesale banks help to simplify and modernise business
operations.
)A

Relationship Management: Building long-term relationships with clients is critical for

merchant banks.

Advantages of Wholesale Banking

We can now say that wholesale banking is a viable option for businesses that
(c

require significant financial assistance on a regular basis. Also for those who want to
take advantage of opportunities for growth and development.

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 54 Principles and Practices of Banking

Other advantages of wholesale banking include the following:

Notes

e
Provides Extra Safety to Depositors: Banks in wholesale banking treat deposited
funds with great care and invest them in relatively safe investment opportunities.

in
Low Transaction Fees: Banks in wholesale banking take great care with deposited
funds and invest them in relatively safe investment opportunities.

nl
Facilitates Large Trade Transactions: It enables large-scale companies to conduct
high-value transactions.

Fulfils Huge Working Capital Requirements: To carry out day-to-day operations,

O
large business associations require a significant amount of funds. Thus, wholesale
banking meets this requirement by providing funds for working capital.

Lending to Government: These banks also lend money to the government of the

ty
country in order for it to carry out various long-term projects.

Provides Cash Management Solution: Wholesale banking also enables effective

cash management, which is the acquisition and investment of cash in the right

si
opportunity.

Drawbacks of Wholesale Banking

r
The transactions of wholesale banking involve large sums of money, making it a
ve
complicated affair.

Let us now look at some of the drawbacks of wholesale banking:

High Risk: Because lumpsum transactions occur in wholesale banking, there is a

high level of risk involved.
ni

Expensive Business Accounts: When compared to traditional bank accounts,

maintaining accounts and records in wholesale banking is an expensive endeavour.
U

High-Interest Rates and Processing Fees: The borrower company is obligated to

repay high interest and processing fees on bank loans and advances.

Relies on Stability of Location: When a company deposits a large sum at a single

ity

location, such as a wholesale bank, there is a risk of loss if the bank experiences a
downturn.

Payment for Unused Services: There is always a complaint in wholesale banking

that client companies are forced to pay for services that they do not use.
m

May Lead to Client’s Exploitation: When the borrowed sum is large, the borrower
company may be taken advantage of by the bank.
)A

Wholesale Banking in India

We all know that India is a developing country, and with increased globalisation,
Indian firms are becoming multinational corporations. These companies operate
on a global scale, necessitating large sums of money to meet their working capital,
(c

investment, and other financial obligations.

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 Principles and Practices of Banking 55

Even the Indian government promotes medium-sized industries in order to build a

Notes

e
dependable infrastructure, foster sound market conditions, reduce deficits, and promote
overall economic development. All of these factors contribute to the need for business
financing.

in
In fact, wholesale banking services account for the majority of the revenue
generated by the banking industry in India. Since these banks meet major corporate

nl
needs such as merchant banking services, project finance, working capital
requirements, investment banking services, leasing finance, facilitating mergers and
acquisitions, and so on.

O
Wholesale banking is a one-stop shop for all of the banking needs of businesses
with high turnover and net worth, facilitating the smooth transfer of funds, proper
allocation and investment of excess capital, internal stock transfers, and so on.

ty
The Indian banking industry has a lot of room for wholesale banking, and it’s
growing quickly as globalisation and industrialization increase.

Digitization and Customer Expectations are Raising the Stakes

si
Despite the fact that banks recognise the need to modernise, determining where
to invest and which initiatives to prioritise has proven difficult in the face of shifting

r
customer expectations and an evolving technological landscape. Wrong bets can result
in wasted resources and missed opportunities, as well as a steeper hill for banks to
ve
climb.

Customers of wholesale banking are also feeling the effects of a volatile market.
Effective liquidity and risk management necessitates treasurers and finance teams
looking across the banking book, anticipating the impact of rates, currencies, and
ni

other variables, and taking proactive action. This difficult task is made more difficult
by an influx of data, increased market volatility, and a more interconnected business
landscape.
U

In light of these challenges, wholesale banking customers seek a dependable and

experienced partner who can provide personalised advice and convenient service.
Customers in corporate banking prefer simple, straightforward transactions and
ity

the option of self-service (such as a single login page for all active services and the
ability to access information and process requests across multiple devices and touch
points). Treasurers, in particular, are in need of assistance due to the growing number
of business and financial risks that they now manage. Treasurers desire a digital and
frictionless experience for managing day-to-day transactions, cash flow, and liquidity-
m

related operations, as well as a trusted business advisor who can advise them on long-
term strategic business and financial issues.
)A

Banks are under increasing pressure to improve their capabilities and provide
services such as real-time execution and proactive forecasting as corporate clients
digitally transform their own businesses. Banks will not be perceived as effective
advisors if they are less digitally savvy than their clients.

Despite this requirement, wholesale banking divisions lag behind in terms of

(c

digital maturity. Few businesses have evolved their service models quickly enough to
take advantage of advanced analytics and other tried-and-true tools. In comparison

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 56 Principles and Practices of Banking

to the digital processes and customer-centric experiences provided by technology

Notes

e
providers and fintechs, many banks continue to rely heavily on outdated technologies
and service models. Rigid infrastructures, for example, frequently result in overly
complicated onboarding processes that require treasurers to complete multiple – and,

in
in many cases, manual – steps that feel out of sync with other professional onboarding
experiences.

nl
Because they have not acquired and implemented the appropriate technologies or
developed high-value use cases, institutions are becoming increasingly vulnerable to
customer shift.

O
Competition Is Intensifying
The wholesale banking market is no longer as focused on banks as it once was.
New players who emerged in key niches over the last decade are now well entrenched,

ty
and their service is raising the bar for incumbents. Commercial, corporate, and
investment banks are coming up against a diverse group of well-funded and aggressive
challengers as the playing field broadens.

si
Fintechs. Although financial technology players aren’t yet large enough to make
a significant dent in bank revenue, they are gaining market share on the outskirts.
MarketAxess, for example, is targeting areas that banks once dominated by developing
r
specialised technology to assist bond market participants in improving workflow and
ve
liquidity management, as well as providing integrated data aggregation, pretrade
information analysis, and execution facilitation. Previously marginalised tech players
(such as proprietary trading firms) are gaining market share in a variety of asset
classes. Many banks are in an unenviable position as a result of fintech pressure:
they must invest heavily to stay relevant while earning less as digitization and
ni

commoditization drive down prices.

Bigtechs and Digital Disruptors. Nonbanks with advanced digital capabilities

U

have introduced disruptive value propositions as well. Amazon Lending, for example,
made $3 billion in loans to 20,000 small-business customers between 2011 and 2017,
based on vast repositories of transactional, product, and customer data. Other big-
tech behemoths, such as PayPal, are making inroads into the wholesale banking value
ity

chain. PayPal increased the cap on its working-capital loan products by a factor of ten
in five years, from $20,000 in 2013 to $200,000 in 2018. These players could pose a
significant threat to banks that serve small and medium-sized customers in the coming
years.
m

Banktechs. Some large banks are making bold investments in order to gain both
innovation and scale advantages, with technology spending that exceeds what others
earn in a year. JP Morgan, for example, set aside $11 billion per year for technology-
)A

related investments from 2016 to 2018. Goldman Sachs announced plans to launch
a dedicated treasury management unit in 2020 to assist investment banking clients
with their payments and cash management needs. Banktech units that combine the
balance-sheet strength of a large, global institution with the entrepreneurial culture
and agile processes of a digital native could pose a significant competitive challenge to
(c

banks with lower levels of digital maturity.

Nonbanking Financial Institutions. Since the end of the financial crisis, funds from
non-bank financial institutions (NBFIs) have accounted for the vast majority of asset
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 Principles and Practices of Banking 57

growth in the small-business and midmarket segments. Globally, NBFI assets under
Notes

e
management increased at a compound annual growth rate of 12 percent between
2009 and 2018. In the United States, where the market is disintermediated, NBFIs now
originate 10% to 15% of all midmarket loans. The success of NBFIs in the United States

in
and elsewhere may loosen commercial and corporate banks’ grip on small-business
and midmarket customer relationships.

nl
The Market Outlook Is Worsening
The banking industry has been operating in a relatively benign macro environment
since the end of the financial crisis. The US economy experienced its longest streak

O
of GDP growth from 2009 to 2019. Bond and loan default rates are at their lowest in
decades, even in emerging markets and niche asset classes that typically have higher
exposure.

ty
Policymakers all over the world have been proactive as well. When the prospect of
an economic slowdown appeared on the horizon in 2018, the US Federal Reserve was
quick to pause interest rate hikes and balance sheet runoffs. Similarly, the European

si
Central Bank backed away from plans to reduce quantitative easing. In China, officials
have increased credit flows and encouraged debt-financed spending in order to keep
the country’s economy stable. These economic tailwinds and accommodating monetary
policies have pushed asset prices to new highs while ensuring a consistent fee stream
for advisory products. r
ve
However, the market outlook for the next several years is likely to be very different.
GDP forecasts in the world’s largest economies have deteriorated dramatically. And,
while private debt is nowhere near as high as it was prior to the last downturn, it is
increasing. Almost three-quarters of those polled believe a recession is likely in the
ni

next two years. Markets, according to two-thirds of investors, are overpriced. Many
wholesale banking clients have begun to take a more defensive, value-oriented
approach to their investment decisions as a result.
U

Volatility is also increasing. Trade tensions between the United States and China
continue to wreak havoc on the capital markets, with many large US corporations
lowering their third-quarter 2019 profit estimates. The slow pace of Brexit negotiations,
ity

as well as concerns about the potentially destabilising impact of rising populist

movements, pose investment risks in Europe.

Central banks are ready to act, but they have fewer monetary tools at their
disposal. It is unclear whether the upcoming slowdown will be mild or severe, but
m

wholesale banks should begin preparing now to strengthen their balance sheets and
improve operational performance.

It’s Time For A New Approach

)A

Business as usual will no longer suffice in the face of the profound changes
sweeping the wholesale banking landscape. Planning for the future will necessitate
a Leadership Agenda for the Next Decade that questions traditional assumptions,
considers shifting competitive bases, and retools their organisations. Plans will
(c

undoubtedly vary, but all banks, regardless of size or region, should consider the
following reinvention imperatives.

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 58 Principles and Practices of Banking

Simplify and focus. Because of the growing performance disparity between top-
Notes

e
and bottom-quartile players, not all banks will be able to succeed in the same ways.
Those who commit to refocusing their strategy on areas where they can provide
superior value—whether through product leadership, service leadership, geographic

in
leadership, or a combination of the three—can open up powerful new avenues of
growth. Banks must assess their client relationships, competitive position, and balance
sheet health to determine where they can create defendable differentiation. They will

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then need to figure out how to execute on those opportunities from start to finish while
exiting deprioritized businesses, a process that will necessitate the dismantling of
relevant support functions as well as associated IT and operations.

O
Create holistic experiences. Star relationship managers, investment bankers,
salespeople, and traders have long been the primary owners of the wholesale banking
client relationship, as well as the conduit for all other banking services. While this talent

ty
is still necessary, client service is a commercial activity that is no longer limited to the
front office.

Top-performing banks will need the combined strength of their product, marketing,

si
and back-office resources as personalization at scale becomes more important. When
operations and IT specialists, for example, bring critical innovation, they add value to
the client relationship. To become more resilient and responsive in the face of changing

r
market and customer demands, leading banks will develop new ways of working
between the front, middle, and back offices. Banks can provide more satisfying, cost-
ve
effective, and integrated service to customers by focusing on core customer journeys
and establishing interconnected teams and processes.

Accelerate the rate of digitization. Banks must invest in advanced analytics,

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cognitive computing, machine learning, and other smart technologies that can process
massive amounts of data, conduct sophisticated modelling, and deliver highly predictive
recommendations at breakneck speed in order to remain competitive. When combined
with automation, the self-correcting mechanisms built into these analytical engines
U

can assist banks in responding to risks and opportunities in real time, allowing them to
remediate routine issues and improve operational resiliency. Speed is also essential.
The ability to provide rapid client onboarding via seamless processes is quickly
ity

becoming a “make or break” factor in attracting and retaining high-value customers.

Some institutions are already working hard to gain a competitive advantage

through digitization. Goldman Sachs, for example, has 3,000 full-time developers
working on a proprietary risk and pricing platform that could provide the firm with a
m

competitive advantage. Others, such as DBS Singapore, are embracing open platforms
and application programming interfaces (APIs), as well as distributed-ledger technology,
in order to improve core processes such as asset distribution. Others, such as Wells
Fargo and American Express, are looking into nonbanking products such as business
)A

planning and tax advice, as well as portals and forums that provide networking
opportunities.

Wholesale banks are at a crossroads. With depleted returns, deteriorating market

conditions, and increasing competitive and customer pressures, most divisions
(c

cannot continue to operate as before. New strategies, new business models, and
new operating fundamentals will be required to propel growth and profitability over
the next decade. However, banks that are willing to rethink their go-to-market strategy
Amity Directorate of Distance & Online Education
 Principles and Practices of Banking 59

and strengthen their core can turn adversity into an advantage. The following articles
Notes

e
in our series will look at how to do so, beginning with the need for reinvention in the
investment banking industry.

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1.4.3 International Banking
An international bank is a financial institution that operates outside of its home

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country and offers financial services to people all over the world. A foreign bank branch
is a type of international bank that is required to follow both the laws of the home
and host countries. Because loan limits are based on total bank capital, foreign bank

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branches can make larger loans than subsidiary banks. The RBI’s policy regarding
foreign banks’ presence in India is based on two fundamental principles: reciprocity and
a single mode of presence. There are currently 46 foreign banks in India, according to
the Reserve Bank of India (As on July 14, 2020). India has attracted massive inflows of

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foreign direct investment in a variety of industries (FDI).

International banking is similar to other types of banking, but it takes place across
different countries or on a global scale. To put it another way, it is the provision of

si
financial services by a residential bank in one country to residents in another. This
banking facility is used for transactions by the majority of multinational corporations
and individuals. International banking is a significant component of the global financial
market.
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ve
Features and Benefits
Flexibility: This banking facility allows multinational corporations to conduct
business in multiple currencies. The euro, dollar, pounds, sterling, and rupee are
ni

the major currencies that multinational corporations and individuals can deal with.
Companies with headquarters in other countries can use this banking to manage their
bank accounts and obtain financial services in other countries without difficulty.
U

Accessibility: Companies from various countries benefit from international

banking’s accessibility and ease of doing business. An individual or a multinational
corporation can use their money anywhere in the world. This gives them the freedom to
transact and use their money to meet any financial need anywhere in the world.
ity

International Bank Transfers/Transaction: International banking enables the

company to pay international bills. The currency conversion facility enables businesses
to easily pay and receive money. Furthermore, benefits such as overdraft facilities,
loans, deposits, and so on are available at all times for international transactions.
m

Correspondent banking is extremely useful in these situations.

Accounts Maintenance: With the assistance of international banking, a

multinational corporation can keep accurate records of global accounts. All of the
)A

company’s transactions are recorded in the books of banks worldwide. The company’s
accounts can be kept up to date by compiling data and figures.

Globalization and the expansion of economies all over the world have resulted
in the development of international banking facilities. The world has become a
(c

marketplace, and every company wants to take advantage of it. Geographical

boundaries are no longer an issue. Banking facilities have expanded dramatically as
a result of increased access to technology. International banking is a prime example.

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 60 Principles and Practices of Banking

Such banks will see increased growth and profitability in the coming years. Large
Notes

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corporations are rapidly expanding their operations. These businesses will require
international banking financial services to maintain their growth. As a result, the demand
for its services will rise.

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Forms and Functions of International Banking
International banking services provide retail, commercial, corporate, and trade

nl
finance services to clients worldwide via branches, agencies, representative offices,
subsidiaries, and affiliates. International banking services can improve the efficiency
and security of international transactions.

O
Functions of International Banking
The following are the functions of international banking:

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●● Accepting deposits and making loans in local currency to foreign governments,
businesses, and individuals.
●● Accepting deposits in foreign currencies and lending in foreign currencies to

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domestic and foreign entities.
●● Managing and acting as an agent for syndicated loans, as well as developing

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special financing requirements for international trade and projects.
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●● Foreign exchange transactions, gold and precious metals trading, and
international money transfers
●● Documentary letters of credit, standby letters of credit, multiple currency credit
lines, bank acceptances, and Euro note insurance are all available.
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●● Investing in currency futures and options, financial futures and options, interest
rate and asset swaps, and setting interest rate caps.
●● Underwriting and placement of Eurobond issues, distribution of Euro commercial
U

paper, cross-border mergers, acquisitions, and sales assistance, financial advisory

and investment services.

Forms of International Banking

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There are various types of international banking offices, ranging from

correspondent bank relationships, which provide a limited range of services to bank
customers, to branch offices and subsidiaries, which provide a broader range of
services.
m

Correspondent Bank: A correspondent bank is a bank located elsewhere that,

in addition to its regular business, provides a service on behalf of another bank.
)A

The correspondent banking system enables a foreign client of a bank to conduct

international business through his local bank or its contacts.

Representative Offices: A representative office is a small service facility staffed

by parent bank personnel that is designed to assist the parent bank’s foreign clients in
dealings with bank correspondents and to provide the clients with a level of service that
(c

is greater than that provided by merely a correspondent relationship.

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 Principles and Practices of Banking 61

Foreign Branches: Foreign branches, which may provide full services, may be
Notes

e
established when the volume of business is large enough and the law of the land allows
it. Foreign branches improve client service and contribute to the company’s growth.

in
Subsidiaries and Affiliates: A subsidiary bank is a locally incorporated bank that
is wholly or largely owned by a foreign parent, whereas an affiliate bank is owned but
not controlled by its foreign parent. Subsidiaries and affiliates are typically intended to

nl
handle a large volume of business.

When compared to branches, their autonomy is more operational and has strategic
management leverage.

O
Offshore Financial Centers: Offshore banking centres have made significant
contributions to the growth of international banking. An offshore banking centre is a
country whose banking system is structured to allow for virtually total freedom from

ty
host country government banking regulations, such as low reserve requirements and
no deposit insurance, low taxes, a favourable time zone that facilitates international
banking transactions, and, to a lesser extent, strict banking secrecy laws. Offshore
banks operate as subsidiaries or branches of the parent bank.

si
Best International Banks in India
Below are some of the best international banks in India.
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CitiBank
Kiplinger’s Personal Finance has named Citibank the “Best Bank for High-Net-
Worth Families” for the fifth year in a row, putting the Citigold option available to high-
net-worth clients at the top of the list. Citibank India is an onshore foreign bank with a
ni

presence in India. Its Indian headquarters are located in the Bandra Kurla Complex in
Mumbai, Maharashtra. It is a subsidiary of Citigroup, a New York-based multinational
financial services corporation. Despite the fact that the bank’s headquarters are in
U

Mumbai, the majority of its employees are based in Chennai, Mumbai, and Gurugram.
Citibank announced on April 15, 2021, that it will exit consumer banking in 13 regions,
including India, as part of a reorganisation.
ity

Standard Chartered Bank

Standard Chartered plc is a British multinational banking and financial services
corporation headquartered in London, England. It employs over 87,000 people and
operates through a network of over 1,200 branches and outlets in over 70 countries.
m

Standard Chartered is a FTSE 100 Index constituent with its primary listing on
the London Stock Exchange. Secondary listings are available on the Hong Kong
Stock Exchange, the National Stock Exchange of India, and OTC Markets Group
)A

Pink. Chartered opened its first offices in Mumbai (Bombay), Kolkata (Calcutta), and
Shanghai in 1858, with Hong Kong and Singapore following in 1859. The Bank of Hong
Kong began printing Hong Kong dollar banknotes in 1862. The bank’s credit card,
private banking, and wealth management services are exceptional.
(c

HSBC Bank
HSBC Bank India is a subsidiary of the UK-based HSBC Holdings plc with

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 62 Principles and Practices of Banking

headquarters in Mumbai. Under the Banking Regulation Act of 1949, the Reserve
Notes

e
Bank of India regulates it as a foreign bank (RBI). HSBC Holdings plc is a multinational
investment bank and financial services holding company based in the United Kingdom.
It is Europe’s second largest bank, with total assets of $2.984 trillion (as of December

in
2020). The Hongkong and Shanghai Banking Corporation established HSBC in London
in 1991 to serve as a new group holding company, with its roots in British Hong Kong. It
has over 50 branches in India and serves a customer base of over 1 lakh people.

nl
Deustche Bank
Deutsche Bank AG is a global investment bank and financial services firm

O
headquartered in Frankfurt that is listed on both the Frankfurt and New York stock
exchanges. The bank’s network spans 58 countries, with 5 lakh employees in Europe,
the Americas, and Asia. With 18 branches, the bank employs up to 11,000 people and

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offers all basic financial services. Among the financial products and services offered are
on-shore investment banking, institutional equities broking, asset and private wealth
management, retail banking, and business process outsourcing.

si
Royal Bank of Scotland
Currently, the bank has over ten branches that provide services such as foreign
exchange, corporate banking, and insurance. It is thought to have over 700 branches
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and is one of the world’s most reputable banks. The Royal Bank of Scotland was
ve
established in India in 1921 with the goal of providing a comprehensive range
of banking services. RBS India began operations in September 2003, with the
establishment of its Microfinance business. RBS created a three-year Microfinance
Technical Assistance initiative in underserved areas. RBS India began operations in
ni

September 2003, with the introduction of its Microfinance division. RBS launched a
three-year Microfinance Technical Assistance initiative in underserved areas.
U

DBS Bank
DBS Bank Ltd is a Singaporean multinational banking and financial services
organisation headquartered in Marina Bay, Singapore. The previous name of the
company was The Development Bank of Singapore Limited before its current name
ity

was adopted on July 21, 2003, to reflect the company’s evolving role as a global bank.
DBS is Asia’s #1 Safest Bank, and its global strength has earned it the highest score
among commercial banks as well as a spot among the world’s 15 Safest Banks. These
findings demonstrate DBS’s dependability in the eyes of investors, business clients,
m

and retail depositors. Loans, credit cards, and a slew of NRI services are among the
services offered by this global bank.

Barclays Bank
)A

Barclays is a FTSE 100 Index constituent with its primary listing on the London
Stock Exchange. It has a secondary listing on the New York Stock Exchange. It is
regarded as a systemically important bank by the Financial Stability Board. Barclays plc
is a British global universal bank headquartered in London, England. Barclays is divided
(c

into two divisions: Barclays UK and Barclays International, with Barclays Execution
Services operating as a service company in between. The bank, headquartered in

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 Principles and Practices of Banking 63

Mumbai, operates seven branches across the country. Commercial banking, loans,
Notes

e
credit cards, and Treasury Solutions are just a few of the bank’s top services.

Bank of America

in
Bank of America Corporation (abbreviated as BofA or BoA) is an American
multinational investment bank and financial services holding company headquartered

nl
in Charlotte, North Carolina. As a result of NationsBank’s acquisition of BankAmerica,
Bank of America was founded in San Francisco in 1998. The bank first opened its doors
in 1964 and currently has only five offices in India. It is still one of the world’s largest
banks, with 4.9 million customers.

O
Bank of Bahrain and Kuwait
On March 16, 1971, the Kingdom of Bahrain and the State of Kuwait established

ty
the Bank of Bahrain and Kuwait. Its shareholders include ordinary Bahrainis, the
Bahraini government, and Kuwaiti banks and investment firms. BBK offers a wide range
of banking services and products through its branches in Bahrain, Kuwait, and India, as

si
well as its representative office in Dubai, United Arab Emirates. BBK has four locations
in India: Mumbai, New Delhi, Hyderabad, and Aluva. mbai, New Delhi, Hyderabad, and
Aluva are all cities in India.

Doha Bank r
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Doha Bank is one of the most well-known commercial banks in Qatar. On March
15, 1979, it began banking services in Doha, Qatar. Doha Bank Q.P.S.C., Qatar opened
its first branch in India on June 10, 2014, in Mumbai, and it now has three branches
in India: Sakhar Bhavan, Nariman Point, Mumbai, Chennai, and Kochi. In addition, the
ni

bank has a large global correspondent network that it uses to provide Trade Finance
and Remittance-related services. The bank offers credit as well as a variety of other
services. These are the top international banks in India based on their presence,
U

operational branches or representative offices, clients, and products and services

offered.

1.5 Money Market

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The money market refers to the trading of very short-term debt investments. It
entails large-volume trades between institutions and traders at the wholesale level. At
the retail level, it includes money market mutual funds purchased by individual investors
m

and money market accounts opened by bank customers. In all of these cases, the
money market is characterised by a high degree of safety and relatively low rates of
return. The money market is one of the pillars of the global financial system. It entails
overnight transfers of vast sums of money between banks and the US government. The
)A

majority of money market transactions are wholesale transactions between financial

institutions and businesses.

1.5.1 Commercial Papers

(c

Commercial paper, also known as CP, is a short-term debt instrument issued by

businesses to raise funds for a period of up to one year. A commercial paper pays
the holder a fixed interest rate. Furthermore, due to the somewhat risky nature of the
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 64 Principles and Practices of Banking

unsecured security, it is generally sold at a discount to its face value. Commercial

Notes

e
paper is frequently required by corporations that have a short-term need to cover their
expenses.

in
A commercial paper is also known as an unsecured promissory note because it
is not backed by anything other than the issuer’s promise to repay the face value at
the maturity date specified on the note. The issuer must also make the pre-specified

nl
interest payments for the duration of the debt.

Companies with high credit ratings frequently use CPs to diversify their sources of
short-term borrowings. This provides investors with an additional tool. Large banks or

O
corporations typically issue them to cover short-term receivables and meet short-term
financial obligations, such as funding for a new project.

From the date of issue, CPs have a minimum maturity of seven days and a

ty
maximum maturity of up to one year. However, the maturity date of the instrument
should typically not exceed the date up to which the issuer’s credit rating is valid. They
can be issued in denominations ranging from Rs 5 lakh to multiples of that amount.
Because such instruments are not backed by collateral, only companies with high credit

si
ratings from a reputable credit rating agency can sell them at a reasonable price. CPs
are typically sold at a discount to face value and have higher interest rates than bonds.

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CP was introduced in India in 1990 with the goal of allowing highly rated corporate
borrowers to diversify their sources of short-term borrowings and providing investors
ve
with an additional instrument. The current guidelines for the issuance of CP are
governed by various directives issued by the Reserve Bank of India, as amended
from time to time. In accordance with the Statement on Monetary and Credit Policy
for the Fiscal Year 2000-2001, it has been decided to modify the guidelines in light
ni

of recommendations made by an Internal Group in order to keep pace with several

developments in the financial markets.

As a result, the following guidelines are issued, superseding all previous directions/
U

guidelines on the subject:

Who has the authority to issue Commercial Paper (CP): Highly rated corporate
borrowers, primary dealers (PDs) and satellite dealers (SDs), and all-India financial
ity

institutions (FIs) that have been allowed to raise resources through money market
instruments under the Reserve Bank of India’s umbrella limit are eligible to issue CP.

A company is eligible to issue CP if the following conditions are met:

m

(a) the company’s tangible net worth, as per the most recent audited balance
sheet, is not less than Rs. 4 crore
(b) the company’s working capital (fund-based) limit from the banking system is
)A

not less than Rs. 4 crore

(c) the company’s borrowal account is classified as a Standard Asset by the
financing bank/s.

Rating Requirement
(c

All eligible participants should obtain a credit rating for the issuance of Commercial
Paper from either the Credit Rating Information Services of India Ltd. (CRISIL), the

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 Principles and Practices of Banking 65

Investment Information and Credit Rating Agency of India Ltd. (ICRA), the Credit
Notes

e
Analysis and Research Ltd. (CARE), the Duff & Phelps Credit Rating India Pvt.
Ltd. (DCR India), or such other credit rating agency as the Reserve Bank of India
may specify from time to time. The minimum credit rating is P-2 from CRISIL or an

in
equivalent rating from another agency. Furthermore, at the time of CP issuance,
participants must ensure that the rating obtained is current and has not expired for
review.

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Maturity
CP can be issued for maturities ranging from 15 days to up to one year from the

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date of issue. If the maturity date falls on a holiday, the company is required to make
payment on the next working day.

Denominations

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CP can be issued in denominations of Rs.5 lakh or multiples of that amount.

Limits and the Amount of Issue of CP

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●● The total amount raised by a corporate through the issuance of CP should not
exceed the working capital (fund-based) limit sanctioned to it by the bank/banks.

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Corporates can automatically raise CP up to 50% of their working capital limits
without obtaining prior approval from the bank/s. (Any outstanding CP would
ve
also be included in the 50% limit.) Companies that want to issue CP in excess of
50% of their working capital limits, on the other hand, can do so after getting prior
approval from their bank/s.
●● The total amount of CP issued by a PD/SD should not exceed the limits
ni

established by their respective Boards.

●● An FI may issue CP within the overall umbrella limit set by the RBI, i.e., the issue
U

of CP in conjunction with other instruments, such as term money borrowings, term

deposits, certificates of deposit, and inter-corporate deposits, should not exceed
100% of its net owned funds, as per the most recent audited balance sheet.
●● The total amount of CP proposed to be issued should be raised within two weeks
ity

of the issuer opening the issue for subscription. CP may be issued on a single
date or in instalments on different dates, provided that each CP has the same
maturity date in the latter case.
●● Every CP issue, including renewals, should be treated as a new issue.
m

Investment in CP
Individuals, banking companies, other corporate bodies registered or incorporated
)A

in India and unincorporated bodies, Non-Resident Indians (NRIs), and Foreign

Institutional Investors may be issued and hold CP (FIIs). FII investment, on the other
hand, would be within the 30% limit set for their investments in debt instruments.

Mode of Issuance
(c

●● CP can be issued as a promissory note (Schedule I) or in a dematerialised form

through any of the depositories approved and registered with SEBI. Concerning

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 66 Principles and Practices of Banking

the existing CP stock, it can either be held in physical form or demateralised if both
Notes

e
the issuer and the investor agree.
●● CP will be issued at a discount to face value at the discretion of the issuer.

in
●● Banks and all-India financial institutions are not permitted to underwrite or co-
accept Commercial Paper issues.

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Preference for Dematerialised form
While both issuers and subscribers have the option of issuing/holding CP in
dematerialised or physical form, issuers and subscribers, particularly banks and

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financial institutions, are encouraged to rely solely on dematerialised form of issue/
holding.

Payment of CP

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When a CP matures and is held in physical form, the holder must present the
instrument for payment to the issuer via the Issuing and Paying Agent (IPA). However,
if the CP is held in demat form, the holder must redeem it through the depository and

si
receive payment from the IPA.

Procedure for Issuance

(a) For Corporates -

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(I) Any company proposing to issue CP should submit to the financing banking
company a proposal incorporating details in the form annexed hereto as
Schedule II.A, as modified from time to time by the Reserve Bank of India,
ni

along with the certificate issued by the credit rating agency. On receipt of the
proposal for the issuance of CP, the financing banking company shall scrutinise
it and, if satisfied, shall take the proposal on record.
U

(ii) A company proposing to issue CP up to 50% of its working capital limits may
open the issue for subscription after submitting the proposal described in
paragraph 18(i) above.
(iii) However, a company proposing to issue CP in excess of 50% of working capital
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limits may open the issue for subscription only after the financing banking
company has taken the proposal on record.
(iv) Companies must ensure that the proposed CP issue is completed within two
weeks of the issue being opened for subscription.
m

(v) Following the exchange of deal confirmations between the investor and the
issuer, the issuing company shall issue physical certificates to the investor or
arrange for the CP to be credited to the investor’s depository account. Investors
)A

will be given a copy of the IPA agreement, a copy of the IPA certificate indicating
that the documents are in order, and a statement of account from the depository
(in case of demat form).
(vi) The initial investor in CP must pay the discounted value of the CP using a
(c

crossed account payee cheque to the issuing company’s account with the
financing banking company only.

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 Principles and Practices of Banking 67

(vii) Once the CP is issued, the financing banking company shall correspondingly
Notes

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reduce the working capital (fund-based) limit of each company issuing the
CP, and the financing banking company shall make necessary adjustments in
such company’s account with the banking company/the other member banking

in
companies.
(viii) Within three days of the completion of the issue, every company issuing CP

nl
must notify the Reserve Bank of India’s Industrial and Export Credit Department,
Central Office, Mumbai (IECD), through the financing banking company, of the
amount of CP actually issued.

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(b) For Primary Dealer/Satellite Dealer -
(i) I Every Primary Dealer (PD)/Satellite Dealer (SD) proposing to issue CP
must notify the Reserve Bank of India (IECD) in the Form annexed hereto as

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Schedule II.B, as modified from time to time by the Reserve Bank of India.
(ii) Following that, each PD/SD shall make arrangements for privately placing the
issue and ensure that the proposed CP issue is completed within two weeks of

si
communication to the Reserve Bank.
(iii) The initial CP investor must pay the discounted value of the CP with a crossed
account payee cheque to the issuing PD/account. SD’s
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(iv) Within three days of the completion of the issue, every PD/SD issuing CP must
ve
notify the Reserve Bank of India (IECD) of the amount of CP actually issued.

(c) For All-India Financial Institutions -

(I) Every financial institution proposing to issue CP must notify the Reserve Bank
ni

of India (IECD) in the Form annexed hereto as Schedule II.C, as modified

from time to time by the Reserve Bank of India.
(ii) The financial institution should ensure that the total amount of CP issued does
U

not exceed the Reserve Bank of India’s overall umbrella limit.

(iii) Following that, each financial institution should make arrangements for
privately placing the issue and ensure that the proposed CP issue is
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completed within two weeks of communication to the Reserve Bank.

(iv) The initial investor in CP shall pay the discounted value of the CP to the
issuing financial institution’s account using a crossed account payee cheque.
(v) Within three days of the completion of the issue, every financial institution
m

issuing CP must notify the Reserve Bank of India (IECD, with a copy to the
Financial Institutions Division, Department of Banking Supervision) of the
amount of CP actually issued.
)A

Role and Responsibilities

The following describes the roles and responsibilities of the issuer, financing
banking company, IPA, and CRA:
(c

(a) Issuer: Corporates/issuers will now have more flexibility as the procedure for CP
issuance is simplified. The following should be ensured by issuers:

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 68 Principles and Practices of Banking

The Reserve Bank of India/SRO guidelines and procedures for CP issuance are
Notes

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strictly followed. Any violation of procedures/guidelines by CP issuers will be taken
very seriously and will result in the concerned issuer being barred from issuing CP
for the next year. Such government actions would be made public as well.

in
(b) Financing Banking Company: A financing banking company is responsible for the
following:

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(I) Upon receipt of the corporate’s proposal for the issuance of CP, the financing
banking company will scrutinise it and satisfy itself about the eligibility criteria
and terms and conditions stipulated herein for the issuance of CP before

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taking the proposal on record.
(ii) Once the CP is issued, the financing banking company will arrange for a
corresponding reduction in the issuer’s working capital fund-based limit.

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(iii) In the event of any discrepancy/non-compliance with guidelines/procedures by
the issuer, immediately notify the Reserve Bank.
(c) Issuing and Paying Agent:

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(I) The IPA must verify all of the documents submitted by the issuer, including
a copy of the board resolution, a certificate issued by a credit rating agency,
and a copy of the authorised signatures (when the CP is in physical form), and
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issue a certificate stating that the documents are in order (Schedule III).
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(ii) Original documents verified by the IPA should be kept in the IPA’s possession.
(iii) In addition to the foregoing, other responsibilities and standardised
procedures/documentation to be followed by IPA would be reviewed by a Self-
Regulatory Organization to be identified by the Reserve Bank.
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(iv) Any violation of the RBI/guidelines SRO’s and procedures will result in
punitive action.
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(d) Credit Rating Agency:

(I) The SEBI Code of Conduct for CRAs undertaking rating of capital market
instruments shall apply to them (CRAs) when rating CP.
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(ii) Furthermore, the credit rating agency would now have the discretion to
determine the validity period of the rating based on its perception of the
issuer’s strength. As a result, CRA must clearly indicate the date when the
rating is due for review at the time of rating.
m

(iii) While CRAs would be given more leeway in determining the validity period
of credit ratings, CRAs would also be required to closely monitor the ratings
assigned to issuers in relation to their track record at regular intervals and
notify the financing banking company (RBI in the case of PD/SD and FI) / IPA
)A

of any revision in the rating, particularly when the rating is downgraded.

Non-applicability of Certain Other Directions

Nothing in the Non-Banking Financial Companies (Reserve Bank) Directions,
(c

1977, as superseded by the Non-Banking Financial Companies Acceptance of Public

Deposits (Reserve Bank) Directions, 1998, shall apply to any NBFC in relation to
deposit acceptance by issuance of CP in accordance with these Directions.
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 Principles and Practices of Banking 69

Risks of Commercial Paper

Notes

e
1. Credit rating: It is important to note that due to the promissory nature of commercial
paper, only large corporations with strong credit ratings will be able to sell it at a

in
reasonable price. These corporations are referred to colloquially as “blue-chip
companies,” and they are the only ones who have the option of issuing such debt
instruments without collateral backing.

nl
If a smaller organisation attempted to issue commercial paper, it is very likely that
investors would not have enough trust in the securities to purchase them. Credit
risk, defined as the likelihood that a borrower will be unable to repay the loan, will be

O
prohibitively expensive for smaller organisations, and there will be no market for this
type of issue.
2. Liquidity: Another potential risk of commercial paper, though less significant than
with other, longer-term debt instruments, is liquidity risk. In general, liquidity refers

ty
to a security’s ability to be converted into cash at a price that reflects its fair value.
That is, liquidity reflects the ease with which a security can be bought or sold in the
market.

si
In the case of commercial paper, liquidity is less of a concern than credit (default) risk
because the debt matures quickly, leaving little room for secondary market trading.
As a result, despite the fact that the issue is one of the most commonly used money
r
market debt instruments, such secondary markets are quite small.
ve
Real-World Example
In the real world, suppose a large corporation, such as Microsoft Corp., wants to
launch a new research and development programme and needs additional low-cost
ni

funding. At this point, the company’s executives would weigh their options and possibly
conclude that commercial paper is a more appealing source of capital than obtaining a
line of credit from a financial institution.
U

In such a case, Microsoft will use its established business status and high credit
rating to issue an unsecured debt instrument, such as commercial paper, lowering its
cost of capital. `
ity

1.5.2 Bancassurance
Bancassurance is a partnership between a bank and an insurance company
that allows the insurance company to sell its products to the bank’s customers. This
m

partnership arrangement has the potential to be profitable for both companies. Banks
increase their revenue by selling insurance products, and insurance companies
increase their customer bases without increasing their sales force.
)A

Generally, insurance products were marketed and sold by individual agents, who
were solely responsible for the retail segment’s business. The point of sale and point
of contact for customers through bancassurance, on the other hand, is none other than
the bank staff and tellers. The insurance company trains and supports bank employees
through wholesale product information, marketing campaigns, sales training, and other
(c

means in order to reach out to the bank’s customers and sell insurance. Although the
insurance company processes and administers the policies, the bank and the insurance
company split the commission.

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 70 Principles and Practices of Banking

The insurance company benefits from selling its products to a larger customer
Notes

e
base without having to pay broker commission, which helps to increase the company’s
sales by giving such companies greater market exposure. The bank, on the other hand,
benefits from the additional revenue generated by selling the insurance product of the

in
affiliated insurance company.

The bank’s primary role in the bancassurance arrangement is to act as an

nl
intermediary for selling the insurance company’s insurance product and assisting the
company in achieving a large customer base and improving its market reach.

Bancassurance has also been the subject of numerous controversies over the

O
years, with many opponents arguing that such an arrangement gives banks too much
control over the finance sector and thus should not be considered. A few countries have
also prohibited bancassurance in order to achieve this goal. Nonetheless, it has not
slowed the global expansion of bancassurance.

ty
In Europe, where the practise has a long history, bancassurance arrangements are
common. The global bancassurance market is dominated by European banks such as
Crédit Agricole (France), ABN AMRO (Netherlands), BNP Paribas (France), and ING

si
(Netherlands).

However, the picture varies greatly from country to country. According to a 2013

r
report, while bancassurance accounted for 83.6 percent of life insurance sales in
Italy, 66.2 percent in Spain, 64.2 percent in France, and 62.6 percent in Austria, it had
ve
a lower market share in Eastern Europe and was nonexistent in the United Kingdom
and Ireland. The United States has been slower to embrace the concept than many
other countries. This is due, in part, to the fact that the question of whether banks in
the United States should be allowed to sell insurance has been a source of contention
ni

for many years. Among the concerns are unfair competition for insurance agents,
potential risks to the banking sector, and the possibility that banks will press customers
to purchase insurance in order to qualify for loans.
U

Meanwhile, supporters argued that the arrangement would benefit both banks
and insurance companies, that it would be a convenience for consumers, and that the
increased competition would result in lower insurance prices.
ity

Bancassurance in India – Overview

The term “Bancassurance” is derived from the combination of the words “Banks”
(Ban) and “Assurance” or “Insurance” (Assurance). The concept of Bancassurance was
developed in France. Only in the year 2000 was the process adopted in India.
m

The Insurance Regulatory and Development Authority (IRDA) proposed regulating

insurance company registration in India. As a result, the Indian government issued a
)A

notification stating that “Insurance” is a permissible form of business that banks can
engage in under Section 6 (1) (o) of the Banking Regulation Act, 1949. However, it
was also stated that any bank intending to engage in such a business would need to
obtain prior approval from the Reserve Bank of India (RBI). As a result, all commercial
scheduled banks have been authorised to conduct insurance business on behalf of
(c

the insurance company without any risk participation on a fee basis. As a result, the
banking and insurance sectors in India are governed by both the IRDA and the RBI.

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 Principles and Practices of Banking 71

Regulations of the Corporate Agency

Notes

e
According to the IRDA regulatory framework, banks can only act as a corporate
agent for one life insurance company in exchange for a commission. Other than their

in
commission, banks are not eligible for any payment. Banks are required to follow a
code of conduct that applies to both the customer and the principal, who is the insurer.
Banks would be unable to act as brokers. The RBI prohibits banks from promoting

nl
separate insurance brokerage firms.

Bancassurance Models

O
Distribution Agreement - In India, it is the most widely used bancassurance model.
The insurer can use the bank’s infrastructure and generates fee income for the bank.
Product management and distribution channels are not well integrated. For example,
the Indian Overseas Bank serves as a distributor for the Life Insurance Corporation of

ty
India Ltd.

Strategic Alliance - The insurer can use the bank’s infrastructure and generates fee
income for the bank. Customer database sharing with the insurance company. Product

si
and distribution channel management are not well integrated. For example, HDFC Bank
collaborates with HDFC Life Insurance Company and HDFC ERGO General Insurance
Company.
r
Joint Venture - The bank is in charge of product and distribution design. For
ve
infrastructure utilisation, joint decision-making and high system integration are required.
For example, India First Life Insurance Co. Ltd. is a joint venture between Bank of
Baroda (44%), Andhra Bank (30%), and ‘Legal and General’, a financial and investment
company based in the United Kingdom (26 percent).
ni

Mixed Models - Marketing is handled by the insurer’s staff, and the bank is only
responsible for lead generation. The bank’s database is given to the insurance
company. It necessitates little technical investment.
U

Regulations for Banks to Enter into the Insurance Business

According to the recommendations of the bank and financial institution regulators,
ity

the Reserve Bank of India and the Insurance Regulatory and Development Authority,
scheduled and commercial banks are permitted to conduct insurance business as
agents for insurance companies. As a result, banks have the right to charge a fee for
their services. Banks must meet the eligibility criteria in order to form a joint venture to
conduct insurance business with risk participation.
m

The following are the requirements for banks to enter the insurance business:

◌◌ The net worth of the bank should be equal to or greater than INR 500 crore.
)A

The CRAR (Capital Adequacy Ratio) of the bank should be equal to or greater
than 10%.
◌◌ NPAs (Non-Performing Assets) should be kept to a manageable level.
◌◌ The bank’s net profit should have increased for the last three years in a row. •
The bank’s subsidiaries (if any) should have a track record that is satisfactory
(c

and comparable to the market.

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 72 Principles and Practices of Banking

Advantages of Bancassurance
Notes

e
Bancassurance has emerged as a critical channel for the distribution of insurance
products and services for both banks and insurance companies in recent years. This

in
partnership can benefit all parties involved – banks, insurers, and customers – if it is
implemented in a well-planned and structured manner.

The benefits of bancassurance to banks, insurers, and customers are as follows:

nl
To Banks
◌◌ Bancassurance is the best way for banks to add another source of income

O
with little or no capital outlay
◌◌ A small capital outlay results in a high return on equity
◌◌ An addition to the product portfolio

ty
◌◌ An easy source of additional fee-based profits
◌◌ Greater manpower efficiency – because existing bank staff can be easily
trained

si
◌◌ The possibility of a high degree of product sales alignment in a customised
manner and support services
◌◌ Selling a wide range of financial services to clients and increasing customer
retention r
ve
◌◌ Optimizing manpower utilisation to increase productivity efficacy

To Insurance Companies
◌◌ A rise in turnover Increased penetration in both rural and urban markets using
ni

the bank’s existing customer database

◌◌ Very cost-effective because the route and network are already in place
U

◌◌ Insurance companies may market their products through existing bank

branches and outlets in rural and/or urban areas.

To Customers
ity

◌◌ The goal of providing one-stop service to all customers. Convenience is

currently one of the primary concerns in managing a customer’s day-to-day
activities. As a result, the bank marketing insurance products gives them a
competitive advantage over others. Customers can obtain comprehensive
financial planning services under one roof.
m

◌◌ It is very simple to make claims

◌◌ It fosters a high level of trust
)A

◌◌ Simple premium payment because it can be linked directly to a bank account

◌◌ Easy access to a plethora of products within a bank
◌◌ Assured services and advice from the bank because customers get
professional experts and trained staff to guide them through finances
(c

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 Principles and Practices of Banking 73

Disadvantages of Bancassurance
Notes

e
◌◌ There is a greater risk of banks and/or insurance companies jeopardising the
security of their customers’ data.

in
◌◌ Customers may become confused about where to invest if there is a conflict
of interest between the bank’s other products and the insurance companies’
products (such as money-back policies).

nl
◌◌ There is hope that banking institutions will provide a better approach and
services to customers. This is due to the fact that many Indian banks are not
known for providing excellent customer service. It could turn out differently

O
because banks are also responsible for the sale of insurance products.

Challenges
◌◌ Bancassurance necessitates collaboration between banks and insurance

ty
companies; however, integrating the business operations of two sectors is not
an easy task.
◌◌ Insurance companies do not have direct control over the sale of their products

si
in bancassurance. Marketing strategies can be difficult to manage. Insurance
companies, for example, may find it difficult to target the right customers.
◌◌ Bank employees must learn about insurance products, which necessitates a
r
greater workload and training. Bank advisors may have conflicting incentives
ve
in the case of multiple bancassurance agreements. Out of self-interest, they
may recommend one product over another. It is also difficult to determine who
should be held legally responsible in the event of a customer dispute.
◌◌ Banks and insurance companies must align their goals in order to solve the
ni

problems. Furthermore, insurance companies can train bank employees

in sales. This aids in the achievement of mutual goals and reduces
miscommunication.
U

Going Digital
◌◌ Digitalization is having a significant impact on the bancassurance business
model, and banks are gradually shifting their bancassurance operations
ity

online.
◌◌ The internet bridges the gap between product creators and customers.
As a result of the bancassurance agreement, banks may lose their network
advantages. Furthermore, insurance companies can collect customer
m

behaviours online in order to tailor products that are more personally tailored
to customers.
◌◌ As a result of digitalization, both banks and insurance companies must refine
)A

their bancassurance agreements. They must work together to respond to the

change and transform the way they serve their clients.

1.6 Risk Management

Risk management is a complex function that necessitates specialised knowledge
(c

and skills. Banks are increasingly relying on sophisticated models to assess and
manage risks. To compete effectively with their competitors, large banks and those

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 74 Principles and Practices of Banking

operating in international markets should develop internal risk management models.

Notes

e
As the domestic market integrates with international markets, banks must have the
necessary expertise and skill in managing various types of risks scientifically. Core
staff at Head Offices should be trained in risk modelling and analytical tools at a more

in
advanced level. As a result, all banks should strive to improve their employees’ skills.

1.6.1 Credit Risk

nl
Lending entails a number of dangers. In addition to the risks associated with the
counterparty’s creditworthiness, banks are also exposed to interest rate, currency,

O
and country risks. Credit risk, also known as default risk, refers to a customer’s or
counterparty’s inability or unwillingness to meet commitments in lending, trading,
hedging, settlement, and other financial transactions. Credit risk is made up of two
components: transaction risk or default risk and portfolio risk. Portfolio risk is made up

ty
of intrinsic and concentration risk. A bank’s portfolio’s credit risk is determined by both
external and internal factors. The state of the economy, large swings in commodity/
equity prices, foreign exchange rates and interest rates, trade restrictions, economic
sanctions, government policies, and so on are examples of external factors. Internal

si
factors include deficiencies in loan policies/administration, the absence of prudential
credit concentration limits, inadequately defined lending limits for Loan Officers/Credit
Committees, deficiencies in assessing borrowers’ financial position, excessive reliance
r
on collaterals and inadequate risk pricing, the absence of a loan review mechanism and
ve
post-sanction surveillance, and so on.

Counterparty risk is a type of credit risk. The counterparty risk arises from the
trading partners’ failure to perform. Non-performance may result from the counterparty’s
refusal/inability to perform as a result of adverse price movements or from external
ni

constraints that the principal did not anticipate. Contrary risk is generally regarded as a
transient financial risk associated with trading, as opposed to standard credit risk.

The management of credit risk should be prioritised by top management, and the
U

process should include:

a) risk measurement via credit rating/scoring; b) risk quantification via estimating

expected loan losses, i.e. the amount of loan losses that the bank would
ity

experience over a chosen time horizon (via portfolio tracking over 5 or more
years) and unexpected loan losses, i.e. the amount by which actual losses
exceed the expected loss (through standard deviation of losses or the
difference between expected loan losses and some selected target credit loss
m

quantile)
c) Risk pricing based on scientific evidence
d) Risk management through an effective Loan Review Mechanism and portfolio
)A

management.
The credit risk management process should be outlined in the bank’s Loan Policy,
which must be approved by the Board of Directors. Each bank should form a high-level
Credit Policy Committee, also known as a Credit Risk Management Committee or a
(c

Credit Control Committee, to deal with credit policy and procedure issues, as well as to
analyse, manage, and control credit risk on a bank-wide basis. The Chairman/CEO/ED
should chair the Committee, which should include the heads of the Credit Department,

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 Principles and Practices of Banking 75

Treasury, Credit Risk Management Department (CRMD), and the Chief Economist.
Notes

e
The Committee should, among other things, develop clear policies on credit proposal
presentation standards, financial covenants, rating standards and benchmarks, credit
approving delegation, prudential limits on large credit exposures, asset concentrations,

in
loan collateral standards, portfolio management, loan review mechanism, risk
concentrations, risk monitoring and evaluation, loan pricing, provisioning, regulatory/
legal compliance, and so on. Concurrently, each bank should establish a separate

nl
Credit Risk Management Department (CRMD) from the Credit Administration
Department. The CRMD should enforce and monitor compliance with the CPC’s risk
parameters and prudential limits. The CRMD should also establish risk assessment

O
systems, monitor loan portfolio quality, identify problems and correct deficiencies,
develop MIS, and conduct loan review/audit. Large banks may consider establishing
a separate unit for loan review/audit. The CRMD should also be held accountable for
the overall loan portfolio’s quality. To test the loan portfolio’s resilience, the Department

ty
should conduct portfolio evaluations and comprehensive environmental studies.

Instruments of Credit Risk Management:

si
Credit Risk Management refers to a variety of management techniques that assist
banks in mitigating the negative effects of credit risk.

Credit Approving Authority: Each bank should have a carefully crafted power
r
delegation scheme. Banks should also develop a multi-tier credit approval system
ve
in which loan proposals are approved by a ‘Approval Grid’ or a ‘Committee.’ Credit
facilities in excess of a specified limit may be approved by the ‘Grid’ or ‘Committee,’
which must include at least three or four officers, one of whom must represent the
CRMD, which has no volume or profit targets. Credit approving committees can also
ni

be considered by banks at various operational levels, such as large branches (when

deemed necessary), Regional Offices, Zonal Offices, Head Offices, and so on. Banks
could consider delegating authority to the ‘Approval Grid’ or the ‘Committee’ to sanction
U

higher limits for better rated / quality customers. The credit approving system’s spirit
may be that no credit proposals should be approved or recommended to higher
authorities if the majority members of the ‘Approval Grid’ or ‘Committee’ do not agree on
the borrower’s creditworthiness. In the event of a disagreement, the specific points of
ity

view of the dissenting member(s) should be recorded.

Banks should also develop an appropriate framework for reporting and assessing
the quality of credit decisions made by various functional groups. Through a well-
defined Loan Review Mechanism, the quality of credit decisions should be evaluated
m

within a reasonable time frame, say 3 – 6 months.

Prudential Constraints: Prudential limits should be set on various aspects of credit

in order to limit the magnitude of credit risk:
)A

a) Establish benchmark current/debt equity and profitability ratios, debt service

coverage ratios, or other ratios, with room for variation. The conditions under
which deviations are permitted, as well as the authority to do so, should be
clearly stated in the Loan Policy;
(c

b) Single/group borrower limits, which may be lower than the limits prescribed by
the Reserve Bank to provide a filtering mechanism;

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 76 Principles and Practices of Banking

c) Substantial exposure limit, which is the sum total of exposures assumed

Notes

e
in respect of those single borrowers enjoying credit facilities in excess of a
threshold limit, say 10% or 15% of capital fun Depending on the degree of
concentration risk to which the bank is exposed, the substantial exposure limit

in
may be set at 600 percent or 800 percent of capital funds;
d) Maximum exposure limits to industry, sector, and so on should be established.

nl
There must also be systems in place to evaluate exposures at reasonable
intervals, and the limits must be adjusted, particularly when a specific sector
or industry experiences a slowdown or other sector/industry-specific problems.
Exposure limits may be imposed on sensitive sectors, such as advances

O
against equity shares, real estate, and so on, which are subject to high levels
of asset price volatility, as well as on specific industries that experience
frequent business cycles. Similarly, high-risk industries, as perceived by the

ty
bank, should be restricted to a smaller portfolio. Any excess risk should be
fully supported by adequate collaterals or strategic considerations.
e) Banks may consider the loan book’s maturity profile while keeping in mind the
market risks inherent in the balance sheet, risk evaluation capability, liquidity,

si
and so on.
Risk Rating: Banks should have a comprehensive risk scoring / rating system that
r
serves as a single point indicator of a counterparty’s diverse risk factors and allows
them to make consistent credit decisions. A high degree of standardisation in ratings
ve
across borrowers is required to facilitate this. The risk rating system should be designed
to reveal the overall risk of lending, provide critical input for setting pricing and non-
price terms of loans, and present meaningful information for loan portfolio review and
management. In short, the risk rating should reflect the underlying credit risk of the loan
ni

book. The rating exercise should also give credit-granting authorities some peace of
mind about loan quality at any time.

The risk rating system should be structured, incorporating financial analysis,

U

projections and sensitivity, industrial and management risks, among other things. Banks
can use any number of financial ratios, operational parameters, and collaterals, as
well as qualitative aspects of management and industry characteristics, to determine
ity

a borrower’s creditworthiness. Banks can also weight the ratios based on the years
they represent in order to prioritise short-term developments. Banks can also prescribe
certain levels of standards or critical parameters within the rating framework, beyond
which no proposals should be considered. Banks may also consider developing a
separate rating framework for large corporate / small borrowers, traders, and other
m

entities with varying types and degrees of risk.

Forex exposures assumed by corporations with no natural hedges have

significantly altered banks’ risk profile. As a result, banks should include unhedged
)A

market risk exposures of borrowers in the rating framework. On the basis of credit
quality, the overall risk score is to be placed on a numerical scale ranging from 1-6, 1-8,
and so on. A quantitative definition of the borrower, the loan’s underlying quality, and an
analytic representation of the borrower’s underlying financials should be presented for
(c

each numerical category. Furthermore, as part of a prudent risk management policy,

each bank should establish a minimum rating below which no exposures would be

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 Principles and Practices of Banking 77

undertaken. Any wiggle room in the minimum standards, as well as the conditions for
Notes

e
relaxation and authority to do so, should be clearly articulated in the Loan Policy.

The credit risk assessment exercise should be repeated biannually (or even

in
more frequently for low-quality customers) and should be invariably separated from
the regular renewal exercise. Credit ratings should be updated on a quarterly or at
least semi-annual basis in order to assess the portfolio’s quality at regular intervals.

nl
Borrower rating changes over time indicate changes in credit quality and expected
loan losses from the credit portfolio. As a result, for the rating system to be meaningful,
credit quality reports should indicate changes in expected loan losses. To ensure
the consistency and accuracy of internal ratings, the responsibility for establishing or

O
confirming such ratings should be delegated to the Loan Review function and reviewed
by an independent Loan Review Group. To improve the accuracy of expected loan loss
calculations, banks should conduct a comprehensive study on the migration (upward –

ty
lower to higher and downward – higher to lower) of borrowers in the ratings.

Risk Pricing: A fundamental tenet of risk management is risk-return pricing.

Borrowers with a weak financial position and thus classified as high credit risk should

si
be priced high in a risk-return setting. As a result, banks should develop scientific
systems to price credit risk, which should be based on the expected probability of
default. Loan pricing should typically be linked to risk rating or credit quality. The

r
probability of default can be derived from the loan portfolio’s past behaviour, which is a
function of loan loss provision/charge offs over the last five years or so. Banks should
ve
create a historical database of portfolio quality and provisioning / charge off in order
to price risk. However, collateral value, market forces, perceived account value, future
business potential, portfolio/industry exposure, and strategic reasons may all play a
role in pricing. Flexibility should also be provided for revising the price (risk premia) in
ni

response to changes in collateral rating / value over time. Large banks around the world
have already implemented the Risk Adjusted Return on Capital (RAROC) framework
for loan pricing, which requires data on portfolio behaviour and capital allocation
U

commensurate with the credit risk inherent in loan proposals. Under the RAROC
framework, the lender begins by charging an interest mark-up to cover the expected
loss – the expected default rate of the borrower’s rating category. The lender then
allots enough capital to the prospective loan to cover some of the unanticipated loss—
ity

variability in default rates.

In general, international banks allocate enough capital to cover 99 percent of the

expected loan loss reserve or provision plus allocated capital. However, there is a need
to compare the prices quoted by competitors for borrowers with the same rating/quality.
m

As a result, any attempt to reduce prices in order to gain market share would result in
risk mispricing and ‘Adverse Selection.’

Portfolio Management: The current framework for tracking non-performing loans

)A

around the balance sheet date does not reflect the overall loan book quality. Banks
should develop appropriate systems for detecting credit weaknesses well in advance.
The majority of international banks have implemented various portfolio management
techniques to assess asset quality. The CRMD, which should be established at Head
Office, should be tasked with monitoring the portfolio on a regular basis. The portfolio’s
(c

quality could be assessed by tracking borrowers’ migration (upward or downward) from

one rating scale to another. This process would be useful only if the borrower-specific

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 78 Principles and Practices of Banking

ratings were updated at quarterly or semi-annual intervals. Data on movement within

Notes

e
grading categories can be used to gain insight into the nature and composition of a loan
book.

in
To maintain portfolio quality, banks could also consider the following measures:

1) establish a quantitative ceiling on aggregate exposure in specified rating categories,

i.e. a certain percentage of total advances should be in the rating categories 1 to 2,

nl
1 to 3, 2 to 4, 4 to 5, and so on.
2) assess the rating-wise distribution of borrowers in various industries, business
segments, and so on.

O
3) assess exposure to one industry/sector based on the overall rating distribution of
borrowers in the sector/group. Banks should weigh the benefits and drawbacks of
specialisation and concentration by industry group in this context. When a bank’s

ty
portfolio exposure to a single industry performs poorly, the quality standards for that
industry may be raised.
4) As a prudent planning exercise, set a target volume of loans based on rating,

si
probable defaults, and provisioning requirements. If there is a deviation from the
expected parameters, an exercise for portfolio restructuring should be undertaken
immediately, and if necessary, the entry level criteria could be enhanced to insulate
r
the portfolio from further deterioration.
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5) Conduct rapid portfolio reviews, stress tests, and scenario analysis when the external
environment undergoes rapid changes (e.g. volatility in the forex market, economic
sanctions, changes in fiscal/monetary policies, general deterioration); The stress
tests would reveal previously undetected areas of potential credit risk exposure as
ni

well as links between different risk categories. Under adverse conditions, there may
be a significant correlation between various risks, particularly credit and market risks.
The use of highly sophisticated models can range from relatively simple changes
in assumptions about one or more financial, structural, or economic variables to
U

relatively simple changes in assumptions about one or more financial, structural,

or economic variables. The results of such portfolio-wide stress tests should be
reviewed by the Board, and appropriate changes in prudential risk limits should be
ity

made to protect the quality. Contingency plans detailing management responses to

stressful situations could also be included in stress tests.
6) Implement discriminatory timetables for renewing borrower limits. Lower-rated
borrowers with financial issues should be subjected to renewal control twice/thrice
m

a year.
Banks should develop a suitable framework for regularly monitoring market risks,
particularly forex risk exposure of corporates with no natural hedges. Banks should
)A

also appoint Portfolio Managers to monitor the loan portfolio’s degree of concentration
and counterparty exposure. Banks may consider appointing Relationship Managers to
ensure that overall exposure to a single borrower is monitored, captured, and controlled
for a comprehensive evaluation of customer exposure.

Relationship Managers must collaborate with the Treasury and Forex Departments.
(c

Relationship Managers may service primarily high-value loans, putting a significant

portion of the loan portfolio under constant scrutiny, which can alter the risk profile.

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 Principles and Practices of Banking 79

Furthermore, transactions with affiliated companies/groups must be aggregated and

Notes

e
kept up to date in near real time. Banks should also establish formalised systems
for identifying accounts with pronounced credit weaknesses well in advance, as well
as prepare internal guidelines for such an exercise and set time frames for deciding

in
courses of action.

Many international banks have used credit risk models to evaluate their credit

nl
portfolios. Credit risk models provide banks with a framework for examining credit risk
exposures across geographical locations and product lines in real time, centralising
data, and analysing marginal and absolute risk contributions. The models also provide
credit risk (unexpected loss) estimates based on individual portfolio composition. The

O
Altman’s Z Score predicts the likelihood of a company going bankrupt within a year.
The model combines five financial ratios with reported accounting data and equity
values to generate an objective measure of the borrower’s financial health. J.P. Morgan

ty
has created a portfolio model called ‘CreditMetrics’ to evaluate credit risk. The model
essentially focuses on estimating the volatility in asset value caused by variations in
asset quality. The volatility is calculated by tracking the likelihood that the borrower will
move from one rating category to another (downgrade or upgrade). As a result, the

si
value of loans can change over time as borrowers move to a different risk-rating grade.

The model can be used to promote credit risk transparency, establish benchmarks

r
for credit risk measurement, and estimate economic capital for credit risk under the
RAROC framework. CreditRisk+ is a statistical method developed by Credit Suisse for
ve
measuring and accounting for credit risk. The model is based on an actuarial calculation
of expected default rates and unanticipated default losses.

Banks may assess the utility of these models with appropriate modifications for the
ni

Indian environment in order to fine-tune credit risk management. Credit risk models’
success is dependent on time series data on historical loan loss rates and other model
variables spanning multiple credit cycles. As a result, banks may attempt to build an
adequate database in order to transition to credit risk modelling after a specified period
U

of time.

LRM (Loan Review Mechanism): LRM is an effective tool for continuously

evaluating loan book quality and bringing about qualitative improvements in credit
ity

administration. Banks should therefore implement a proper Loan Review Mechanism

for high-value accounts, with responsibilities assigned in areas such as evaluating
the effectiveness of loan administration, maintaining the integrity of the credit grading
process, assessing loan loss provision, portfolio quality, and so on. The complexity and
m

scope of LRM typically vary according to the size, type of operations, and management
practises of banks.

In large banks, it may be independent of the CRMD or even a separate

)A

Department.

The primary goals of LRM could be:

◌◌ To identify promptly loans that develop credit weaknesses and initiate timely
corrective action
(c

◌◌ To evaluate portfolio quality and isolate potential problem areas

◌◌ To provide information for determining the adequacy of loan loss provision

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 80 Principles and Practices of Banking

◌◌ To assess the adequacy of and adherence to loan policies and procedures,

Notes

e
and to monitor compliance with relevant laws and regulations
One of the fundamental components of an effective LRM is accurate and timely

in
credit grading. Credit grading entails evaluating credit quality, identifying problem
loans, and assigning risk ratings. A proper Credit Grading System should aid in the
evaluation of portfolio quality and the establishment of loan loss provisions. Given the
importance and subjective nature of credit ratings, the credit ratings awarded by the

nl
Credit Administration Department should be reviewed by Loan Review Officers who are
not involved in loan administration.

O
Banks should develop a loan review policy, which should be reviewed annually by
the Board of Directors. The Policy should, among other things, address.

Qualification and Independence

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Loan Review Officers should be well-versed in credit appraisal, lending practises,
and bank loan policies. They should also be well-versed in the applicable laws and
regulations governing lending activities. Loan Review Officers’ independence should be

si
ensured, and the results of the reviews should be reported directly to the Board or a
Committee of the Board.

Frequency and Scope of Reviews

r
ve
Loan Reviews are intended to provide feedback on the effectiveness of credit
sanction and to detect early signs of deterioration in portfolio quality. High-value
loans should be reviewed within three months of sanction/renewal, or more frequently
if factors indicate a potential for credit deterioration. The scope of the review should
include all loans above a certain threshold. In addition, banks should target other
ni

accounts with high risk characteristics. To provide reasonable assurance that all major
credit risks embedded in the balance sheet have been tracked, at least 30-40% of the
portfolio should be subjected to LRM once a year.
U

Depth of Reviews
Loan reviews should focus on the following areas:
ity

◌◌ Approval process
◌◌ Accuracy and timeliness of credit ratings assigned by loan officers
◌◌ Adherence to internal policies and procedures, as well as applicable laws and
regulations
m

◌◌ Compliance with loan covenants

◌◌ Post-sanction follow-up
)A

◌◌ Loan documentation sufficiency

◌◌ Portfolio quality
◌◌ Recommendations for improving portfolio quality.
The findings of Reviews should be discussed with line managers, and corrective
(c

actions for all deficiencies should be elicited. Unresolved deficiencies should be

reported to top management.

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 Principles and Practices of Banking 81

The Basle Committee on Banking Supervision’s Risk Management Group has

Notes

e
issued a consultative paper on Principles for Credit Risk Management. The Paper
discusses various aspects of credit risk management. The paper is enclosed for the
convenience of banks..

in
1.6.2 Market Risk

nl
Credit risk management has traditionally been the most difficult challenge for
banks. Market risk arising from adverse changes in market variables such as interest
rate, foreign exchange rate, equity price, and commodity price has become relatively

O
more important as deregulation has progressed.

Even minor changes in market variables cause significant changes in bank income
and economic value. Market risk can be divided into two categories:

ty
1) liquidity risk
2) interest rate risk
3) Forex (Foreign Exchange Rate) Risk

si
4) Price Risk in Commodities
5) Stock Price Risk

Market Risk Management

r
ve
Market risk management should be a top priority for bank executives. Market
risk management policies, procedures, prudential risk limits, review mechanisms, and
reporting and auditing systems should be clearly articulated by the Boards. The policies
ni

should address the bank’s exposure on a consolidated basis and clearly articulate the
risk measurement systems that capture all material sources of market risk and assess
the bank’s exposure. Operating prudential limits and line management accountability
should also be clearly defined.
U

The Asset-Liability Management Committee (ALCO) should serve as the top

operational unit in charge of managing the balance sheet within the performance/risk
parameters established by the Board. Banks should also establish an independent
ity

Middle Office to monitor the magnitude of market risk in real time. The Middle Office
should be made up of market risk management experts, economists, statisticians, and
general bankers, and it should report directly to the ALCO. The Middle Office should
also be separated from the Treasury Department and should not be involved in day-to-
m

day Treasury management. The Middle Office should notify top management / ALCO /
Treasury of any deviations from prudential / risk parameters, as well as aggregate the
total market risk exposures assumed by the bank at any given time.
)A

1.6.3 Liquidity Risk

Liquidity Risk
Liquidity planning is an important aspect of a bank’s risk management framework.
(c

Liquidity is defined as the ability to efficiently accommodate decreases in deposits and

other liabilities, as well as fund loan portfolio growth and the potential funding of off-
balance-sheet claims. A bank has adequate liquidity when sufficient funds can be raised

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 82 Principles and Practices of Banking

quickly and at a reasonable cost, either by increasing liabilities or converting assets. It

Notes

e
includes the potential sale of liquid assets as well as borrowings from money, capital,
and currency markets. As a result, liquidity should be regarded as a safeguard against
losses resulting from fire sales of assets.

in
Banks’ liquidity risk arises from funding long-term assets with short-term liabilities,
exposing the liabilities to rollover or refinancing risk.

nl
Liquidity risk manifests itself in various dimensions in banks:

i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/

non-renewal of deposits (wholesale and retail)

O
ii) Time Risk – need to compensate for non-receipt of expected inflows of funds,
i.e. performing assets turning into non-performing assets
iii) Call Risk – unable to pursue profitable business opportunities when desired

ty
due to crystallisation of contingent liabilities.
The first step toward effective liquidity management is to implement an effective
liquidity management policy, which should outline, among other things, funding

si
strategies, liquidity planning under alternative scenarios, prudential limits, liquidity
reporting / reviewing, and so on.

r
Liquidity measurement is a difficult task that can be accomplished using either
the stock or cash flow approaches. The key ratios used by the banking system are as
ve
follows:

i) Loans as a percentage of total assets

ii) Loans to Core Deposits
ni

iii) Significant Liabilities (less) Temporary Investments in Earning Assets (minus)

Temporary Investments, in which large liabilities represent market sensitive and
U

temporary wholesale deposits Investments are those that mature within one year and
are held in the trading book and can be easily sold in the market; iv) Purchased Funds
to Total Assets, where purchased funds include all inter-bank and other money market
borrowings, including Certificates of Deposit and institutional deposits; and v) Loan
ity

Losses/Net Loans.

While liquidity ratios are an excellent indicator of a bank’s liquidity in developed

financial markets, they do not reveal the intrinsic liquidity profile of Indian banks, which
operate in an illiquid market. Experiments have shown that assets commonly thought to
m

be liquid, such as government securities, other money market instruments, and so on,
have limited liquidity because the market and players are unidirectional. Thus, liquidity
analysis entails keeping track of cash flow mismatches.
)A

The use of a maturity ladder and the calculation of cumulative surplus or deficit of
funds at selected maturity dates is recommended as a standard tool for measuring and
managing net funding requirements. The format prescribed by the RBI under the ALM
System in this regard should be used to measure cash flow mismatches at different
time bands.
(c

The cash flows should be classified into time bands based on the expected
behaviour of assets, liabilities, and off-balance-sheet items. In other words, banks
Amity Directorate of Distance & Online Education
 Principles and Practices of Banking 83

should be required to examine the behavioural maturity profile of various components

Notes

e
of on- and off-balance-sheet items using assumptions and trend analysis supported by
time series analysis. Banks should perform variance analysis at least once every six
months to validate their assumptions. The assumptions should be fine-tuned over time

in
in order to make near-realistic predictions about the future behaviour of on- and off-
balance-sheet items.

nl
Aside from the cash flows mentioned above, banks should monitor the impact of
loan prepayments, premature deposit closures, and the exercise of options built into
certain instruments that offer put/call options after certain time periods. Thus, cash
outflows can be ranked according to the date liabilities become due, the earliest

O
date a liability holder can exercise an early repayment option, or the earliest date
contingencies can be crystallised.

The difference between cash inflows and outflows in each time period, known as

ty
the excess or deficit of funds, serves as the starting point for calculating a bank’s future
liquidity surplus or deficit at a series of points in time. To avoid a liquidity crisis, banks
should consider implementing the following prudential limits:

si
1. Inter-bank borrowing limit, particularly call borrowings
2. Purchased funds relative to liquid assets
3. r
Core deposits relative to core assets, i.e. Cash Reserve Ratio, Liquidity Reserve
ve
Ratio, and Loans;
4. Liabilities and investment portfolio duration
5. Maximum Cumulative Outflows Banks should correct cumulative mismatches across
all time intervals.
ni

6. Commitment Ratio – track total commitments made to corporations/banks and other

financial institutions in order to limit off-balance-sheet exposure.
U

7. Swapped Funds Ratio, or the amount of Indian rupees raised in foreign currency.
In order to track volatile liabilities, banks should also develop a system for tracking
high-value deposits (other than interbank deposits) of Rs.1 crore or more. Furthermore,
in a normal situation, the cash flows arising from contingent liabilities should be
ity

estimated, as should the potential for an increase in cash flows during times of stress.
A market downturn could result in a significant increase in withdrawals from cash credit/
overdraft accounts, contingent liabilities such as letters of credit, and so on.

The liquidity profiles of the banks could be examined on a static basis, in which
m

assets and liabilities, as well as off-balance-sheet items, are pegged on a specific day,
and the behavioural pattern and sensitivity of these items to changes in market interest
rates and the environment are properly accounted for. Banks can also estimate the
)A

liquidity profile dynamically by taking the following factors into account:

1) seasonal deposit/loan pattern

2) potential liquidity needs for meeting new loan demands, unavailed credit
limits, loan policy, potential deposit losses, investment obligations, statutory
(c

obligations, and so on

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 84 Principles and Practices of Banking

Alternative Scenarios
Notes

e
Bank liquidity profiles are influenced by market conditions, which influence cash
flow behaviour. As a result, banks should assess their liquidity profile under various

in
conditions, such as a normal situation, a bank-specific crisis, and a market-crisis
scenario. Banks should establish a normal situation benchmark, a cash flow profile of
on and off balance sheet items, and manage net funding requirements.

nl
Estimating liquidity in the event of a bank-specific crisis should provide a worst-
case reference point. It should be assumed that the purchased funds cannot be easily
rolled over; that some of the core deposits may be prematurely closed; and that a

O
significant portion of assets have become nonperforming and thus completely illiquid.
These developments would result in rating downgrades and high liquidity costs. Banks
should develop contingency plans to deal with such situations.

ty
The market crisis scenario examines cases of extreme tightening of liquidity
conditions caused by the Reserve Bank’s monetary policy stance, general perception
of the banking system’s risk profile, severe market disruptions, failure of one or
more major market players, financial crisis, contagion, and so on. Aside from the

si
flight of volatile deposits/liabilities, the rollover of high-value customer deposits and
purchased funds could be extremely difficult in this scenario. Banks could also sell their
investments at steep discounts, resulting in significant capital loss.

Contingency Plan
r
ve
Banks should develop contingency plans to assess their ability to withstand bank-
specific or market-wide crises. The blueprint for asset sales, market access, and the
ability to restructure the maturity and composition of assets and liabilities should be
ni

clearly documented, and alternative funding options should be clearly articulated in the
event of the bank’s failure to raise liquidity from existing source/s. Liquidity provided by
the Reserve Bank through its refinancing window, interim liquidity adjustment facility,
U

or as lender of last resort should not be considered for contingency planning. Back-
up liquidity support in the form of committed lines of credit, reciprocal arrangements,
liquidity support from other external sources, asset liquidity, and so on should also be
clearly established.
ity

1.6.4 Operational Risk

With the phenomenal increase in transaction volume, high degree of structural
changes, and complex support systems, managing operational risk is becoming an
m

important feature of sound risk management practises in modern financial markets.

Breakdowns in internal controls and corporate governance are the most serious type
of operational risk. Such breakdowns can result in financial loss due to error, fraud, or
)A

failure to perform in a timely manner, or they can jeopardise the bank’s interests.

In general, operational risk is defined as any risk that is not classified as market or
credit risk, as well as the risk of loss resulting from various types of human or technical
error. It is also synonymous with payment risk, business interruption, administrative risk,
and legal risk. Operational risk is linked to credit and market risks in some way. A credit
(c

or market risk could be triggered by an operational issue with a business transaction.

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 Principles and Practices of Banking 85

Measurement: There is no consistency in the approach to measuring operational

Notes

e
risk in the banking system. Furthermore, the existing methods are relatively simple
and experimental, despite the fact that some international banks have made significant
progress in developing more advanced techniques for allocating capital based on

in
operational risk.

Measuring operational risk necessitates estimating the likelihood of an operational

nl
loss event as well as the potential size of the loss. It is based on a risk factor that
indicates the likelihood of an operational loss event occurring. The operational risk
assessment process must address the likelihood (or frequency) of a specific operational
risk occurring, the magnitude (or severity) of the operational risk’s impact on business

O
objectives, and the options available to manage and initiate actions to reduce/ mitigate
operational risk. The set of risk factors that measure risk in each business unit, such
as audit ratings, operational data such as volume, turnover, and complexity, and data

ty
on operational quality such as error rate or measure of business risks such as revenue
volatility, could be linked to historical loss experience. Banks can also employ various
analytical or judgmental techniques to determine the overall operational risk level.
Some international banks have already created operational risk rating matrices, which

si
are similar to bond credit ratings. The operational risk assessment should be conducted
on a bank-wide scale and reviewed on a regular basis. Banks should gradually develop
internal systems to evaluate risk profiles and allocate economic capital within the
RAROC framework. r
ve
So far, no scientific methods for quantifying operational risk have been developed
by Indian banks. In the absence of sophisticated models, banks could develop simple
benchmarks based on aggregate business activity measures such as gross revenue,
fee income, operating costs, managed assets, total assets adjusted for off-balance-
ni

sheet exposures, or a combination of these variables.

Risk Monitoring: The operational risk monitoring system focuses on operational

performance measures such as volume, turnover, settlement facts, delays, and errors,
U

among other things. It may also be necessary to directly monitor operational loss with
an analysis of each occurrence and a description of the nature and causes of the loss.

Control of Operational Risk: Internal controls and internal audits are the primary
ity

methods for mitigating operational risk. Banks could also consider establishing
operational risk limits based on operational risk measures. The contingent processing
capabilities could also be used to mitigate the negative effects of operational risk.
Insurance can also help to mitigate some types of operational risk. Risk education at
m

all levels of staff to familiarise them with complex operations can also help to reduce
operational risk.

Policies and Procedures: Banks should have well-defined operational risk

)A

management policies. Policies and procedures should be based on elements that

are common across business lines or risks. The policy should address the product
review process, which should include business, risk management, and internal control
functions.

Internal Control: The well-established internal control system, which includes

(c

segregation of duties, clear management reporting lines, and adequate operating

procedures, is one of the most important tools for managing operational risk. The

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 86 Principles and Practices of Banking

majority of operational risk events are linked to weak links in internal control systems or
Notes

e
lax compliance with existing internal control procedures.

The technique of self-assessment of the internal control environment is the

in
best method for identifying problem areas. The self-assessment could be used in
conjunction with internal/external audit reports/ratings or RBI inspection findings to
assess operational risk. Banks should strive to detect operational problems rather than

nl
having them pointed out by supervisors/internal or external auditors.

In addition to activating internal audit systems, Audit Committees should play a

larger role in ensuring independent financial and internal control functions.

O
The Basel Committee on Banking Supervision proposes establishing a separate
capital charge for operational risk.

ty
1.6.5 Interest Rate Risk
Interest rate risk management should be one of the critical components of market
risk management in banks. Many of the risks in the banking system had been greatly

si
reduced by regulatory restrictions in the past. However, interest rate deregulation
has exposed them to the negative effects of interest rate risk. Banks’ Net Interest
Income (NII) or Net Interest Margin (NIM) is affected by interest rate movements. Any
r
misalignment in cash flows (fixed assets or liabilities) or repricing dates (floating assets
or liabilities) exposes banks’ NII or NIM to fluctuations. The earning of assets and the
ve
cost of liabilities are now inextricably linked to the volatility of market interest rates.

Interest Rate Risk (IRR) is the potential impact on NII, NIM, or MVE caused by
unexpected changes in market interest rates. Interest rate risk can manifest itself in a
ni

variety of ways.

Types of Interest Rate Risk

U

Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and
liabilities, as well as off-balance-sheet items, with differing principal amounts, maturity
dates, or repricing dates, exposing the company to unexpected changes in market
interest rates.
ity

Basis Risk: Market interest rates of various instruments rarely change to the same
extent over a given time period. The risk that the interest rates on various assets,
liabilities, and off-balance-sheet items will change in varying magnitudes is referred
to as basis risk. In the case of banks that create composite assets from composite
m

liabilities, the degree of basis risk is relatively high. In India, the loan book is funded by
a composite liability portfolio and is subject to significant basis risk. In volatile interest
rate scenarios, the basis risk is quite visible. When the market interest rate changes
)A

cause the NII to expand, the banks’ basis shifts favourably; when the interest rate
changes cause the NII to contract, the basis shifts against the banks.

Embedded Option Risk: Significant changes in market interest rates introduce

a new source of risk to bank profitability by encouraging the early repayment of cash
credit/demand loans/term loans, the exercise of call/put options on bonds/debentures,
(c

and/or the premature withdrawal of term deposits before their stated maturities. In India,
embedded option risk is becoming a reality and is being felt in volatile situations. The

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 Principles and Practices of Banking 87

faster and greater the magnitude of interest rate changes, the greater the embedded
Notes

e
option risk to the banks’ NII. As a result, banks should develop scientific techniques
to estimate the likely embedded options and adjust the Gap statements (Liquidity and
Interest Rate Sensitivity) to more accurately estimate the risk profiles in their balance

in
sheets.

Banks should also strive to impose appropriate penalties based on opportunity

nl
costs in order to prevent the exercise of options, which is always detrimental to banks.

Yield Curve Risk: In a floating interest rate environment, banks may price their
assets and liabilities using various benchmarks, such as TBs yields, fixed deposit

O
rates, call money rates, MIBOR, and so on. If the banks price their assets and liabilities
using two different instruments maturing at different time horizons, any non-parallel
movements in yield curves will affect the NII. When the economy goes through a
business cycle, the yield curve moves quite frequently. As a result, banks should assess

ty
the movement of yield curves and the impact on portfolio values and income.

Price Risk: When assets are sold before their stated maturities, they expose
themselves to price risk. Bond prices and yields are inversely related in the financial

si
market. The price risk is inextricably linked to the trading book, which was created
to profit from short-term interest rate movements. Banks with an active trading book
should develop policies to limit portfolio size, holding period, duration, defeasance
r
period, stop loss limits, marking to market, and so on.
ve
Reinvestment Risk: Uncertainty about the interest rate at which future cash flows
could be reinvested is referred to as reinvestment risk. Any mismatches in cash flows
would expose the banks to NII fluctuations as market interest rates moved in opposite
directions.
ni

Net Interest Position Risk: One of the important factors influencing bank profitability
is the size of nonpaying liabilities. When a bank’s earning assets exceed its paying
liabilities, interest rate risk arises when market interest rates fall. Thus, banks with
U

positive net interest positions will see their NII decrease as market interest rates fall
and increase as interest rates rise. As a result, a large float is a natural hedge against
interest rate fluctuations.
ity

Measuring Interest Rate Risk

Interest rate risk must first be identified and quantified before it can be managed.
It is impossible to quantify the degree of risk to which banks are exposed unless the
quantum of IRR inherent in the balance sheet is identified. It is also impossible to
m

develop effective risk management strategies/hedging techniques unless banks

understand their true risk position. The IRR measurement system should account for
all material sources of interest rate risk, such as the gap or mismatch, basis, embedded
)A

option, yield curve, price, reinvestment, and net interest position risks. The IRR
measurement system should also take into account the unique characteristics of each
individual interest rate sensitive position, as well as capture the full range of potential
interest rate movements in detail.
(c

Interest rate risk can be measured using a variety of techniques, including the
traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings),
Duration (to measure the interest rate sensitivity of capital), Simulation, and Value at

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 88 Principles and Practices of Banking

Risk. While each of these methods focuses on a different aspect of interest rate risk,
Notes

e
many banks use them in tandem or employ hybrid methods that combine features from
all of the techniques.

in
In general, the approach to measuring and hedging IRR varies according to the
balance sheet segmentation. A well-functioning risk management system divides a
bank’s balance sheet into Trading and Investment or Banking Books. While the assets

nl
in the trading book are held primarily for the purpose of profiting from short-term price/
yield differences, the assets and liabilities in the banking book are contracted primarily
for the purpose of relationship or for steady income and statutory obligations and are
generally held until maturity. Thus, while price risk is the primary concern of banks in the

O
trading book, earnings or economic value changes are the primary concern of banks in
the banking book.

ty
Trading Book
Banks’ top management should establish policies regarding volume, maximum
maturity, holding period, duration, stop loss, defeasance period, rating standards, and

si
so on. To categorise securities in the trading book. While securities in the trading book
should ideally be marked to market daily, the potential price risk to changes in market
risk factors should be estimated using internally developed Value at Risk (VaR) models.

r
The VaR method is used to assess potential loss on a trading position or portfolio
ve
due to changes in market interest rates and prices over a specified time period, using a
given confidence level, usually 95 percent to 99 percent. The VaR method should take
into account the market factors to which the trading position’s market value is exposed.

Top management should establish bank-wide VaR exposure limits for the trading
ni

portfolio (including forex and gold positions, derivative products, and so on), which
should then be disaggregated across different desks and departments. The level of
loss-making tolerance should also be specified to ensure that the potential impact on
U

earnings is kept within acceptable limits. The Middle Office should match the potential
loss in Present Value Basis Points on a daily basis in relation to the prudential limits set
by the Board.

The benefit of using VaR is that it is comparable across products, desks, and
ity

departments, and it can be validated via ‘back testing.’ VaR models, on the other hand,
necessitate the use of extensive historical data to forecast future volatility. In addition,
the VaR model may not produce good results in extreme volatile conditions or outlier
events, necessitating the use of a stress test to supplement VaR.
m

The stress tests give management an idea of the potential impact of large market
movements, as well as an attempt to estimate the size of potential losses due to
stress events that occur in the ‘tails’ of the loss distribution. Banks may also conduct
)A

scenario analysis with specific potential stress situations (recently experienced in some
countries) by connecting hypothetical, simultaneous, and related changes in multiple
risk factors present in the trading portfolio to determine the impact of moves on the rest
of the portfolio. VaR models could also be tweaked to account for differences in liquidity
risk observed across assets over time.
(c

International banks are now calculating Liquidity Adjusted Value at Risk (LaVaR)
using variable time horizons based on position size and relative turnover. Non-statistical

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 Principles and Practices of Banking 89

concepts such as stop loss and gross/net positions can be used in situations where
Notes

e
VaR is difficult to estimate due to a lack of data.

Banking Book

in
Changes in market interest rates have an impact on the banks’ banking books in
terms of earnings and economic value. Given the complexity and breadth of balance-
sheet products, banks should have IRR measurement systems that assess the effects

nl
of rate changes on earnings as well as economic value. The techniques range from
simple maturity (fixed rate) and repricing (floating rate) simulations based on current on-
and off-balance-sheet positions to highly sophisticated dynamic modelling techniques

O
that incorporate assumptions on the behavioural pattern of assets, liabilities, and off-
balance-sheet items and can easily capture the full range of exposures against basis
risk, embedded option risk, yield curve risk, and so on.

ty
Maturity Gap Analysis
The most basic analytical techniques for calculating IRR exposure start with
maturity. Gap analysis divides interest-rate sensitive assets, liabilities, and off-balance-

si
sheet positions into a pre-defined number of time-bands based on their maturity
(fixed rate) or time remaining until their next repricing (floating rate). Those assets
and liabilities that do not have definite repricing intervals (savings bank, cash credit,
r
overdraft, loans, export finance, RBI refinance, etc.) or whose actual maturities differ
ve
from contractual maturities (embedded option in bonds with put/call options, loans,
cash credit/overdraft, time deposits, etc.) are assigned time-bands based on bank
judgement, empirical studies, and past experiences.

A gap report can be built using a variety of time bands. Most banks, in general,
ni

focus on short-term periods, such as monthly, quarterly, half-yearly, or one year. It is

extremely difficult to forecast interest rate movements beyond a year. Banks with large
short-term exposures should test the sensitivity of their assets and liabilities at shorter
U

intervals such as overnight, 1-7 days, 8-14 days, and so on.

To assess earnings exposure, the interest Rate Sensitive Assets (RSAs) in each
time band are netted against the interest Rate Sensitive Liabilities (RSLs) to produce a
ity

repricing ‘Gap’ for that time band. The positive Gap indicates that banks have a higher
proportion of RSAs than RSLs. A positive or asset sensitive Gap indicates that an
increase in market interest rates may result in an increase in NII. A negative or liability
sensitive Gap, on the other hand, indicates that the banks’ NII may fall as market
interest rates rise. The negative gap indicates that banks have a higher proportion of
m

RSLs than RSAs. The Gap is used to calculate interest rate sensitivity. The Earnings
at Risk are calculated by multiplying the Positive or Negative Gap by the assumed
interest rate changes (EaR). The EaR method makes it easier to estimate how much
)A

an adverse change in interest rates will affect earnings. Interest rate changes could be
estimated using past trends, interest rate forecasting, and so on. Banks should fix EaR,
which could be based on last/current year’s income, and a trigger point at which line
management should implement on- or off-balance-sheet hedging strategies should be
clearly defined.
(c

The gap calculations can be supplemented with information on the average

coupon on assets and liabilities in each time band, which can then be used to calculate

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 90 Principles and Practices of Banking

estimates of the level of NII from positions maturing or due for repricing within a given
Notes

e
time band, providing a scale to assess the changes in income implied by the gap
analysis.

in
The periodic gap analysis identifies banks’ interest rate risk exposure over different
maturities and suggests the magnitude of portfolio changes required to change the risk
profile. The Gap report, on the other hand, quantifies only the time difference between

nl
asset and liability repricing dates and fails to account for the impact of basis and
embedded option risks. The Gap report also fails to measure the entire impact of an
interest rate change (Gap report assumes that all assets and liabilities mature or are
repriced at the same time) within a given time-band, as well as the effect of interest rate

O
changes on the economic or market value of assets, liabilities, and offbalance-sheet
position. It also does not account for any differences in payment timing that may occur
as a result of changes in the interest rate environment. Furthermore, in the financial

ty
market, the assumption of a parallel shift in yield curves is rare. The Gap report also
fails to account for variation in non-interest revenue and expenses, which could be a
significant source of risk to current income.

si
If banks could accurately predict the magnitude of changes in market interest rates
for various assets and liabilities (basis risk) and their historical behaviour (embedded
option risk), they could standardise the gap by multiplying the individual assets and

r
liabilities by how much they will change for a given change in interest rate. As a result,
one or more assumptions of the standardised gap method appear to be more consistent
ve
with reality than the simple gap method. Banks could estimate the EaR more accurately
using the Adjusted Gap.

Duration Gap Analysis

ni

Matching the duration of assets and liabilities, rather than the maturity or repricing
dates, is the most effective way to protect banks’ economic values from IRR exposure
than the simple gap model. The duration gap model focuses on managing banks’
U

economic value by taking into account changes in the market value of assets, liabilities,
and off-balance-sheet (OBS) items. When weighted assets and liabilities, as well as
OBS duration, are matched, market interest rate movements have nearly the same
impact on assets, liabilities, and OBS, protecting the bank’s total equity or net worth.
ity

Duration is a measure of the percentage change in the economic value of a position

caused by a small change in interest rate levels.

Measuring the duration gap is more difficult than measuring the simple gap
model. The simple gap schedule can be used to approximate the duration of assets
m

and liabilities by applying weights to each time-band. The weights are determined by
estimating the duration of assets, liabilities, and OBS in each time band. The weighted
duration of assets and liabilities, as well as OBS, provide a rough estimate of how the
)A

economic value of banks changes in response to changes in market interest rates. It is

also possible to assign different weights and interest rates to assets, liabilities, and OBS
in different time buckets in order to capture differences in coupons and maturities as
well as interest rate volatility along the yield curve.
(c

Banks can more precisely estimate the economic value changes to market interest
rates by calculating the duration of each asset, liability, and OBS position and weighing
them to arrive at the weighted duration of assets, liabilities, and OBS. After estimating

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 Principles and Practices of Banking 91

the weighted duration of assets and liabilities, the duration gap can be calculated using
Notes

e
standard mathematical formulae. The Duration Gap measure can be used to estimate
the expected change in Market Value of Equity (MVE) for a given market interest rate
change.

in
The net duration of a bank is the difference between the duration of its assets (DA)
and liabilities (DL). If the net duration is positive (DA>DL), a drop in market interest

nl
rates will raise the bank’s market value of equity. When the duration gap is negative
(DL> DA), the MVE rises when interest rates rise but falls when rates fall. Thus, the
Duration Gap demonstrates the impact of market interest rate movements on the MVE
by influencing the market value of assets, liabilities, and OBS.

O
The allure of duration analysis is that it provides a complete measure of IRR for the
entire portfolio. The duration analysis also takes into account the time value of money.
Because the duration measure is additive, banks can match total assets and liabilities

ty
rather than individual accounts. Duration Gap analysis, on the other hand, assumes
parallel shifts in the yield curve. As a result, it fails to recognise basis risk.

si
Simulation
Many international banks are now employing balance sheet simulation models to
assess the impact of market interest rate fluctuations on reported earnings/economic
r
values across time zones. By computer modelling the bank’s interest rate sensitivity,
ve
the simulation technique attempts to overcome the limitations of the Gap and Duration
approaches. This type of modelling entails making assumptions about the future path
of interest rates, the shape of the yield curve, changes in business activity, pricing
and hedging strategies, and so on. The simulation includes a thorough examination
of the potential effects of interest rate changes on earnings and economic value. The
ni

simulation techniques entail a thorough examination of various components of on- and

off-balance-sheet positions. Changes in the slope and shape of the yield curve, as well
as interest rate scenarios derived from Monte Carlo simulations, can all be incorporated
U

into simulations for a more varied and refined interest rate environment.

Depending on the needs of the users, simulation output can take a variety of forms.
Simulation can provide current and anticipated periodic gaps, duration gaps, balance
ity

sheet and income statements, performance measures, budget and financial reports,
and so on. The simulation model is a useful tool for determining risk exposure under
a variety of interest rate/balance-sheet scenarios. This technique is also used in risk-
adjustment planning to assess the impact of alternative business strategies on risk
exposures. The simulation can be run in both static and dynamic environments. While
m

the current on- and off-balance-sheet positions are evaluated in a static environment,
the dynamic simulation incorporates more detailed assumptions about the future path of
interest rates as well as unexpected changes in the bank’s business activity.
)A

The usefulness of the simulation technique is determined by the model’s structure,

the validity of assumptions, technology support, and the technical expertise of banks.

The application of various techniques is heavily reliant on the quality of data and
the degree of automation in the system of operations. As a result, banks may begin
(c

with the gap, duration gap, or simulation techniques based on the availability of data,
information technology, and technical expertise. In any case, as suggested by the

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 92 Principles and Practices of Banking

RBI in the ALM System guidelines, banks should begin estimating interest rate risk
Notes

e
exposure using the Maturity Gap approach. Once banks are familiar with the Gap
model, they can progress to more sophisticated approaches.

in
Funds Transfer Pricing
Many banks’ use of the Transfer Pricing mechanism does not support good ALM
systems. Many international banks, which have a variety of products and operate in a

nl
variety of geographic markets, have used internal Funds Transfer Pricing (FTP). FTP is
an internal measurement used to assess the financial impact of fund uses and sources
and can be used to assess profitability. It can also be used to separate returns for

O
different risks assumed during the intermediation process. FTP also aids in determining
the cost of opportunity value of funds.

Despite the fact that banks have used a variety of FTP frameworks and techniques,

ty
Matched Funds Pricing (MFP) is the most efficient. MFP is used by the majority of
international banks. The FTP envisions allocating specific assets and liabilities to
various functional units (profit centres) such as lending, investment, deposit taking, and

si
funds management. Each unit attracts and expends funds.

At appropriate transfer prices, the lending, investment, and deposit taking profit
centres sell their liabilities to and buy funds for financing their assets from the funds
r
management profit centre. Transfer prices are set on the basis of a single curve
ve
(MIBOR, derived cash curve, etc.) so that asset-liability transactions with identical
attributes have the same transfer prices. Transfer prices, on the other hand, may vary
depending on maturity, purpose, terms, and other factors.

The FTP allocates margin (franchise and credit spreads) to profit centres based
ni

on original transfer rates, with any residual spread (mismatch spread) credited to the
funds management profit centre. This spread is the result of mismatches that have
accumulated over time.
U

●● Deposit profit centre: Transfer Price (TP) on deposits – cost of deposits – deposit
insurance – overheads
●● Lending profit centre: loan yields + TP on deposits – TP on loan financing –
ity

deposit cost –
●● deposit insurance – operating expenses – loan loss provisions
●● Investment profit centre: security yields plus TP on deposits – TP on security
financing – deposit cost – deposit insurance - Overheads – provisions for
m

investment depreciation and loan loss.

●● Funds Management profit centre: TP on lent funds – TP on borrowed funds –
Statutory Reserves cost – overheads
)A

1.7 Others

1.7.1 VaR Analysis

(c

Volatility is the most widely used and traditional risk indicator. However, the main
issue with volatility is that it is unconcerned about the direction of an investment’s

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 Principles and Practices of Banking 93

movement: a stock can be volatile because it suddenly jumps higher. Gains, of course,
Notes

e
do not bother investors.

For investors, risk is defined as the likelihood of losing money, and VAR is based

in
on this common-sense fact. VAR answers the question, “What is my worst-case
scenario?” or “How much could I lose in a really bad month?” by assuming investors
care about the odds of a really big loss.

nl
Let’s get specific now. A VAR statistic is made up of three parts: a time period,
a confidence level, and a loss amount (or loss percentage). Keep these three
components in mind as we provide some examples of VAR-answered questions:

O
What is the most I can expect to lose in dollars over the next month with a 95
percent or 99 percent certainty?

What is the maximum percentage I can expect to lose over the next year with 95

ty
percent or 99 percent certainty?

The “VAR question” has three components: a relatively high level of confidence
(typically 95 percent or 99 percent), a time period (a day, a month, or a year), and an

si
estimate of investment loss (expressed either in dollar or percentage terms).

Value at Risk (VaR) is a financial metric that estimates an investment’s risk. VaR is

r
a statistical technique used to calculate the amount of potential loss that could occur in
an investment portfolio over a given time period. Value at Risk expresses the likelihood
ve
of losing more than a specified amount in a given portfolio.

History of VaR
While the term “Value at Risk” was not widely used prior to the mid-1990s, the
ni

measure’s origins can be traced back further. The mathematics that underpin VaR were
developed largely in the context of portfolio theory by Harry Markowitz and others,
though their efforts were aimed at a different goal – devising optimal portfolios for equity
U

investors. The focus on market risks, in particular, and the effects of co-movements in
these risks, are central to how VaR is computed.

The impetus for the use of VaR measures, on the other hand, came from the
ity

various crises that have befallen financial service firms over time, as well as the
regulatory responses to these crises. In the aftermath of the Great Depression
and the era’s bank failures, the Securities Exchange Act established the Securities
Exchange Commission (SEC) and required banks to keep their borrowings below
2000 percent of their equity capital. Banks devised risk measures and control devices
m

in the decades that followed to ensure that they met these capital requirements. With
the introduction of derivative markets and floating exchange rates in the early 1970s,
capital requirements were refined and expanded in the SEC’s Uniform Net Capital Rule
)A

(UNCR) in 1975, which classified financial assets held by banks into twelve classes
based on risk and required different capital requirements for each, ranging from 0% for
short-term treasuries to 30% for equities. Banks were required to report on their capital
calculations in quarterly reports titled Financial and Operating Combined Uniform Single
(FOCUS).
(c

However, the first regulatory measures that evoke Value at Risk were implemented
in 1980, when the SEC tied financial service firms’ capital requirements to the losses

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 94 Principles and Practices of Banking

that would be incurred, with 95 percent confidence, over a thirty-day interval in various
Notes

e
security classes; historical returns were used to compute these potential losses.
Although the measures were referred to as haircuts rather than Value or Capital at Risk,
it was clear that the SEC was requiring financial service firms to estimate one-month 95

in
percent VaRs and hold sufficient capital to cover the potential losses.

Around the same time, investment and commercial banks’ trading portfolios grew

nl
larger and more volatile, necessitating more sophisticated and timely risk control
measures. Ken Garbade of Banker’s Trust presented sophisticated measures of Value
at Risk for the firm’s fixed income portfolios in internal documents in 1986, based on
the covariance in yields on bonds of various maturities. Many financial service firms

O
had developed rudimentary measures of Value at Risk by the early 1990s, with wide
variations in how it was measured. Firms were ready for more comprehensive risk
measures in the aftermath of numerous disastrous losses associated with the use of

ty
derivatives and leverage between 1993 and 1995, culminating in the failure of Barings,
the British investment bank, as a result of unauthorised trading in Nikkei futures and
options by Nick Leeson, a young trader in Singapore.

si
In 1995, J.P. Morgan made available to the public data on the variances and
covariances of various security and asset classes that it had used internally for nearly
a decade to manage risk, and allowed software developers to create risk-measurement

r
software. The service was dubbed “RiskMetrics,” and the risk measure derived from
the data was dubbed “Value at Risk.” The measure found an eager audience among
ve
commercial and investment banks, as well as the regulatory authorities that oversee
them, who were won over by its intuitive appeal. VaR has become the established
measure of risk exposure in financial service firms over the last decade, and it has even
begun to gain acceptance in non-financial service firms.
ni

Advantages of Value at Risk (VaR)

1. Easy to understand: Value at Risk is a single number that represents the degree
U

of risk in a given portfolio. Value at Risk can be expressed as a price unit or as a

percentage. This simplifies the interpretation and comprehension of VaR.
2. Applicability: Value at Risk applies to all types of assets, including bonds, stocks,
ity

derivatives, currencies, and so on. Thus, VaR can be easily used by various banks
and financial institutions to assess the profitability and risk of various investments,
and risk can be allocated based on VaR.
3. Universal: Because the Value at Risk figure is widely used, it has become an accepted
m

standard when buying, selling, or recommending assets.

Limitations of Value at Risk

)A

1. Large portfolios: Calculating Value at Risk for a portfolio necessitates not only
determining the risk and return of each asset, but also the correlations between
them. As a result, the more assets in a portfolio there are, the more difficult it is to
calculate VaR.
2. Difference in methods: Different methods for calculating VaR can produce disparate
(c

results for the same portfolio.

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 Principles and Practices of Banking 95

3. Assumptions: To calculate VaR, some assumptions must be made and used as

Notes

e
inputs. If the assumptions are invalid, then the VaR figure is invalid as well.

Key Elements of Value at Risk

in
●● Specified amount of loss in value or percentage
●● Time period over which the risk is assessed

nl
●● Confidence interval

Methods Used for Calculating VaR

O
There are three basic approaches to calculating Value at Risk, with numerous
variations within each approach. Analytically, the measure can be computed by making
assumptions about return distributions for market risks and using variances in and
covariances across these risks. It can also be estimated using hypothetical portfolios

ty
based on historical data or Monte Carlo simulations.

In this section, we describe and compare the approaches.

si
1. Historical Method: The historical method is the most straightforward method for
calculating Value at Risk. The percentage change for each risk factor on each day is
calculated using market data from the previous 250 days. Each percentage change
r
is then multiplied by current market values to generate 250 future value scenarios.
ve
The portfolio is valued using full, non-linear pricing models for each scenario. The
third worst day chosen is assumed to have a VaR of 99 percent.
ni

Where:
U

vi is the number of variables on day i

m is the number of days from which historical data is taken

For many portfolios, historical simulations are the simplest way to estimate the
ity

Value at Risk. The VaR for a portfolio is estimated using this method by generating a
hypothetical time series of returns on that portfolio, which is obtained by running the
portfolio through actual historical data and calculating the changes that would have
occurred in each period.
m

General Approach
To run a historical simulation, we start with time series data on each market risk
)A

factor, just like the variance-covariance approach. However, we do not use the data to
forecast variances and covariances because changes in the portfolio over time provide
all of the information required to calculate the Value at Risk.

Cabedo and Moya provide a simple example of how historical simulation can be
used to calculate the Value at Risk in oil prices. They obtained daily prices in Brent
(c

Crude Oil from 1992 to 1998 and graphed the prices in Figure below using historical
data from 1992 to 1998:

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 96 Principles and Practices of Banking

Notes

e
in
nl
O
ty
They divided the daily price changes into positive and negative numbers and
examined each group separately. The positive VaR was defined as the price change
in the 99th percentile of the positive price changes, and the negative VaR as the

si
price change in the 99th percentile of the negative price changes, with a 99 percent
confidence interval. During the study period, the daily Value at Risk at the 99th
percentile was about 1% in both directions.
r
In this simple example, the implicit assumptions of the historical simulation
ve
approach are visible. The first is that the approach is agnostic in terms of distributional
assumptions, with the VaR determined solely by price movements. In other words, the
conclusion is not based on any underlying assumptions of normalcy. The second issue
is that when measuring the VaR, each day in the time series is given equal weight,
ni

which could be problematic if there is a trend in the variability – for example, lower in
the earlier periods and higher in the later periods. The third point is that the approach
is based on the assumption that history repeats itself, with the period used providing
U

a full and complete snapshot of the risks to which the oil market is vulnerable in other
periods.

Assessment
ity

While historical simulations are popular and relatively simple to run, they do have
some drawbacks. The model’s underlying assumptions, in particular, give rise to its
flaws.

a. Past is not prologue: While all three approaches to estimating VaR use historical
m

data, historical simulations rely on it far more than the other two because the Value
at Risk is computed entirely from historical price changes. There is little room for
introducing subjective information or superimposing distributional assumptions
)A

(as we do with the Variance-covariance approach) (as we can with Monte Carlo
simulations). The example with oil prices provided in the previous section is a classic
example. A portfolio manager or corporation that calculated its oil price VaR using
data from 1992 to 1998 would have faced much larger losses than expected from
1999 to 2004 as a long period of oil price stability ended and price volatility increased.
(c

b. Trends in the data: A similar argument can be made about how we compute Value
at Risk using historical data, with all data points weighted equally. In other words,

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 Principles and Practices of Banking 97

price changes from trading days in 1992 have the same effect on the VaR as price
Notes

e
changes from trading days in 1998. We will understate the Value at Risk to the extent
that there is a trend of increasing volatility even within the historical time period.

in
c. New assets or market risks: While this could be a criticism of any of the three
approaches for estimating VaR, the historical simulation approach has the most
difficulty dealing with new risks and assets for obvious reasons: there is no historical

nl
data to compute the Value at Risk. Assessing the Value at Risk to a firm from
developments in online commerce in the late 1990s would have been difficult due to
the nascent stage of the online business.

O
As a result, the previously mentioned trade-off is at the heart of the historic
simulation debate. The approach saves us the trouble and problems associated with
making specific assumptions about return distributions, but it implicitly assumes that the
distribution of past returns is a good and complete representation of expected future

ty
returns. This assumption is difficult to maintain in a market where risks are volatile and
structural shifts occur at regular intervals.

Modifications

si
As with the other approaches to computing VaR, modifications to the approach
have been proposed, primarily to address some of the criticisms raised in the previous
section.
r
ve
a. Weighting the recent past more: Returns in the recent past are better predictors
of the immediate future than returns in the distant past, according to a reasonable
argument. Boudoukh, Richardson, and Whitelaw present a variation on historical
simulations in which recent data is weighted more heavily, with a decay factor serving
ni

as the time weighting mechanism. In simple terms, rather than being weighted equally,
each return is assigned a probability weight based on its recency. In other words, if the
decay factor is.90, the most recent observation has the probability weight p, the one
before it has the probability weight 0.9p, the one before that has the probability weight
U

0.81p, and so on. In fact, the traditional historical simulation approach is a subset of this
approach, with the decay factor set to one.

Volatility Updating: Hull and White propose a new method for updating historical
ity

data to account for changes in volatility. They recommend that historical data be
adjusted to reflect the change for assets where recent volatility is higher than historical
volatility. Assume, for illustration, that the updated standard deviation in prices is 0.8
percent and that it was only 0.6 percent when estimated 20 days ago. Rather than
m

using the price change from 20 days ago, they recommend scaling it to reflect the
change in volatility; a 1% return on that day would be converted into a 1.33 % return.
)A

Their method necessitates day-specific estimates of variance that change

over time, which they obtain by employing GARCH models. It is worth noting that all
of these variants are intended to capture recent shifts that are underweighted by the
conventional approach. None of them are intended to include risks that are outside
(c

of the sampled historical period (but are still relevant risks) or to capture structural
changes in the market and economy.

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 98 Principles and Practices of Banking

2. Parametric Method: The variance-covariance method is another name for the

Notes

e
parametric method. It is based on the assumption of a normal distribution of returns.
Two variables must be estimated: the expected return and the standard deviation.

in
The parametric method is best suited to risk measurement problems with known
and reliable distributions. When the sample size is very small, the method is unreliable.

Let’s call the loss ‘l’ for a portfolio ‘p’ with ‘n’ instruments.

nl
O
ty
si
The figure below depicts the VaR calculation for a six-month dollar/euro forward
r
contract. The contract’s standardised instruments are identified as six-month risk-free
ve
securities in the dollar and euro, as well as the spot dollar/euro exchange rate. The
dollar values of the instruments are computed, and the VaR is estimated based on the
covariances between the three instruments.

Assumptions about how returns on the standardised risk measures are distributed
ni

are implicit in the computation of the VaR in step 4. Normality is the most convenient
assumption, both computationally and in terms of estimating probabilities, and it
should come as no surprise that many VaR measures are based on some variant of
U

that assumption. If, for example, we assume that the returns on each market risk factor
are normally distributed, we ensure that the returns on any portfolio that is exposed
to multiple market risk factors will also be normally distributed. Even VaR approaches
that permit non-normal return distributions for individual risk factors end up with normal
ity

distributions for final portfolio values.

The Risk Metrics Contribution

The term Value at Risk and its application can be traced back to J.P. Morgan’s
m

RiskMetrics service in 1995. The service’s main contribution was that it made the
variances and covariances across asset classes freely available to anyone who wanted
to access them, making it easier for anyone to compute the Value at Risk analytically
for a portfolio. J.P. Morgan’s 1996 publications describe the assumptions underlying
)A

their VaR computation.

Individual risk factor returns are assumed to have conditional normal distributions.
While returns may not be normally distributed, and large outliers are far too common
(i.e., the distributions have fat tails), the assumption is that the standardised return
(c

(calculated as the return divided by the forecasted standard deviation) is.

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 Principles and Practices of Banking 99

●● The emphasis on standardised returns implies that we should be concerned with

Notes

e
the size of the return relative to the standard deviation rather than the size of the
return itself. In other words, a large (positive or negative) return during a period
of high volatility may result in a low standardised return, whereas a similar return

in
following a period of low volatility will result in an abnormally high standardised
return.

nl
Because of the emphasis on normalised standardised returns, the VaR
computation was exposed to the risk of more frequent large outliers than would be
expected with a normal distribution. The RiskMetrics approach was later extended to
cover normal mixture distributions, allowing for the assignment of higher probabilities to

O
outliers. The graph below compares the two distributions:

ty
r si
ve
ni
U

These distributions, in effect, necessitate estimates of the probabilities of outsized

ity

returns occurring, as well as the expected size and standard deviations of such returns,
in addition to the standard normal distribution parameters. Even proponents of these
models admit that estimating the parameters for jump processes is difficult given how
infrequently jumps occur.
m

Assessment
The Variance-Covariance approach’s strength is that once you’ve made an
)A

assumption about the distribution of returns and inputted the means, variances, and
covariances of returns, calculating the Value at Risk is simple. However, the estimation
process exposes the approach’s three major flaws:

●● Wrong distributional assumption: If the conditional returns are not normally

distributed, the calculated VaR will be lower than the true VaR. In other words,
(c

if the actual return distribution contains far more outliers than would be expected

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 100 Principles and Practices of Banking

given the normality assumption, the actual Value at Risk will be much higher than
Notes

e
the computed Value at Risk.
●● Input error: Even if the standardised return distribution assumption is correct,

in
the VaR may be incorrect if the variances and co-variances used to estimate it
are incorrect. There is a standard error associated with each estimate because
these numbers are estimated using historical data. In other words, the variance-

nl
covariance matrix used to calculate VaR is a collection of estimates, some of
which have extremely large error terms.
●● Non-stationary variables: A similar issue arises when the variances and co-

O
variances among assets change over time. Because the fundamentals driving
these numbers change over time, non-stationary in values is not uncommon.
As a result, if oil prices rise by 15%, the correlation between the US dollar and
the Japanese yen may change. This, in turn, may result in a breakdown in the

ty
calculated VaR. Not surprisingly, much of the work done to revitalise the approach
has been aimed at addressing these criticisms.

General Description

si
Consider the following example. Assume you’re calculating the VaR for a single
asset with a potential value distribution that is normally distributed with a mean of $

r
120 million and an annual standard deviation of $ 10 million. You can estimate with 95
percent certainty that the value of this asset will not fall below $ 80 million (two standard
ve
deviations below the mean) or rise above $120 million (two standard deviations above
the mean) over the next year. 2 The same reasoning applies when working with asset
portfolios, but the process of estimating the parameters is complicated by the fact that
the assets in the portfolio frequently move together. The covariances of the pairs of
ni

assets in the portfolio are the central inputs to estimating the variance of a portfolio; in
a portfolio of 100 assets, 49,500 covariances must be estimated in addition to the 100
individual asset variances. This is obviously impractical for large portfolios with shifting
U

asset positions.

When we compute Value at Risk, we map the risk in individual investments in

the portfolio to more general market risks in order to simplify this process, and then
ity

estimate the measure based on these market risk exposures. This procedure generally
consists of four steps:
m

The first step is to map each asset in a portfolio onto simpler, standardised
instruments. A ten-year coupon bond with annual coupons C, for example, can be
divided into ten zero coupon bonds with matching cash flows:
)A

The first coupon corresponds to a one-year zero coupon bond with a face value of
C, the second coupon to a two-year zero coupon bond with a face value of C, and so on
until the tenth cash flow, which corresponds to a 10-year zero coupon bond with a face
value of FV (corresponding to the 10-year bond’s face value) plus C. For more complex
(c

assets, such as stocks and options, the mapping process becomes more complicated,
but the basic intuition remains unchanged. Every financial asset is attempted to be
mapped into a set of instruments representing the underlying market risks. What is the

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 Principles and Practices of Banking 101

point of mapping? Instead of estimating the variances and covariances of thousands of

Notes

e
individual assets, we estimate those statistics for the common market risk instruments
to which these assets are exposed; there are far fewer of the latter than of the former.
The resulting matrix can be used to calculate the Value at Risk of any asset subject to a

in
combination of these market risks.

In the second step, each financial asset is described as a collection of positions

nl
in standardised market instruments. This is straightforward for the 10-year coupon
bond, where the intermediate zero coupon bonds have face values that correspond to
the coupons and the final zero coupon bond has the face value plus the coupon for
that period. This process, like mapping, becomes more complicated when working with

O
convertible bonds, stocks, or derivatives.

After identifying the standardised instruments that affect the asset or assets in a
portfolio, the next step is to estimate the variances in each of these instruments as well

ty
as the covariances across the instruments. In practise, these estimates of variance and
covariance are obtained by examining historical data. They are critical in calculating
the VaR. In the final step, the portfolio’s Value at Risk is calculated using the weights

si
assigned to the standardised instruments in step 2 and the variances and covariances
assigned to these instruments in step 3.

3. Monte Carlo Method: Value at Risk is calculated using the Monte Carlo method by
r
randomly creating a number of scenarios for future rates, using non-linear pricing
ve
models to estimate the change in value for each scenario, and then calculating the
VaR based on the worst losses.
The Monte Carlo method is appropriate for a wide range of risk measurement
problems, particularly when dealing with complex factors. It is assumed that risk factors
ni

have a known probability distribution.

Marginal Value at Risk (MVaR)

U

The marginal value at risk (MVaR) method calculates the amount of additional
risk introduced into a portfolio by a new investment. MVaR assists fund managers in
understanding the change in a portfolio caused by the removal or addition of a specific
investment.
ity

An investment may have a high Value at Risk on its own, but if it is negatively
correlated with the portfolio, it may contribute significantly less risk to the portfolio than
its standalone risk.
m

Incremental Value at Risk

The amount of uncertainty added to or subtracted from a portfolio as a result of the
purchase or sale of an investment is referred to as incremental VaR. The incremental
)A

VaR is calculated by taking into account the portfolio’s standard deviation and rate of
return, as well as the rate of return and portfolio share of each individual investment.
(The portfolio share denotes the proportion of the portfolio that the individual investment
represents.)
(c

Conditional Value at Risk (CVaR)

The expected shortfall is also known as the average value at risk, tail VaR, mean

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 102 Principles and Practices of Banking

excess loss, or mean shortfall. CVaR is a variation on VaR. CVaR aids in calculating the
Notes

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average of losses that occur in a distribution beyond the Value at Risk point. The lower
the CVaR value, the better.

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Uses of Value at Risk (VaR)
VaR has four primary applications in finance:

nl
●● Risk management
●● Financial control

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●● Financial reporting
●● Computing regulatory capital
VaR is also used in non-financial applications on occasion.

ty
The most significant advantage of VAR is that it imposes a structured methodology
for critically assessing risk. Institutions that are in the process of calculating their VAR
are compelled to monitor their exposure to financial risks and to establish a proper risk

si
management function. As a result, the process of arriving at VAR may be as important
as the number itself.

Another advantage of VaR is that it enables organisations to divide risk into two
parts. r
ve
●● Within the VaR Limit
●● Outside of the VaR Limit
“A risk manager has two jobs: make people take more risks when it is safe to do
ni

so 99 percent of the time, and survive the other 1 percent of the time.” The border is
represented by VaR. So, by using VaR, the maximum amount of risk that can be taken
is defined.
U

Three events in the early 1990s significantly increased the use of value-at-risk:

The Group of 30 issued a groundbreaking report on derivatives practises in 1993.

It had an impact on the emerging field of financial risk management. It appears to be
ity

the first publication to use the phrase “value-at-risk” to promote the use of value-at-
risk by derivatives dealers. As part of its free Risk Metrics service, JP Morgan (1994)
published the first detailed description of value-at-risk. This was done to encourage
the firm’s institutional clients to use value-at-risk. The service included a technical
document describing how to implement a VaR measure as well as a covariance matrix
m

for hundreds of key factors that was updated daily on the internet.

The Basel Committee on Banking Supervision imposed market risk capital

)A

requirements on banks in 1995. These were based on a crude value-at-risk measure,

but the committee also approved the use of banks’ own proprietary VaR measures in
certain circumstances as an alternative.

Criticism of VaR
(c

VaR is likened to “an airbag that works all the time except when there’s a car
accident.”

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 Principles and Practices of Banking 103

The main criticism levelled at VaR is:

Notes

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◌◌ Led to excessive risk-taking and leverage at financial institutions
◌◌ Focused on manageable risks near the centre of the distribution while ignoring

in
the tails
◌◌ Created an incentive to take “excessive but remote risks”
◌◌ Was “potentially catastrophic when its use creates a false sense of security

nl
among senior executives and watchdogs”

Limitation of VaR

O
These are some of the most common VaR limitations:

●● Using VaR to describe a “worst-case” or “maximum tolerable” loss. In fact, you

anticipate two or three losses per year that exceed one-day 1% VaR.

ty
●● Making VaR control or reduction the primary focus of risk management. Worrying
about what happens when losses exceed VaR is far more important.
●● Assuming that plausible losses will be less than a multiple of VaR, usually three.

si
The entire point of VaR is that once you pass the VaR point, losses can be
extremely large and sometimes impossible to define. A risk manager defines VaR
as the level of loss at which you stop guessing what will happen next and start
preparing for anything. r
ve
●● Reporting a VaR that failed a backtest. Regardless of how VaR is calculated, it
should have produced the correct number of breaks in the past (within sampling
error). A common example of this is reporting a VaR based on the unsubstantiated
assumption that everything follows a multivariate normal distribution.
ni

1.7.2 Banking Codes

Banks face a variety of financial and non-financial risks during the financial
U

intermediation process, including credit, interest rate, foreign exchange rate, liquidity,
equity price, commodity price, legal, regulatory, reputational, operational, and so on.
These risks are highly interconnected, and events affecting one risk category can have
ity

ramifications for a variety of other risk categories. As a result, bank top management
should place a high priority on improving the ability to identify, measure, monitor, and
control the overall level of risk taken.

The broad parameters of the risk management function should include:

m

i) organisational structure
ii) comprehensive risk measurement approach
)A

iii) Board-approved risk management policies that are consistent with the broader
business strategies, capital strength, management expertise, and overall
willingness to assume risk.
iv) Risk-taking guidelines and other parameters, including the detailed structure
of prudential limits
(c

v) Effective MIS for risk reporting, monitoring, and control

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 104 Principles and Practices of Banking

vi) Well-defined procedures, effective risk management, and a comprehensive

Notes

e
risk reporting framework
vii) A separate risk management framework, independent of operational

in
Departments, with clear delineation of risk management levels of
responsibility.
viii) Ongoing review and evaluation

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Risk Management Structure
The choice between a centralised and decentralised risk management

O
organisation structure is a major issue in establishing an appropriate risk management
organisation structure. Globally, there is a trend toward centralising risk management
with an integrated treasury management function to benefit from aggregate exposure
information, natural netting of exposures, economies of scale, and easier reporting to

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top management. The Board of Directors should clearly bear the primary responsibility
for understanding the bank’s risks and ensuring that the risks are appropriately
managed. The Board of Directors should establish risk limits by assessing the bank’s

si
risk and risk-bearing capacity.

Overall risk management should be delegated to an independent Risk

Management Committee or Executive Committee of top executives that reports
r
directly to the Board of Directors at the organisational level. The purpose of this top-
ve
level committee is to charge one group with evaluating the bank’s overall risks and
determining the level of risk that will be in the bank’s best interests. Simultaneously,
the Committee should hold line management more accountable for the risks under their
control and the bank’s performance in that area.
ni

The Risk Management Committee’s primary functions should be to identify,

monitor, and measure the bank’s risk profile. The Committee should also develop
policies and procedures, validate the models used to price complex products, review
U

risk models as markets evolve, and identify new risks. The quantitative prudential limits
on various segments of a bank’s operations should be clearly stated in the risk policies.

Internationally, the trend is toward assigning risk limits in terms of portfolio

ity

standards or Credit at Risk (credit risk), Earnings at Risk (earnings risk), and Value
at Risk (value at risk) (market risk). The Committee should create stress scenarios to
assess the impact of unusual market conditions and track the difference between actual
portfolio volatility and that predicted by risk measures. The Committee should also
monitor operating Departments’ compliance with various risk parameters.
m

The presence of a solid, high-quality MIS is required for the establishment of an

effective risk management system. To ensure the integrity and reliability of data, the
existing MIS requires significant upgrading and strengthening of the data collection
)A

machinery.

Given the diversity of balance-sheet profiles, it is difficult to implement a

standardised framework for risk management in India. The design of risk management
functions should be bank-specific, based on the size, complexity of functions, level
(c

of technical expertise, and MIS quality. The proposed guidelines only provide broad
parameters; each bank is free to develop their own systems that are compatible with
their risk management architecture and expertise.
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 Principles and Practices of Banking 105

A committee approach to risk management is being used on a global scale. While

Notes

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the Asset-Liability Management Committee (ALCO) manages various types of market
risk, the Credit Policy Committee (CPC) manages credit/counterparty risk and country
risk. Thus, banks manage market and credit risks in a parallel two-track approach.

in
Banks could also form a single Committee to manage credit and market risks together.
In general, market risk policies and procedures are articulated in ALM policies, while
credit risk policies and procedures are addressed in Loan Policies and Procedures.

nl
Currently, credit variables are held constant in estimating market risk while market
variables are held constant in quantifying credit risk. Some countries’ economic crises
have revealed a strong correlation between unhedged market risk and credit risk.

O
Forex exposures assumed by corporations with no natural hedges will increase the
credit risk that banks face in dealing with their counterparties. The volatility of collateral
prices has a significant impact on the loan book’s quality. As a result, there is a need

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for the ALCO and the CPC’s activities to be integrated, and a consultation process
should be established to assess the impact of market and credit risks on bank financial
strength. Banks may also think about incorporating market risk factors into their credit

si
risk assessment process.

Credit Risk and Investment Banking

r
Investment banking entails a significant amount of credit risk, in addition to market
ve
risk. Investment proposals should be subjected to the same level of credit risk analysis
as loan proposals. The proposals should be subjected to a detailed appraisal and rating
framework that takes into account issuers’ financial and non-financial parameters,
sensitivity to external developments, and so on. The maximum exposure to a customer
should be bank-wide, encompassing all exposures assumed by the Credit and Treasury
ni

Departments.

Non-sovereign paper coupons should be proportionate to their risk profile. Banks

U

should exercise due caution, particularly in unrated investment proposals, and ensure
comprehensive risk evaluation. Greater interaction between the Credit and Treasury
Departments is required, and portfolio analysis should include total exposures, including
investments. The issuers’ rating migration and the resulting decrease in portfolio quality
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should also be monitored on a regular basis.

To mitigate the negative effects of concentration and the risk of illiquidity, banks
should stipulate entry level minimum ratings/quality standards, industry, maturity,
duration, issuer-wise, and other limits in investment proposals.
m

Credit Risk in Off-balance Sheet Exposure

Banks should develop an adequate framework for managing their exposure to off-
)A

balance-sheet products such as forex forward contracts, swaps, options, and so on as

part of their overall credit to individual customer relationships and subject to the same
credit appraisal, limits, and monitoring procedures.

Banks should categorise their off-balance-sheet exposures into three broad

(c

categories: full risk (credit substitutes) - standby letters of credit, money guarantees,
and so on, medium risk, and low risk (not direct credit substitutes, which do not support
existing financial obligations) - bid bonds, letters of credit, indemnities, and warranties,

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 106 Principles and Practices of Banking

as well as a low risk - reverse repos, currency swaps, options, futures contracts, and so
Notes

e
on.

Trading credit exposure to counterparties can be measured both statically (as a

in
constant percentage of the notional principal over the life of the transaction) and
dynamically. On a dynamic basis, the total exposures to counterparties should be the
sum of:

nl
1) the current replacement cost (unrealised loss to the counterparty)
2) the potential increase in replacement cost (estimated using VaR or other methods to
capture future volatility in the value of outstanding contracts/obligations).

O
On a daily basis, current and potential credit exposures can be measured
to assess the impact of potential changes in market conditions on the value of
counterparty positions. Potential exposures can also be quantified by subjecting the

ty
position to market movements such as normal and abnormal changes in interest rates,
foreign exchange rates, equity prices, liquidity conditions, and so on.

Inter-bank Exposure and Country Risk

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A suitable framework should be developed to provide a centralised overview of
other banks’ aggregate exposure. Bank-specific exposure limits could be established
r
based on an evaluation of financial performance, operational efficiency, management
quality, past experience, and so on. Banks, like corporate clients, should be rated and
ve
placed in a range of 1-5, 1-8, depending on their credit quality. The limits established
should be assigned to various operating centres, followed up on, and half-yearly/annual
reviews conducted at a single location.
ni

In terms of exposure to foreign banks, banks can use international rating agencies’
country ratings to categorise countries as low, moderate, or high risk. Banks should
strive to create an internal matrix that accounts for counterparty and country risks.
The maximum exposure should be subject to adherence to existing country and bank
U

exposure limits. While the exposure should be monitored at least weekly until banks are
equipped to monitor exposures in real time, all exposures to problem countries should
be evaluated in real time.
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Foreign Exchange (Forex) Risk

The risk of holding open foreign exchange positions has been heightened in recent
years by pronounced volatility in currency rates, adding a new dimension to the risk
profile of banks’ balance sheets.
m

Forex risk is the risk that a bank will incur losses as a result of adverse exchange
rate movements while holding an open position, either spot, forward, or a combination
)A

of the two, in a specific foreign currency. Banks are also exposed to interest rate risk
as a result of maturity mismatches in foreign currency positions. Even if spot and
forward positions in individual currencies are balanced, the maturity pattern of forward
transactions may result in mismatches. As a result, banks may incur losses due
to changes in the premia/discounts of the currencies in question. Banks in the forex
(c

business must also deal with the risk of counterparty default or settlement risk. While
this type of risk crystallisation does not result in principal loss, banks may be forced
to conduct new transactions in the cash/spot market to replace failed transactions. As
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 Principles and Practices of Banking 107

a result, banks may incur replacement costs as a result of currency rate fluctuations.
Notes

e
Banks also face a risk known as time-zone risk or Herstatt risk, which arises from
time lags between the settlement of one currency in one centre and the settlement
of another currency in another timezone. Foreign exchange transactions with

in
counterparties from another country entail sovereign or country risk.

Forex Risk Management Measures

nl
1. Establish appropriate boundaries – open positions and gaps.
2. A distinct and well-defined division of responsibilities between the front, middle, and

O
back offices.
The VaR approach should also be used by top management to assess the
risk associated with exposures. The Reserve Bank of India recently introduced two
statements for measuring forex risk exposures: Maturity and Position (MAP) and

ty
Interest Rate Sensitivity (SIR). Banks should use these statements on a regular basis to
monitor their forex risk exposures.

si
Capital for Market Risk
The Basel Committee on Banking Supervision (BCBS) issued comprehensive
guidelines to provide an explicit capital cushion for price risks to which banks are
r
exposed, particularly those arising from trading activities. As an alternative to the
ve
standardised measurement framework proposed by the Basel Committee, banks have
been given the flexibility to use in-house models based on VaR for measuring market
risk. Internal models, on the other hand, must meet the quantitative and qualitative
criteria established by the Basle Committee.
ni

The Reserve Bank of India has agreed to the general framework proposed by the
Basel Committee. The RBI has also taken several steps toward prescribing capital
for market risk. As a first step, a risk weight of 2.5 percent has been prescribed for
U

investments in government and other approved securities, in addition to a risk weight of

100 percent for open position limits in forex and gold. The RBI has also issued detailed
operating guidelines for banks’ Asset Liability Management Systems. As banks’ ability
to identify and measure market risk improves, an explicit capital charge for market
ity

risk will be required. Meanwhile, banks should read the Basle Committee’s paper
titled “Overview of the Amendment to the Capital Accord to Incorporate Market Risks”
(January 1996). (copy enclosed).

While small banks primarily based in India could use the standardised
m

methodology, large banks and those based in international markets should develop
expertise in developing internal models for measuring market risk.

The Basel Committee on Banking Supervision proposes establishing a capital

)A

charge for interest rate risk in the banking book, as well as for banks with interest
rate risks that are significantly above average (‘outliers’). The Committee is currently
investigating various methodologies for identifying ‘outliers,’ as well as how to best
apply and calibrate a capital charge for interest rate risk for banks. Once the Committee
has finalised the modalities, banks operating in international markets may be required
(c

to comply with the explicit capital charge requirements for interest rate risk in the
banking book.

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 108 Principles and Practices of Banking

Risk Aggregation and Capital Allocation

Notes

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The majority of internally active banks have developed internal processes and
techniques for assessing and evaluating their own capital requirements in light of their

in
risk profiles and business plans. To assess economic capital, such banks consider
both qualitative and quantitative factors. The Basle Committee now acknowledges that
capital adequacy in relation to economic risk is a necessary condition for banks’ long-

nl
term viability. As a result, in addition to meeting the established minimum regulatory
capital requirements, banks should critically assess their internal capital adequacy
and future capital needs based on the risks assumed by individual lines of business,
products, and so on. A bank should be able to identify and evaluate its risks across all

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of its activities as part of the process of determining internal capital adequacy.

As a result, aggregate risk exposure should be scrutinised more closely at the

bank’s headquarters. To do so, however, the various types of risks must be added up.

ty
Banks all over the world use various methods to estimate aggregate risk exposures.
The Risk Adjusted Return on Capital is the most commonly used method (RAROC).

The RAROC is intended to evaluate all business streams of a financial institution

si
on an equal footing. Using a VaR or worst-case type analytical model, each type of
risk is measured to determine both expected and unexpected losses. The matching of
revenues, costs, and risks on a transaction or portfolio basis over a defined time period
r
is critical to RAROC. This starts with distinguishing between expected and unexpected
ve
losses.

Reserves and provisions cover expected losses, while unexpected losses

necessitate capital allocation based on the principles of confidence levels, time horizon,
diversification, and correlation. Risk is measured in terms of income variability in this
ni

approach. Under this framework, the frequency distribution of return is estimated

wherever possible, as is the standard deviation (SD) of this distribution. Following
that, capital is allocated to activities based on this risk or volatility measure. The
U

risky position must then carry an expected rate of return on allocated capital that
compensates the bank for the associated incremental risk. Risk is aggregated and
priced by dimensioning all risks in terms of loss distribution and allocating capital based
on the volatility of the new activity.
ity

The second approach is similar to the RAROC, but it is based on cash flows or
earnings variability rather than capital allocation. When used to assess interest rate
risk, this is referred to as EaR. The frequency distribution of returns for any one type of
risk can also be estimated from historical data using this analytical framework. The tail
m

of the distribution can be used to estimate the extreme outcome. Either a worst-case
scenario or Standard Deviation 1/2/2.69 could be considered. As a result, each bank
has the option of capping the maximum potential loss at a certain percentage of past/
)A

current income or market value.

Following that, rather than proceeding through capital volatility to current earnings
implications from a risky position, this approach proceeds directly to current earnings
implications from a risky position. This method, on the other hand, is based on cash
flows and disregards the value changes in assets and liabilities caused by changes in
(c

market interest rates. It also relies on a subjectively defined range of risky environments
to determine the worst-case scenario.

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 Principles and Practices of Banking 109

Given the current level of risk management practises, most Indian banks may be
Notes

e
unable to adopt the RAROC framework and allocate capital to various business units
based on risk. Banks operating in international markets, on the other hand, should
develop suitable methodologies for estimating economic capital by March 31, 2001.

in
1.7.3 Basel I

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The Basel Committee on Banking Supervision established Basel I, a set of
international banking regulations (BCBS). It establishes minimum capital requirements
for financial institutions in order to reduce credit risk. Under Basel I, international banks

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were required to maintain a minimum amount of capital (8 percent) based on their risk-
weighted assets. Basel I is the first of three sets of regulations known as Basel I, II, and
III, as well as the Basel Accords as a whole.

ty
History of the Basel Committee
The BCBS was established in 1974 as an international forum for members to
collaborate on banking supervision issues. According to the BCBS, its goal is to

si
improve “financial stability by improving supervisory know-how and the quality of
banking supervision globally.” This is accomplished through the use of regulations
known as accords.

r
The committee’s first agreement, Basel I, was issued in 1988 and focused primarily
ve
on credit risk by establishing a classification system for bank assets.

The BCBS regulations are not legally binding. Members are responsible for
implementing the agreement in their respective countries. Basel I originally called for
a minimum capital-to-risk-weighted-assets ratio of 8% to be implemented by the end of
ni

1992. In September 1993, the BCBS announced that banks in the G10 countries with
significant international banking operations had met the Basel I minimum requirements.
According to the BCBS, the minimum capital ratio framework has been implemented
U

not only in its member countries, but in nearly every other country with active
international banks.

Requirements for Basel I

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The Basel I classification system divides a bank’s assets into five risk categories,
denoted by the percentages 0 percent, 10%, 20%, 50%, and 100%. The assets of a
bank are classified into these categories based on the nature of the debtor.

Cash, central bank and government debt, and any Organisation for Economic Co-
m

operation and Development (OECD) government debt fall into the 0% risk category.
Depending on the debtor, public sector debt can be classified as zero percent, ten
percent, twenty percent, or fifty percent.
)A

Development bank debt, OECD bank debt, OECD securities firm debt, non-OECD
bank debt (less than one year of maturity), non-OECD public sector debt, and cash in
collection are all included in the 20% category. Residential mortgages fall into the 50%
category, while private sector debt, non-OECD bank debt (maturity greater than a year),
(c

real estate, plant and equipment, and capital instruments issued by other banks fall into
the 100% category.

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 110 Principles and Practices of Banking

The bank must keep capital (known as Tier 1 and Tier 2 capital) equal to at least
Notes

e
8% of its risk-weighted assets. This is done to ensure that banks have enough capital to
meet their obligations. For example, if a bank has risk-weighted assets of $100 million,
it must keep at least $8 million in capital. Tier 1 capital is the most liquid and serves

in
as the bank’s core funding, whereas Tier 2 capital consists of less liquid hybrid capital
instruments, loan-loss and revaluation reserves, and undisclosed reserves.

nl
Purpose of Basel I
Basel I was designed to establish an international standard for how much capital
banks must keep in reserve in order to meet their obligations. Its regulations were

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designed to improve the global banking system’s safety and stability.

Benefits of Basel I

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Basel I was created to reduce risk for consumers, financial institutions, and
the economy as a whole. Basel II, introduced a few years later, reduced the capital
reserve requirements for banks. Because Basel II did not supersede Basel I, many
banks continued to operate under the original Basel I framework, which was later

si
supplemented by Basel III addendums.

Perhaps the most important legacy of Basel I was that it contributed to the ongoing
r
adjustment of banking regulations and best practises, paving the way for additional
safeguards.
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Criticism of Basel I
Basel I has been chastised for impeding bank activity and slowing global economic
ni

growth by making less capital available for lending. On the other hand, critics argue that
the Basel I reforms did not go far enough. Basel I and Basel II were both chastised for
failing to prevent the financial crisis and Great Recession of 2007–2009, events that
served as a catalyst for Basel III.
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1.7.4 Basel II
The Basel Committee on Banking Supervision issued a set of recommendations
ity

known as Basel II, or International Convergence of Capital Measurement and Capital

Standards. The most recent version of this standard is a comprehensive version
released in June 2006. It is a compilation of the Basel II Framework from June 2004,
the elements of the 1988 Accord that were not revised during the Basel II process, the
m

1996 Amendment to the Capital Accord to Incorporate Market Risks, and the Basel
II paper from November 2005: International Convergence of Capital Measurement
and Capital Standards: A Revised Framework. The goal of Basel II is to establish an
international standard that banking regulators can use when developing regulations
)A

governing how much capital banks must set aside to protect against the various
financial and operational risks that banks face.

Basel II Requirements
(c

Building on Basel I, Basel II established guidelines for calculating minimum

regulatory capital ratios and reaffirmed the requirement that banks keep a capital
reserve equal to at least 8% of their risk-weighted assets.
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 Principles and Practices of Banking 111

Basel II divides a bank’s eligible regulatory capital into three tiers. The higher the
Notes

e
tier, the safer and more liquid the assets.

Tier 1 capital is the bank’s core capital and is made up of common stock, disclosed

in
reserves, and certain other assets. Tier 1 assets must account for at least 4% of the
bank’s capital reserve.

Tier 2 is supplemental capital and includes items such as revaluation reserves,

nl
hybrid instruments, and medium- and long-term subordinated loans. Tier 3 is made up
of low-quality unsecured subordinated debt.

Basel II also refined the definition of risk-weighted assets, which is used to

O
determine whether a bank’s capital reserve requirements are met. The purpose of risk
weighting is to discourage banks from taking on excessive amounts of risk in terms of
the assets they own. The main difference between Basel II and Basel I is that Basel II

ty
considers asset credit ratings when determining risk weights. The lower the risk weight,
the higher the credit rating.

Basel II’s goals are as follows:

si
◌◌ Ensuring that capital allocation reflects the level of risk
◌◌ Separating operational risk from credit risk and quantifying both
◌◌ r
Attempting to align economic and regulatory capital more closely in order to
ve
reduce the scope for regulatory arbitrage
The scope of application of this framework is depicted in the figure below. It
demonstrates that Basel II can be applied at both the banking group and lower levels.
ni

Basel 2 The Basel II approach is built on three pillars:

◌◌ Capital Requirements (Minimum)
◌◌ Market Discipline
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◌◌ Supervisory Review Process

The first pillar is concerned with calculating the amount of capital required for a
given level of risk. Credit risk, operational risk, and market risk are all considered types
ity

of risks. The first pillar provides several approaches for risk calculation, allowing a bank
to select which technique to use.

The second pillar specifies how the supervisory review should be structured to
ensure that internal processes and controls are properly implemented. It also addresses
m

risk types that are not addressed in the first pillar.

The third pillar refers to the disclosures that banks are required to make in order to
provide the general public with information about the framework’s implementation.
)A

The impact of implementing Basel II on IT is primarily related to operational

security.

◌◌ Preventing improper information disclosure

(c

◌◌ Preventing the execution of unauthorised transactions

◌◌ Providing a means of transmission that does not allow modifications or access
to confidential data

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 112 Principles and Practices of Banking

◌◌ Preventing system outages and unauthorised changes in the system that

Notes

e
would compromise existing security measures.
◌◌ •It should be noted that banks implement country-specific Basel II regulations

in
rather than Basel II itself.
In practise, financial institutions use Basel II requirements/methods to rate their
customers. As a result, while Basel II was designed for financial institutions, it is highly

nl
relevant for all industries, whether for credit risk rating or supply chain management.

Pros and Cons of Basel II

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On the plus side, Basel II clarified and expanded the original Basel I Accord’s
regulations. It also aided regulators in addressing some of the financial innovations and
new financial products that had emerged since Basel I’s introduction in 1988.

Basel II, on the other hand, was not entirely successful, and has even been dubbed

ty
a miserable failure in its primary mission of making the financial world safer.

Despite Basel II’s requirements, the subprime mortgage meltdown and Great

si
Recession of 2008 demonstrated that Basel II underestimated the risks involved
in current banking practises and that the financial system was overleveraged and
undercapitalized.

r
Even the Bank for International Settlements, the organisation that oversees the
ve
Basel Committee on Banking Supervision, admits today, “The banking sector went
into the financial crisis with excessive leverage and insufficient liquidity buffers. These
flaws were accompanied by ineffective governance and risk management, as well as
ineffective incentive structures. Mispricing of credit and liquidity risks, as well as excess
credit growth, demonstrated the perilous combination of these factors.”
ni

In response to the financial crisis, the Basel Committee issued new risk
management and supervision guidelines in 2008 and 2009 to strengthen Basel II.
U

These and other reforms issued in 2010 and later represented the beginnings of the
next Basel Accord, Basel III, which is still being phased in as of 2022.

1.7.5 Basel III

ity

Basel III is an international regulatory agreement that introduced a set of reforms

designed to mitigate risk in the international banking sector by requiring banks to
maintain certain leverage ratios and reserve capital levels on hand. It began in 2009
and is still in use as of 2022.
m

Understanding Basel III

Shortly after the 2007–2008 financial crisis, the Basel Committee on Banking
)A

Supervision—a consortium of central banks from 28 countries based in Basel,

Switzerland—implemented Basel III. Despite previous reforms, many banks were found
to be overleveraged and undercapitalized during the crisis.

Although the voluntary deadline for implementing the new rules was originally set
(c

for 2015, it has been repeatedly pushed back and is now set for January 1, 2023.

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 Principles and Practices of Banking 113

Basel III, also known as the Third Basel Accord, is part of a continuing effort
Notes

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to improve the international banking regulatory framework that began in 1975. It
expands on the Basel I and Basel II agreements in an effort to strengthen the banking
system’s ability to deal with financial stress, improve risk management, and promote

in
transparency. On a more granular level, Basel III aims to strengthen individual banks’
resilience in order to reduce the risk of system-wide shocks and prevent future
economic meltdowns.

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Minimum Capital Requirements Under Basel III
Banks have two major capital silos that are qualitatively distinct from one another.

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Tier 1 refers to a bank’s core capital, equity, and disclosed reserves as reported on
its financial statements. If a bank suffers significant losses, Tier 1 capital provides a
cushion that allows it to weather the storm while maintaining operational continuity.

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Tier 2 refers to a bank’s supplementary capital, which includes things like
undisclosed reserves and unsecured subordinated debt instruments.

Tier 1 capital is considered more liquid and secure than Tier 2 capital.

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The total capital of a bank is calculated by adding both tiers together. The minimum
total capital ratio that a bank must maintain under Basel III is 8% of its risk-weighted
assets (RWAs), with a minimum Tier 1 capital ratio of 6%. The remainder can be
classified as Tier 2. r
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While Basel II required banks to have a minimum total capital ratio of 8%, Basel III
increased the portion of that capital that must be in the form of Tier 1 assets from 4% to
6%. Basel III also removed an even riskier capital tier, Tier 3, from the calculation.
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Capital Buffers for Tough Times

Basel III introduced new rules requiring banks to keep additional reserves known
as countercyclical capital buffers—basically a bank’s rainy day fund. During periods
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of economic expansion, these buffers, which can range from 0% to 2.50% of a bank’s
RWAs, can be imposed on banks. As a result, they should have more capital on hand
during times of economic contraction, such as a recession, when they face higher
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potential losses.

Taking both the minimum capital and buffer requirements into account, a bank may
be required to maintain reserves of up to 10.5 percent.

Countercyclical capital buffers must also be entirely composed of Tier 1 assets.

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Leverage and Liquidity Measures

Basel III also introduced new leverage and liquidity requirements aimed at
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protecting banks from excessive and risky lending while ensuring adequate liquidity
during times of financial stress. It specifically established a leverage ratio for so-called
“globally systemically important banks.” The ratio is calculated as Tier 1 capital divided
by total assets, with a minimum ratio requirement of 3%.
(c

Furthermore, Basel III established a number of liquidity-related rules. The liquidity

coverage ratio, for example, requires banks to maintain a “sufficient reserve of high-
quality liquid assets (HQLA) to allow them to survive a period of significant liquidity

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 114 Principles and Practices of Banking

stress lasting 30 calendar days.” HQLA refers to assets that can be quickly converted
Notes

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into cash with no significant loss of value.

The net stable funding (NSF) ratio compares the bank’s “available stable funding”

in
(basically capital and liabilities with a time horizon of more than one year) to the amount
of stable funding that it is required to hold based on the liquidity, outstanding maturities,
and risk level of its assets. The NSF ratio of a bank must be at least 100%. This rule’s

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goal is to create “incentives for banks to fund their activities with more stable sources
of funding on an ongoing basis” rather than load up their balance sheets with “relatively
cheap and abundant short-term wholesale funding.”

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1.7.6 Capital Adequacy Ratio
The Capital Adequacy Ratio establishes standards for banks by examining a
bank’s ability to pay liabilities as well as respond to credit and operational risks. A bank

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with a high CAR has sufficient capital to absorb potential losses. As a result, it is less
likely to go bankrupt and lose depositors’ money. Following the 2008 financial crisis, the
Bank of International Settlements (BIS) began imposing stricter CAR requirements in

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order to protect depositors.

Capital Adequacy Ratio Formula

the CAR formula is: r
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CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets
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The Bank of International Settlements classifies capital into Tier 1 and Tier 2 based
on its function and quality. Tier 1 capital is the primary metric used to assess a bank’s
financial health. It includes shareholder equity and retained earnings, both of which are
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reported on financial statements.

Tier 1 capital can absorb losses without affecting business operations because it
is the core capital held in reserves. Tier 2 capital, on the other hand, includes revalued
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reserves, undisclosed reserves, and hybrid securities. This type of capital is known as
supplementary capital because it has a lower quality, is less liquid, and is more difficult
to measure.

Risk-weighted assets make up the bottom half of the equation. Risk-weighted

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assets are the sum of a bank’s assets that have been risk-weighted. Banks typically
hold various asset classes, such as cash, debentures, and bonds, and each class of
asset carries a different level of risk. Risk weighting is determined by the likelihood of
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an asset’s value decreasing.

Safe asset classes, such as government debt, have a risk weighting close to zero
percent. Other assets, such as debentures, have a higher risk weighting because they
are backed by little or no collateral. This is due to the increased likelihood that the bank
(c

will be unable to collect the loan. Risk weightings can also be applied to the same asset
class. For example, if a bank lends money to three different companies, the loans may
have different risk weightings based on each company’s ability to repay its loan.

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 Principles and Practices of Banking 115

Calculating the Capital Adequacy Ratio (CAR) – Worked Example

Notes

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Consider Bank A as an example. The information about Bank A’s Tier 1 and 2
capital, as well as the risks associated with their assets, is provided below.

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O
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Bank A has three types of assets: debentures, mortgages, and government loans.
The first step in calculating risk-weighted assets is to multiply the amount of each asset
by the corresponding risk weighting.

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Debenture: $9,000 * 90% = $8,100

Mortgage: $45,000 * 75% = $33,750

Loan to Government: $4,000 * 0% = $0

r
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Because the loan to the government is risk-free, it adds $0 to the risk-weighted
assets.

The risk-weighted assets are then added to arrive at the total:

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Risk-Weighted Assets: $8,100 + $33,750 + $0 = $41,850

The calculation can be easily done on Excel using the SUMPRODUCT function.
U
ity
m

The Capital Adequacy Ratio of Bank A is as follows :

)A
(c

Where:

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 116 Principles and Practices of Banking

CAR : $4,000 / $41,850 = 10%

Notes

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As Bank A has a CAR of 10%, it has enough capital to cushion potential losses and
protect depositors’ money.

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What are the Requirements?
All banks are required by Basel III to have a Capital Adequacy Ratio of at least 8%.

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Because Tier 1 Capital is more important, banks are required to have a certain amount
of it. Tier 1 Capital divided by Risk-Weighted Assets must be at least 6% under Basel III.

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Summary
●● A financial system is a collection of global, regional, or firm-specific institutions,
such as banks, insurance companies, and stock exchanges, that facilitate the
transfer of funds between lenders, borrowers, and investors.

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●● A ‘financial system’ is a framework that allows funds to be traded between
lenders, investors, and borrowers. It is a collection of institutions, such as banks,
stock exchanges, and insurance companies, that collaborate on a national and

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international scale to facilitate the exchange of funds. Regional banks, government
treasures, and stock exchanges are all examples of financial institutions.
●●
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A plethora of central agencies regulate the Indian financial system in the areas
of banking, capital markets, insurance, commodity markets, and pension funds.
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However, the central government, or the government of India, wields significant
power over the Indian financial system, which includes financial institutions. It also
has a significant impact on the regulators of Indian financial systems.
●● The banking system is critical in promoting economic growth, not only by
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channelling savings into investments, but also by improving resource allocative

efficiency. The banking system in India is comprised of the Reserve Bank of India,
which serves as the central bank, commercial banks (both public and private),
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development banks, and cooperative banks. Banking institutions serve as a

meeting place for both investors and savers in order to mobilise resources and
better allocate them in order to accelerate the country’s development process.
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Glossary
●● Basel I: It was created to reduce risk for consumers, financial institutions, and the
economy as a whole.
m

●● Basel II: It is to establish an international standard that banking regulators can use
when developing regulations governing how much capital banks must set aside to
protect against the various financial and operational risks that banks face.
)A

●● Basel III: Basel III is an international regulatory agreement that introduced a set of
reforms designed to mitigate risk in the international banking sector by requiring
banks to maintain certain leverage ratios and reserve capital levels on hand.
●● Monte Carlo Method: Value at Risk is calculated using the Monte Carlo method by
randomly creating a number of scenarios for future rates, using non-linear pricing
(c

models to estimate the change in value for each scenario, and then calculating the
VaR based on the worst losses.

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 Principles and Practices of Banking 117

●● Parametric Method: The variance-covariance method is another name for the

Notes

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parametric method. It is based on the assumption of a normal distribution of
returns. Two variables must be estimated: the expected return and the standard
deviation.

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●● Price Risk: When assets are sold before their stated maturities, they expose
themselves to price risk. Bond prices and yields are inversely related in the

nl
financial market. The price risk is inextricably linked to the trading book, which was
created to profit from short-term interest rate movements.
●● Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and

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liabilities, as well as off-balance-sheet items, with differing principal amounts,
maturity dates, or repricing dates, exposing the company to unexpected changes
in market interest rates.
●● Bancassurance: Bancassurance is a partnership between a bank and an

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insurance company that allows the insurance company to sell its products to the
bank’s customers. This partnership arrangement has the potential to be profitable
for both companies. Banks increase their revenue by selling insurance products,

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and insurance companies increase their customer bases without increasing their
sales force.
●● Commercial Papers: Commercial paper, also known as CP, is a short-term debt
r
instrument issued by businesses to raise funds for a period of up to one year. A
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commercial paper pays the holder a fixed interest rate. Furthermore, due to the
somewhat risky nature of the unsecured security, it is generally sold at a discount
to its face value. Commercial paper is frequently required by corporations that
have a short-term need to cover their expenses.
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●● Wholesale banking: It provides an opportunity for businesses to grow, even if they

lack the necessary capital.
●● NEFT: National Electronic Funds Transfer (NEFT), according to the Reserve
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Bank of India, is a nationwide payment system that facilitates one-to-one funds

transfers. Individuals, firms, and corporations can use NEFT to electronically
transfer funds from any bank branch to any other bank branch in the country that
participates in the Scheme.
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●● Financial Markets: It refers to any marketplace in which buyers and sellers trade
assets such as stocks, bonds, currencies, and other financial instruments.
●● Financial Institutions: Financial institutions act as financial market intermediaries,
m

facilitating financial transactions between individuals and financial customers.

●● Non- Banking Institutions or Non-Depository institutions: These are brokerage
firms, insurance companies, and mutual funds that cannot accept money deposits
)A

but can sell financial products to financial customers.

Check Your Understanding

1. A financial system is a collection of institutions, instruments, and markets that
encourage ............ and channel them to their most efficient use.
(c

(a) savings
(b) spendings
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 118 Principles and Practices of Banking

(c) high spendings

Notes

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(d) low spendings
2. The financial system of a country is an important tool for the country’s economic

in
development because it aids in the .............. by linking savings with investments.
(a) creation of wealth

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(b) creation of fortune
(c) creation of money
(d) creation of finances

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3. Financial services are concerned with the development and provision of ......
instruments and ........... services to individuals and businesses in the areas of
banking and related institutions, personal financial planning, leasing, investment,

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assets, insurance, and so on.
(a) financial, advisory
(b) regulatory, advisory

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(c) banking, advisory
(d) advisory, financial
4. r
Capital markets, as opposed to the money market, deal in ............securities.
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(a) long-term
(b) short term
(c) mid-term
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(d) extra long term

5. Venture capital is a fund or initial capital provided to businesses at the ........... stage
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for new ideas and small businesses with high growth potential.
(a) start-up
(b) mid-term
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(c) end
(d) short term
6. The Insurance Regulatory and Development Authority of India (IRDAI) is an ...........
regulatory body that protects policyholder interests.
m

(a) independent
(b) state owned
)A

(c) international
(d) national
7. The Reserve Bank of India (RBI) regulates the Indian banking system through the
provisions of the Banking Regulation Act, ...........
(c

(a) 1949
(b) 1951
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 Principles and Practices of Banking 119

(c) 1948
Notes

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(d) 1950
8. Non-performing assets (NPA) are divided into three types: ............, ..........., and loss.

in
(a) substandard, doubtful
(b) high standard, certified

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(c) certified standard, doubtful standard
(d) high, low

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9. Under Sections........... and .........., the RBI has the authority to fix interest rates
(including the Bank Rate) as well as exercise selective credit controls in order to
control inflation and money supply in order to ensure economic growth and price
stability.

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(a) 21, 3SA
(b) 23, 24 A

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(c) 25, 15B
(d) 30, 31 A
10. A ........... bank is a locally incorporated bank that is wholly or largely owned by a
foreign parent. r
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(a) subsidiary
(b) national
(c) state
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(d) regional
11. Commercial paper, also known as CP, is a ............ debt instrument issued by
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businesses to raise funds for a period of up to one year.

(a) short-term
(b) long term
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(c) mid-term
(d) very long term
12. .............. is a partnership between a bank and an insurance company that allows the
insurance company to sell its products to the bank’s customers.
m

(a) Bancassurance
(b) Bank-insurance
)A

(c) Banks and insurance

(d) Insurance and banks
13. Value at Risk is calculated using the .......... method by randomly creating a number
of scenarios for future rates, using non-linear pricing models to estimate the change
(c

in value for each scenario.

(a) Monte Carlo

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 120 Principles and Practices of Banking

(b) Historical
Notes

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(c) Monte
(d) Carlo

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14. Basel III is an international regulatory agreement that introduced a set of reforms
designed to mitigate risk in the ............. banking sector by requiring banks to maintain
certain leverage ratios and reserve capital levels on hand.

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(a) international
(b) regional

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(c) state
(d) national

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Exercise
1. What is the structure, objectives, functions and components of Indian Financial
system?

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2. What are the five parts of financial system?
3. What are the recent developments in the financial sector?
4. r
What are the roles and functions of RBI?
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5. What is the role and function of SEBI?
6. What is the role and function of IRDA?
7. What is banking regulation act 1949?
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8. What is RBI act 1935?

9. Define commercial papers and Bancassurance.
10. Define credit, liquidity, operational, interest rate and market risk management.
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11. What is VaR analysis?

12. Define Basel I, Basel II and Basel III regulations.
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13. What is capital adequacy ratio?

Learning Activities
1. Discuss the desired financial reforms that would be needed in transforming India into
m

a $5 trillion economy by 2025.

2. Discuss the financial market structure in India.
3. Discuss the role of financial innovation in boosting up the economic system.
)A

4. Discuss the role and functions of retail, wholesale, commercial and international
banking.

Check Your Understanding - Answers

(c

1. Savings
2. creation of wealth

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 Principles and Practices of Banking 121

3. financial, advisory
Notes

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4. long-term
5. start-up

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6. independent
7. 1949

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8. substandard, doubtful
9. 21, 3SA

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10. Subsidiary
11. short-term
12. Bancassurance

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13. Monte Carlo
14. International

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Further Readings and Bibliography
1. The Indian Financial System: Markets, Institutions and Services, 3rd Edition,
Bharati Pathak
2.
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Indian Financial System, Fifth Edition, By Pearson
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3. Financial Management, Theory and Practice, 10th Edition, Prasanna Chandra
4. Indian Financial System, MY Khan
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U
ity
m
)A
(c

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 122 Principles and Practices of Banking

Module - II: Introduction to Banking and Its

Notes

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Regulations

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Learning Objectives:
●● Banking services - Deposits, Services (Locker), Ancillary Services

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●● Functions - Mandate and Power of Attorney, Paying and Collecting Banker,
Remittance
●● Banker - Customer

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●● KYC
●● Banking isues - Forged Instruments and Bouncing of Cheque

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Introduction
Any modern economy’s lifeline is the banking sector. It is one of the most important
financial pillars of the financial sector, and it is critical to the functioning of an economy.

si
It is critical for a country’s economic development that its financing requirements for
trade, industry, and agriculture are met with greater commitment and responsibility.
Thus, a country’s development is inextricably linked to the development of banking.
r
Banks are to be regarded as development leaders rather than money dealers in
ve
a modern economy. They play an important role in deposit mobilisation and credit
disbursement to various sectors of the economy.

The banking system reflects the country’s economic health. The strength of
an economy is determined by the financial system’s strength and efficiency, which is
ni

determined by a sound and solvent banking system. A sound banking system efficiently
mobilises savings in productive sectors, while a solvent banking system ensures that
the bank can meet its obligations to depositors.
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Banks in India have played a critical role in the country’s socioeconomic progress
since independence. In India, the banking sector is dominant, accounting for more
than half of the financial sector’s assets. Indian banks have been undergoing a
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fascinating period of rapid change as a result of financial sector reforms that are being
implemented in stages.

The current transformation process should be viewed as an opportunity to

transform Indian banking into a sound, strong, and vibrant system capable of playing
m

its role efficiently and effectively on its own without imposing any burden on the
government.

Following the liberalisation of the Indian economy, the government announced a

)A

number of reform measures based on the Narasimhan Committee’s recommendations

to make the banking sector economically viable and competitively strong.

Many macroeconomic developments in India have occurred over the last six
decades. Several changes have been made to the monitoring, external, and banking
(c

policies. The structural changes in the Indian financial system, particularly in the
banking system, have had a variety of effects on the evaluation of Indian banking.

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 Principles and Practices of Banking 123

The functioning of commercial banks has changed since their independence and
Notes

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the implementation of banking reforms. To understand the changing role of commercial
banks, as well as the problems and challenges they face, it is necessary to examine
major developments in the Indian banking sector.

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2.1 Functions of Banks

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In common parlance, the term “bank” refers to a commercial bank and its
operations. The Central Bank is a distinct entity with distinct roles. A bank’s function is
to collect public deposits and lend those deposits for the development of agriculture,

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industry, trade, and commerce. The bank pays lower interest rates to depositors while
receiving higher interest rates on loans and advances from them.

In modern banking, the bank performs a variety of other functions, such as the
creation of debts and money, the transmission of money from one country to another,

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the expansion of foreign trade, the safekeeping of valuables, and so on. Thus, the bank
generates profits by engaging in a variety of activities.

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2.1.1 Deposits
Deposits are sums of money that a customer gives to the bank. This is referred

r
to as making a deposit. There are four types of deposits: Saving Deposits, Fixed
Deposits, Current Deposits, and Recurrent Deposits. The various deposit schemes
ve
are determined by the type of deposit and the frequency with which it is made. For
example, in a fixed deposit, a predetermined sum is given to the bank for a set period of
time. If the deposit term is completed, the interest is only compounded once. One of the
primary functions of a bank is to provide deposit services.
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How Bank Deposits Work

The deposit is a liability that the bank owes to the depositor. The term “bank
U

deposits” refers to this liability rather than the funds that have been deposited. When a
person opens a bank account and deposits cash, he relinquishes legal title to the cash,
which becomes an asset of the bank. As a result, the account is a liability for the bank.
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Types of Bank Deposits

Current (Demand Deposit) Account: A current account, also known as a demand
deposit account, is the most basic type of checking account. Consumers deposit
money, and the money can be withdrawn as the account holder sees fit. These
m

accounts frequently permit the account holder to withdraw funds via bank cards,
checks, or over-the-counter withdrawal slips. Banks may charge monthly fees for
current accounts in some cases, but the fee may be waived if the account holder meets
)A

other requirements, such as setting up direct deposit or making a certain number of

monthly transfers to a savings account.

Savings Accounts: Savings accounts pay interest on deposits made by account

holders. Account holders may, however, be charged a monthly fee if they do not
(c

maintain a certain balance or a certain number of deposits. Although savings accounts

are not linked to paper checks or cards like current accounts, account holders have
relatively easy access to their funds.

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 124 Principles and Practices of Banking

A money market account, on the other hand, offers slightly higher interest rates
Notes

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than a savings account, but account holders are restricted in the number of checks or
transfers they can make from money market accounts.

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Call Deposit Accounts: These accounts are known as interest-bearing checking
accounts, Checking Plus, or Advantage Accounts by financial institutions. These
accounts combine the features of checking and savings accounts, allowing customers

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to access their funds while also earning interest on their deposits.

Certificates of Deposit/Time Deposit Accounts: A time deposit account, like a

savings account, is an investment vehicle for consumers. Time deposit accounts,

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also known as certificates of deposit (CD), typically offer a higher rate of return than
traditional savings accounts, but the money must remain in the account for a specified
period of time. Time deposit accounts are also known as term deposits, fixed-term
accounts, and savings bonds in other countries.

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2.1.2 Services (Locker)
Bank lockers, also known as safe deposit boxes, are a popular way to keep

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valuables safe. For this service, banks charge a fee based on the size of the locker.
Many banks and some of their branches provide customers with bank lockers in
exchange for a deposit, and the locker is assigned based on availability.
r
Most bank branches have safe deposit boxes where you can keep valuables like
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jewellery or important documents. The nearest bank branch where one has an account
would be an ideal location to rent a locker. The size of the locker can be chosen based
on the need and the rent.
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Opening
Lockers are usually in high demand, and one must apply to the bank for one. If
a locker is available, the bank and the customer enter into a locker rental agreement
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outlining the terms and conditions, liabilities, and responsibilities of the bank and the
customer.

Maintenance
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A locker rental is collected when entering into a locker agreement, depending on

the bank, branch, and size or location of the locker. The customer should maintain a
sufficient balance in their bank account to cover the annual rental of the locker via a
direct debit instruction. Banks typically require collateral in the form of deposits that
m

cover a three-year rent.

Holding and nomination

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A locker can be shared by multiple people. When one of the holders dies,
the nominee and other holders gain access to the contents of the locker upon the
submission of the necessary documents. Nominations for the locker must be registered.
In the absence of a nominee, the legal heir usually has access to the locker.
(c

Closing
If a person wishes to close a locker, he or she may apply to surrender it. The
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 Principles and Practices of Banking 125

customer is responsible for emptying the locker and returning the key to the bank. The
Notes

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agreement is terminated, and the customer’s locker rental from the beginning of the
year is refunded.

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Points to note
●● Each locker has two keys, one of which is in the possession of the customer. If the
customer misplaces the key, a fee is levied to open the locker and replace the key.

nl
●● One can purchase a jewellery insurance policy that covers items kept in specified
bank safe deposit boxes.

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RBI’s New Guidelines For Bank Lockers
The Reserve Bank of India (RBI) has revised its guidelines for banks’ safe deposit
locker and safe custody article facilities. In its new instructions for lockers in banks,

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the Reserve Bank of India (RBI) stated that banks would be allowed to take a “Term
Deposit” at the time of locker allotment to ensure prompt payment of locker rent. This
would cover three years’ rent as well as the costs of breaking open the locker in the

si
event of such an occurrence. Banks, on the other hand, can exercise their discretion
and refuse to require such Term Deposits from existing locker holders or those with a
satisfactory operative account.

r
However, in a move that will benefit bank customers, the RBI has made it
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mandatory for banks to settle claims of deceased lockers, hirers, and release contents
of the locker to survivor(s)/nominee(s) within 15 days of receipt of the claim. This is
subject to the bank’s acceptance of proof of the depositor’s death and appropriate
identification of the claimant(s) with reference to the nomination.
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The primary characteristics of these guidelines are as follows:

Locker Rental Rules: To ensure timely payment of locker rent, the RBI has
authorised banks to accept a “Term Deposit” at the time of locker allotment. This would
U

cover three years’ rent as well as the costs of breaking open the locker in the event of
such an occurrence.

Also, banks should not require such term deposits from existing locker holders or
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those with a satisfactory operating account. Furthermore, if a customer has not paid the
rent for three years in a row, the banks will have the discretion to break open any locker
using proper procedure.

In urban and metro areas, state-owned banks currently charge Rs 2,000 per year
m

for a small safe deposit box and Rs 4,000 for a medium-sized safe deposit box. A large
locker costs Rs 8,000 per year to rent. In addition, the applicable GST must be paid by
the customer.
)A

What Will Be Banks’ Responsibility

Banks have been directed to implement a board-approved policy outlining
their liability for any loss or damage to the contents of the lockers caused by their
negligence.
(c

“The bank shall not be liable for any damage and/or loss of locker contents
arising from natural calamities or Acts of God such as earthquake, floods, lightning,

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 126 Principles and Practices of Banking

and thunderstorm, or any act attributable to the customer’s sole fault or negligence,” it
Notes

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stated.

Banks, on the other hand, should take proper care of their locker systems in order

in
to protect their premises from such disasters. In addition to the above rules, banks will
include an additional clause in the locker agreement prohibiting the hirer from storing
anything hazardous in the locker.

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Furthermore, in the event of an event such as fraud by banking professionals, a
fire, or a building collapse, the banks’ liability has been set at 100 times the amount of
the yearly rent.

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Customer Due Diligence
Existing bank customers who have applied for a locker facility and are fully
compliant with the criteria of Know Your Customer (KYC) Directions may be granted

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access to safe deposit lockers/safe custody articles. Customers who do not have a
banking relationship can hire a safe deposit box/safe custody article after meeting the
criteria outlined in the Master Direction Know Your Customer (KYC) Directions.

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Banks must conduct due diligence on all customers who intend to hire a locker
in whatever capacity. Due to an increase in complaints about lockers being used to
store illegal goods and assets, the RBI has asked banks to include a clause in the
r
locker agreement stating that the locker-hirer/s shall not keep anything illegal or any
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hazardous substance in the safe deposit box.

If a bank suspects a customer of depositing any illegal or hazardous substance in

a safe deposit box, the bank now has the authority to take appropriate action against
such customers.
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Model Locker Agreement

The Supreme Court issued a nudge to fix the rules in February of this year. The
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Supreme Court had directed the RBI to develop regulations for bank locker facility
management within six months.

According to a bench consisting of Justices MM Shantanagoudar and Vineet

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Saran, “Because of rapid technological advancements, lockers have become an

essential service provided by every banking institution, as evidenced by the rising
demand for such services. We are in the process of replacing dual key-operated lockers
with electronically operated lockers. Miscreants may exploit the technologies used
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in these systems to gain access to the lockers without the customers’ knowledge or
consent.”

The court ruled that a customer is completely at the mercy of the bank, which
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cannot wash their hands of responsibility and claim that they are not liable to their
customers for the operation of the locker.

As a result, the RBI has mandated that all banks have a board-approved
agreement for safe deposit boxes. Banks may use the model locker agreement
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developed by IBA for this purpose (Indian Banks Association).

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 Principles and Practices of Banking 127

Model locker agreement

Notes

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●● Banks have been warned to ensure that no unfair terms or conditions are
incorporated into their locker agreements. By January 1, 2023, banks can also

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renew their locker agreements with existing locker customers.
●● For each locker hiring application, banks will take recent passport-size
photographs of the locker-hirer(s) as well as the individual(s) authorised by the

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locker-hirer(s) to operate the locker, and the records pertaining to the locker-hirer
will be kept in the bank’s branch.
●● At the time of allotment of the locker to a customer, the bank shall enter into an

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agreement on duly stamped paper with the customer to whom the locker facility is
provided.
●● A copy of the locker agreement, signed in duplicate by both parties, must be

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provided to the locker-hirer so that he or she is aware of his or her rights and
responsibilities. The original agreement must be kept at the bank branch where
the locker is located.

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●● To avoid situations in which the locker-hirer does not operate the locker or pay the
rent, banks have been allowed to obtain a Term Deposit at the time of allotment.
This would cover three years’ rent as well as the costs of breaking open the locker
in the event of such an occurrence.
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●● If locker rent is collected in advance, and a customer surrenders a locker, the
proportionate amount of advance rent collected is refunded to the customer.
●● If an event occurs, such as a merger, closure, or branch relocation, that
necessitates physical relocation of the lockers, the bank must publish a public
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notice in two newspapers (including one local daily in vernacular language).

Customers must be notified at least two months in advance, with options to
change or close the facility. • In the event of an unplanned relocation due to natural
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disasters or other emergency situations, banks must make every effort to notify
their customers as soon as possible.

Security of the Strong Room/Vault

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With the number of locker heists on the rise, the RBI has asked banks to take the
necessary precautions to ensure that the area in which the locker facility is housed is
properly secured to prevent criminal break-ins.

The risks of an allotted locker being accessed from any direction without the
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involvement of the locker-hirer in question can be assessed and recorded. The locker
room/vault should have a single defined point of entry and exit for banks.

The location of the lockers must be secure enough to prevent rain/flood water from
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entering and damaging the lockers in emergency situations. The risks posed by the
area’s fire hazards should also be assessed and minimised.

Banks must also cover the entry and exit of the strong room and the common
areas of operation with CCTV cameras and keep the recordings for at least 180 days.
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If a customer files a complaint with the bank alleging that his or her locker was opened
without their knowledge, or if any theft or security breach is discovered, the bank is

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 128 Principles and Practices of Banking

required to keep the CCTV recording until the police investigation is completed and the
Notes

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dispute is resolved.

2.1.3 Ancillary Services

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The main goal of the establishment of banks was to keep people’s money safe
and to provide loans to those in need. People used to deposit their hard-earned money

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in banks, and banks would lend this money to those who deserved it (Repayment
capacity). Banks now provide a variety of financial services to their customers in
addition to basic banking functions such as deposit and lending facilities. These product

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and service expansions are the result of a variety of factors, including increased
competition among public, private, and foreign banks, technological advancement,
openness to national economies for business transitions, and many others.

Because the concept of time value of money is well-known among the general

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public these days, and they are aware of future opportunities for their money, they do
not rely solely on savings accounts and other investment schemes. As a result, banks
can no longer rely on money deposited by customers and must diversify into other

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financial services to make a profit. Other than lending and deposit, these banking
services are referred to as ancillary services.

The following are some ancillary services:

◌◌ Bank draft
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◌◌ Mail/ telex transfer
◌◌ Fund Transfer (NEFT/RTGS)
◌◌ Travelers cheque
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◌◌ Custodial Services
◌◌ Pension
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◌◌ Merchant banking
◌◌ Retail banking
◌◌ Factoring
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◌◌ Bank assurance/ Guaranty

◌◌ Mutual funds
◌◌ Sale and purchase of gold
◌◌ Insurance
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◌◌ Foreign exchange / Forex services

◌◌ Notary services
◌◌ Bank cards
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◌◌ Venture capitalist
◌◌ Internet banking
◌◌ Mobile banking
1. Bank Drafts: According to Section 85 (A) of the Negotiable Investment Act, a bank
(c

draught is an order to pay money drawn by one office to the bank upon other offices
of the same bank for a sum of money payable to order on demand. A bank draught,

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 Principles and Practices of Banking 129

in other words, is a payment made on behalf of a payer that is guaranteed by the

Notes

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issuing bank. The payee receives payment assurance from a bank draught. A bank
draught is a type of cheque in which payment is guaranteed by the issuing bank and
is issued after sufficient funds have been confirmed in the payer’s account. It is a

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more complicated process than issuing a bank cheque.
2. Mail/ Telex transfer: Mail transfer refers to the transfer of funds from one account of

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the same bank to another account of the same bank in a different location. A mail
transfer is an internal message sent through the regular postal system instructing the
payee branch or bank to pay the amount to a specific payee. Telex transfer service
is when a message is sent via telex machine rather than the postal channel.

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3. Fund Transfer (NEFT/RTGS):
RTGS: Real Time Gross Settlement is abbreviated as RTGS. According to the RBI,
RTGS is a system that allows for the continuous and real-time settlement of fund

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transfers on a transaction by transaction basis. It is a quick service because it does
not take long to transfer funds from one account to another. Currently, the RTGS
system is primarily intended for high-value transactions. The minimum amount that

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can be remitted via RTGS is Rs. 2,00,000/-, with no upper or lower limit.
With effect from July 1, 2019, the Reserve Bank has eliminated the processing fees
it charges for RTGS transactions. Banks may be able to pass on the benefit to their
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customers. A broad framework of charges has been mandated in order to rationalise the
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service charges levied by banks for offering funds transfer via the RTGS system:

a) Inward transactions – Free, no charge to be levied.

b) Outward transactions – ` 2,00,000/- to 5,00,000/- : not exceeding `
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24.50/-;(exclusive of tax, if any)

Above ` 5,00,000/- : not exceeding ` 49.50/-. (exclusive of tax, if any)
Banks may decide to charge a lower rate but cannot charge more than the rates
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prescribed by RBI

NEFT: According to the Reserve Bank of India, National Electronic Funds Transfer
(NEFT) is a nationwide payment system that allows for one-to-one fund transfers.
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Individuals, firms, and corporations can use this Scheme to electronically transfer funds
from any bank branch to any other bank branch in the country that is a participant in the
Scheme. This scheme is very similar to RTGS, except that there is no minimum limit
with NEFT. However, the maximum amount per transaction for cash-based remittances
within India and remittances to Nepal under the Indo-Nepal Remittance Facility Scheme
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is 50,000/-. Unlike RTGS, these transactions take time to complete in terms of fund
transfer. Typically, a transaction takes 30 minutes.
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Charges for the NEFT Transactions

The structure of charges that can be levied on the customer for NEFT is given
below:

a) Inward transactions at destination bank branches (for credit to beneficiary

(c

accounts)
– Free, no charges to be levied on beneficiaries

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 130 Principles and Practices of Banking

b) Outward transactions at originating bank branches – charges applicable for

Notes

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the remitter
- For transactions up to ` 10,000: not exceeding ` 2.50 (+ Applicable GST)

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- For transactions above ` 10,000 up to ` 1 lakh: not exceeding ` 5 (+
Applicable GST)
- For transactions above ` 1 lakh and up to ` 2 lakhs: not exceeding ` 15 (+

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Applicable GST)
- For transactions above ` 2 lakhs: not exceeding ` 25 (+ Applicable GST)

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4. Travelers cheque: A traveller’s cheque is a prepaid fixed amount that works like
cash and can be used to purchase goods or services while travelling. A traveler’s
check can also be exchanged for cash by a customer. These cheques are used by
travellers instead of currency notes because they are safer and more convenient

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to travel with. In the event that the traveller is lost, the cheque bank may cancel
the previous one and issue a new one. Nowadays, these cheques are uncommon
because we have more convenient methods of payment, such as plastic money.

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5. Custodial Services: These are commonly referred to as bank locker services.
Customers can store valuables such as jewellery, documents, and other items in
these lockers. These lockers can be obtained based on availability in the bank and
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after paying a fee to the bank as a locker fee. In the event of theft or loss, the bank
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will only pay the insured amount to the customer rather than the actual value of the
items stored in the locker.
6. Pension services: Pension is a social security scheme in which retired and
superannuated employees receive a lump sum payment. The EPF (Employee’s
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Provident Fund) office assists in the distribution of the pension, and banks provide
them with banking and financial assistance. Different banks and their branches are
responsible for distributing pensions for various organisations. The pensioner is
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required to open an account with the nearest bank branch, and the account number
is forwarded to the relevant pension department for direct credit to the pensioner’s
pension amount.
7. Merchant banking: Corporate houses that generate capital by issuing financial
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securities such as shares, bonds, debentures, mutual funds, and so on must deal
with disputes and problems that arise as a result of this. To address such issues, a
variety of financial and non-financial institutions offer merchant banking services.
Essentially, it is a consultancy service that advises clients on financial, marketing,
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managerial, and legal issues concerning financial and banking services.

8. Retail banking: Retail banking, also known as consumer banking or personal
banking, is financial services provided to the general public. Retail banking allows
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the average customer to manage their money, obtain credit, and deposit funds in a
secure manner. Checking and savings accounts, mortgages, personal loans, credit
cards, and certificates of deposit are all services offered by retail banks. The majority
of bank customers visit the local branch office, where representatives and managers
provide customer service and financial advice.
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9. Factoring: This is a financial service in which all services are provided, beginning
with the sale of goods and services and ending with the collection of receivables. A

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 Principles and Practices of Banking 131

factor is a financial receivables intermediary agent. A factor is essentially a funding

Notes

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source that agrees to pay the company the invoice value less a commission and fee
discount.

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10. Bank assurance: Bank assurance is also referred to as bank guaranty. It means
that the lending institution guarantees that the debtor’s liabilities will be met. A bank
guarantees another party on behalf of a party that it will not fail to keep its promises.

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If that party fails to keep its promises, the bank compensates another party and
recovers its losses from the party that took the bank’s guaranty.
11. Mutual funds: The primary goal of mutual funds is to collect investments from a large

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number of investors and depositors and then diversify the capital. These investment
schemes, like equity investments, reduce the risk of loss. These services are
extremely beneficial to investors who are unfamiliar with the investment and equity
markets.

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12. Sale and purchase of gold: Commercial banks are also involved in the sale and
purchase of gold. Nowadays, all banks issue goad bonds on a regular basis. Aside
from that, the bank also buys and sells cold coins and bars. Customers buy and sell

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gold through banks to avoid any risks or fraud.
13. Insurance: Commercial banks offer a wide range of insurance products such as life
insurance, health insurance, vehicle insurance, loan insurance, and so on. Banks
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offer insurance through joint ventures with insurance companies such as PNB
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MetLife, SBI Life, and others.
14. Foreign exchange / Forex services: Foreign currency is also handled by commercial
banks. These banks offer a wide range of forex services, primarily currency
conversion. They also assist customers in the sale and purchase of foreign currency.
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15. Notary services: Banks in India operate in accordance with the RBI’s guidelines.
Know your customer (KYC) is now required for all commercial bank operations. Aside
from that, banks provide life certificates, which can be used in other government
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schemes, as well as identification documents.

16. Bank cards: Customers can obtain various types of cards from banks, such as debit
cards, credit cards, gift cards, and so on. The card holder can transact without the
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use of hard cash currency with the help of these cards. These cards are also referred
to as plastic money.
17. Venture capitalist: A venture is a concept in which an entrepreneur deals with a new
high-risk project. Venture capital is the availability of funds for high-risk projects.
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These are high-risk, high-reward ventures. After calculating the risk, the bank will
provide capital for such projects in exchange for higher returns.
18. Internet Banking: Such banking services allow customers to complete all of their
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banking transactions without ever having to visit a bank. Customers may be charged
a small maintenance fee by their bank for using their internet services.
19. Mobile banking: As the name implies, such services can be obtained through the use
of a smart phone and banking applications. With a few exceptions, such services
are similar to internet banking. Typically, such applications are free to download and
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install on a smart phone.

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 132 Principles and Practices of Banking

2.1.4 Mandate and Power of Attorney

Notes

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A resident Indian can be appointed as a mandate holder by a Non-Resident
Indian (NRI) who has an NRE/NRO account. The mandate holder has the authority to

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manage the account on behalf of the NRI. The Indian resident must be a close relative
(family member). A company or a minor cannot hold a mandate. There can only be one
mandate holder per account.

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The mandate and power of attorney are the authority granted to a third party to
act on behalf of the principal person or persons. In the operation of bank accounts, the
rights of mandate and power of attorney holders are very similar, but they are issued for

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different reasons and purposes.

A mandate is a simple letter of authority signed by a constituent that authorises

the bank to allow a specific named person (agent) to operate the account on his or her

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behalf. A mandate to operate an account does not include the authority to overdraw the
account unless specifically stated in the mandate letter. In the case of a joint account,
all depositors must sign the mandate letter. In the case of a partnership, all of the
partners must sign the mandate letter. By writing to the bank, one of the joint account

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holders or any partner of the firm, as the case may be, can revoke this authority.

In the case of H.U.F, the mandate must be signed by the Karta as well as all of the

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major co-parcelers. If the mandate is to be issued in favour of a third party, an indemnity
must be executed by the Karta and major H.U.F. co-parceners.
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When it comes to the NRI’s bank account, a mandate holder and a power of
attorney have similar rights and responsibilities.

Need for NRI to Appoint a Mandate Holder

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The NRI spends the majority of his time outside of the country. There are times
when financial matters necessitate a physical presence. Many times, family members
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require cash immediately and cannot wait for the NRI to transfer funds, etc. In such
cases, the mandate holder may act on the NRI’s behalf and carry out the transactions.

Rights of a Mandate Holder

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The mandate holder can perform day-to-day banking transactions such as

withdrawing money for local payments, drawing cheques for local disbursements,
managing FDs, and making NRI-friendly investments. The NRI can set a maximum
amount that a mandate holder can debit from the account. The mandate holder can
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also make deposits into the account.

Rights Mandate Holder does not have

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A mandate holder has no authority to:

●● Open or close an NRI account.

●● Modify account information such as name and address.
●● Transfer funds outside of India except to the holder of an NRI account.
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●● Make a gift of money to anyone..

Steps to register a Mandate Holder for an NRE/NRO account
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 Principles and Practices of Banking 133

Most banks permit the registration of a mandate holder. The steps that follow cover
Notes

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the process of registering a mandate holder in broad strokes. You must check with your
specific bank to determine the exact process and documentation.

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How to Register –
●● Obtain the appointment form from the branch or from the bank’s website.

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●● Sign the form with all account holders’ signatures.
●● The holder submits the form along with KYC details, photographs of the mandate
holder, and self-attested copies of the holder’s identity and address proof. The

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copies must also be signed by the account holders.
●● The appointment is approved by the bank, and the mandate is registered. The
mandate holder receives a chequebook and an ATM card..

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Revoking of a Mandate
If the NRI wishes to revoke the mandate on his NRE/NRO accounts, he must
submit a written request to the bank.

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Difference between a Mandate Holder and a Nominee

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The bank account is managed by a mandate holder on behalf of the NRI. He or
she has no control over the account. A nominee, on the other hand, is the person who
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will be entitled to the bank account balance when the account holder dies. The account
holder appoints the nominee.

Power of Attorney
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A power of attorney (POA) is a written instruction that allows one person to act on
behalf of another. That is, the agent may perform any lawful act or series of lawful acts
on behalf of the principal person. There are two types of Powers of Attorney: special
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and general. A special power of attorney is granted for a specific purpose, whereas a
general power of attorney is granted for a general purpose and is intended to be valid
for a specific period of time.
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A power of attorney must be stamped in accordance with the provisions of

the Indian Stamp Act as well as various state amendments. It must be notarised but
does not have to be registered with the Registrar of Assurances. A power of attorney
executed outside India for use in India must be signed before the Indian Embassy/High
Commission in the country in which it is executed and stamped in accordance with the
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Indian Stamp Act within three months of its receipt in India. The power of attorney must
not include any provisional or conditional clauses, such as “during my absence,” “during
my illness,” or similar language, as such clauses are not acceptable to banks. The
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Power of Attorney must include specific conditions.

In all cases where accounts are opened with Power of Attorney, the principal
should give a written undertaking that, in addition to the public notice, he will notify the
bank about power of attorney cancellation/revocation.
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 134 Principles and Practices of Banking

2.1.5 Paying and Collecting Banker

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Paying Banker

While there are many aspects to modern banking, and the range of activities of

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clearing banks today is very broad, the payment and processing of cheques remains
a central and fundamental feature. The paying banker is the banker who holds the
drawer’s cheques and is required to make payment if the customer’s funds are

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sufficient to cover the amount of his cheque drawn.

The paying banker is the banker who cancels the drawer’s signature upon payment
of the cheque, either by the usual method of authorising a drawer’s signature or by

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any method used by the bank, which also reflects the point of payment. Cheques are
sometimes paid by stamping them “Paid,” usually with the date included in the stamped
crossing, or by perforating the payment date onto the cheque.

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As a paying banker, the banker is obligated to accept the customer’s check if it is
valid and if it is issued in its original form by the holder within a reasonable period of
time and before the banker has provided orders to stop paying or received notice of the

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customer’s death, etc., and if sufficient funds are available to the customer’s account
and that balance is available to the banker.

Safety measures and obligatory roles of Paying Banker

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Any customer who deposits cash with a creditor has the right to seek repayment
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from bankers who are debtors. Section 31 of the Negotiable Instruments Act of 1881
establishes the banker’s obligation.

While honouring cheques, the banker must take the following precautions:
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Crossed Cheque: Crossed cheques are an area where a banker must exercise
the greatest caution. A banker must check to see if the cheque is open or crossed. He
should not pay cash across the counter, just as he should not pay crossed cheques. If
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the cheque is crossed, he should determine whether it is crossed general or crossed

special. If it is a general crossing, the holder must bring the cheque over to the banker
and pay it to a banker. If the cheque is carrying a special crossing, the banker will pay
for the bank whose name appears at the crossing. If the banker pays a cheque that
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does not comply with the transit requirements, the real owner can hold the banker
liable.

Open Cheque: When an open cheque is presented, a banker will pay cash across
the counter to the payee or manager. If the banker pays against the above-mentioned
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instructions, he is liable for any loss incurred in paying the amount to the true owner. In
fact, a banker loses legal protection if an endorsement is forged.

Proper Form: A banker should check to see if the cheque is properly formatted.
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This means that the test should be conducted in accordance with the provisions of the
Negotiable Instruments Act. It should be free of any conditions.

Presentment of Cheque: Cheques should be presented in the proper format and

location. A banker will accept checks if they are addressed to the bank branch where
(c

the drawer has an account, or to another branch if the search is multi-city.

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 Principles and Practices of Banking 135

Date of the Cheque: The cheque date is expected to be seen by the paying banker.
Notes

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It must be correctly dated. It should not be a stale or post-dated cheque. When a
cheque is accompanied by a future date, it is referred to as a post-dated cheque. There
is no need for the banker to honour the cheque if it is submitted on the date specified

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in the report. If the banker disregards a cheque before the date specified in the cheque,
he loses statutory security. Normally, undated checks are not accepted.

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Words and Figures: The total amount of the cheque should be represented in
terms or words and figures that are consistent with one another. If the sum in words and
figures varies, the banker should refuse payment.

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Alterations and Overwriting: If there are any changes or overwritings on the
cheque, the banker should see them. If there is a change, the drawer will validate
it by inserting his full signature. The banker should not pay a cheque containing
material modification unless the drawer proof is provided. The banker should exercise

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reasonable caution in detecting these changes. He has no choice but to take the risk.
Cheques become invalid due to material changes.

Proper Endorsements: Cheques must be properly endorsed. A bearer cheque does

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not need to be legally endorsed. In the case of an order cheque, it is given. A cheque
to bearer will always be a cheque to bearer. Before making payment, the paying banker
should double-check all cheque endorsements.
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Dishonour of Cheque
When a cheque is presented to a bank, it is said to be dishonoured if it is refused
to be accepted or paid. It is a circumstance in which the paying banker does not pay the
full amount of the cheque to the payee.
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Reasons for dishonour of cheque - Payment on cheques issued by customers may

be refused by a paying banker for the following reasons:
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Insufficiency of funds: If there are insufficient funds in a customer’s account, the

cheque may be returned. If the banker pays a counterclaimed cheque, he is not only
required to cancel the application, but he is also liable for damages for dishonouring
cheques that would otherwise have been honoured.
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Notice of the Customer’s Death - Payments on cheques presented after the

customer’s death should not be made by the banker. He should return the check with
the inscription ‘Drawer Deceased.’

Notice of the Customer’s Insolvency - A banker must refuse payment on the

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cheques as soon as the consumer is declared insolvent.

Receipt of the Garnishee Order - When a Garnishee order is received that includes
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the entire amount, the banker will stop payment on cheques received. However, if the
order is for a specific amount, cheques should be honoured if the remaining amount is
sufficient to satisfy them.

Presentation of a post-dated cheque - When a cheque is presented before the valid

date, the banker has the right to refuse it.
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Stale Cheques: When a cheque is presented three months after the date it bears,
the banker may refuse to make payment.

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 136 Principles and Practices of Banking

Material Alterations: When there is a significant change in the cheque, the banker
Notes

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may refuse payment.

Drawer’s Signature: If the drawer’s signature on the cheque does not match the

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signature on the specimen, the banker has the authority to refuse payment.

Types of dishonour –

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There are two categories for which a cheque is dishonoured:

Rightful Dishonour: Cheque dishonour by the drawee banker for any of the reasons
listed above or for any other legitimate reason In this case, there is no recourse against

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the banker, but the holder will eventually have both civil and criminal remedies against
the drawer.

Wrongful Dishonour: Cheque dishonour by the banker as a result of negligence or

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carelessness on the part of its employees. The drawer has the right to sue the bank for
the losses he has incurred. In this case, the payee has no recourse against the banker.

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Paying Bankers duties & responsibilities
When the cheque is presented for payment, the banker on whom it is drawn should
pay it. Section 31 of the NI Act requires him to do so. A banker is obligated to honour
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a customer’s cheque to the extent of the available funds and the absence of any legal
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bar to payment. When paying a cheque, the paying banker should exercise reasonable
care and diligence to avoid taking any action that could harm his customer’s credit.

When making payment, he should pay close attention to the following:

◌◌ Verification of the drawer’s signature.

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◌◌ Confirmation of the instrument’s authenticity.

◌◌ Payment has not been halted by the account holder.
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◌◌ The cheque’s holder’s title is correct.

◌◌ The air conditioner is not turned off.
◌◌ The account holder is not bankrupt, deceased, or insane.
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◌◌ The a/c is not in the process of being liquidated.

◌◌ A ‘Guernsey Order’ is given out by count.
◌◌ Appropriately endorsed
◌◌ The cheque is not drawn beyond the amount limit set by the drawer.
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◌◌ The presented instrument is crossed.

◌◌ The instrument is not state-issued or post-dated.
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◌◌ No material changes are made.

◌◌ Appropriate a/c balance

Liabilities of Paying Banker

Proper Form: The banker should check to see if the cheque is in proper form. That
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is, the cheque must be written in accordance with the provisions of the commercial
code. There should be no conditions in it.

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 Principles and Practices of Banking 137

Open or Crossed Cheque: The most important precaution a banker should take is
Notes

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to avoid crossing crossed cheques. A banker must check to see if the cheque is open
or crossed. He should not pay crossed cheques in cash over the counter. If the cheque
is crossed, he should check to see if it is a general crossing or a special crossing. If it

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is a general crossing, the holder must present the cheque through a banker. It should
go to a banker. If the cheque contains a special crossing, the banker should only pay
the bank whose name appears in the crossing. If the cheque is open, a banker can

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pay cash to the payee or holder across the counter. If the banker pays against the
above-mentioned instructions, he is obligated to reimburse the true owner for any
losses incurred. In addition, a banker loses statutory protection in the event of a forged

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endorsement. If the crossing is marked ‘Not Negotiable,’ the paying banker must verify
the authenticity of all endorsements. If it is a ‘Account Payee’ crossing, the banker can
only credit the payee’s account and not any other person’s.

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Place of Presentment of Cheque: A banker can honour cheques if they are
presented to the branch where the drawer has an account. If the cheque is presented
at another branch of the same bank, it should not be honoured unless the customer
makes special arrangements in advance.

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The Explanations are as Follows:
A banker agrees to pay checks only at the branch where the account is maintained.
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The customer’s specimen signature will be kept at the bank’s office where he has an
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account. Other branches cannot be aware that the customer has sufficient funds to
cover the cheque.

Date of the Cheque: The date of the cheque must be visible to the paying banker.
It must be correctly dated. It should not be a post-dated check or a stale check. If a
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cheque has a future date, it is referred to as a post-dated cheque. If the cheque is

presented on the date specified on the cheque, the banker has no objection to
honouring it. If a banker honours a cheque before the date specified on the cheque,
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he forfeits his statutory protection. If the drawer dies, becomes insolvent, or refuses
payment before the cheque’s expiration date, he forfeits the amount.

Cheques that are not dated are usually not honoured. A stale cheque is one that
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has been in circulation for an unusually long period of time. Bankers’ practises in this
regard vary. When a cheque has been in circulation for more than six months, it is
considered stale. Such checks are not honoured by the banker. However, the banker
may obtain confirmation from the drawer and honour cheques that have been in
circulation for an extended period of time. As a result, date verification is critical.
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Mutilated Cheque: When mutilated cheques are presented for payment, the
banker should exercise caution. When a cheque is mutilated, it has been cut or torn,
)A

or a portion of it is missing. Mutilation can be unintentional or intentional. If the error is

unintentional, the banker should obtain the drawer’s approval before honouring it.

Words and Figures: The amount of the cheque should be expressed in words or in
words and figures that agree with one another. When the amount is different in words
and figures, the banker should refuse payment. However, there is a distinction between
(c

the amount in words and the amount payable; the amount in words is the amount
payable. If the banker returns the cheque, he should make a notation that the “amount
in words and figures differs.”
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 138 Principles and Practices of Banking

Alterations and Overwritings: The banker should inspect the cheque for any
Notes

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alterations or over-writing. If there is an alteration, the drawer must confirm it by
signing his full name. The banker should not pay a cheque that has been materially
altered without the drawer’s confirmation. The banker is expected to take reasonable

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precautions to detect such changes. Otherwise, he will have to take a risk. Material
changes render a cheque null and void.

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Proper Endorsements: Cheques must be properly signed and endorsed. In the
case of a bearer cheque, legal endorsement is not required. Endorsement is required
in the case of an order cheque. A bearer cheque is always a bearer cheque. Before
making payment, the paying banker should carefully examine all of the endorsements

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on the cheque. They must be consistent. However, unless the cheque bears the ‘Not-
Negotiable’ crossing, it is not the paying banker’s responsibility to verify the authenticity
of the endorsements. He is not expected to be familiar with the signatures of all payees.

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As a result, he is legally protected in the event of forged endorsements. Even with
bearer cheques, bankers in India insist on endorsement, even though it is not required.

Sufficiency of Funds: The banker must determine whether the credit balance in the

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customer’s account is sufficient to cover the cheque. If an overdraft agreement exists,
he must ensure that the limit is not exceeded. Part-payment of the cheque should not
be made by the banker. He should either pay the full amount or refuse to pay. In the

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event that funds are insufficient, the banker should return the cheque with the remark
‘No Funds’ or ‘Not Sufficient Funds.’
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Verification of Drawer’s Signature: At the time of account opening, the banker
obtains specimen signatures from his customers. He should compare the drawer’s
signature on the cheque to the customer’s specimen signature. He should carefully
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examine the signature to determine whether or not the drawer’s signature is forged. If
there is any disagreement or doubt, he should refuse to honour the cheque. He should
receive the drawer’s approval. There is no protection for the banker if there is forgery
and the banker is negligent in detecting it.
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Liabilities of Collecting Banker

Due Care and Diligence in the Collection of Cheques: The collecting banker is
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obligated to collect cheques presented to him with due care and diligence. If a cheque
is entrusted to the banker for collection, he must show it to the drawee banker within a
reasonable time frame. If a cheque is not presented for payment within a reasonable
time of its issuance, and the drawer or person on whose account it is drawn had the
right, as between himself and the banker, to have the cheque paid at the time when
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presentment ought to have been made and suffers actual damage as a result of the
delay, he is discharged to the extent of such damage, that is to say, to the extent to
which such drawer or person is a creditor of the banker to a greater extent.
)A

The customer may suffer loss if a collecting banker fails to present the cheque for
collection through the proper channel within a reasonable time. If the collecting banker
and the paying banker work for the same bank or if the collecting branch is also the
drawee branch, the collecting banker must present the cheque by the next business
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day. If the cheque is drawn on a bank in another location, it must be presented on the
day it is received..

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 Principles and Practices of Banking 139

Serving Notice of Dishonor: When a cheque is dishonoured, the collecting banker

Notes

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is required to notify the customer within a reasonable time. It should be noted that when
a cheque is returned for confirmation of endorsement, notification must be sent to the
customer. If he fails to provide such notice, the collecting banker will be liable to the

in
customer for any loss incurred as a result of such failure. It is not considered dishonour
when a cheque is returned by the drawee banker for confirmation of endorsement.
However, in this case, the customer must be notified. If the cheque is returned for

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the second time and the customer suffers a loss in the absence of such a notice, the
collecting banker will be liable for the loss.

Agent for Collection: If a cheque is drawn in a location where the banker is not a

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member of the clearing-house, he may hire another banker who is a member of the
clearing-house to collect the cheque. In this case, the banker acts as a substituted
agent. An agent who has express or implied authority to name another person to act in

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the agency’s business has done so, and that person is known as a substituted agent.
Such an agent shall be considered the agent of a principal for the portion of the work
entrusted to him.

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Remittance of Proceeds to the Customer: If a collecting banker realises the
cheque, he must pay the proceeds to the customer in accordance with his (the
customer’s) instructions. Generally, the amount is credited to the customer’s account

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upon his written request; the proceeds may be remitted to him via demand draught.
In such cases, if the customer gives his banker instructions, the draught may be
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forwarded. As a result, the principal-agent relationship is terminated, and a new debtor-
creditor relationship is established.

Collection of Bills of Exchange: A banker is not required by law to collect bills

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of exchange for its customers. However, most banks provide such a service to their
customers. As statutory protection, a banker should examine the depositor’s title when
collecting bills. As a result, the collecting banker must carefully examine his customer’s
title to the bill. If a new customer comes in, the banker should extend this facility to him
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along with a reliable reference.

Based on the preceding discussion, there is no doubt that the banker is acting
solely as a collection agent and not in the capacity of a banker. If the customer allows
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his banker to use the collected funds for its own purposes now and repay an equivalent
amount on a future date, the contract between the banker and the customer will be
terminated.

Collecting Banker
m

A Collecting banker is someone who works on behalf of a customer to collect

cheques, draughts, bills, pay orders, traveller cheques, letters of credit, dividends,
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debenture interest, and so on. A banker is not legally required to accept cheques from
clients, but with a broader banking procedure and a broader use of crossed checks,
which are invariably only obtained by a banker, check collection has become a main
feature of a banker.

When a banker receives a client’s check, he must act appropriately:

(c

◌◌ As a holder for value

◌◌ As his agent
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 140 Principles and Practices of Banking

Banker as a holder for value - In the following ways, a banking entity becomes the
Notes

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holder of value:

(a) by lending the same amount as the cheque

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(b) by paying the amount of the cheque or any portion of it in cash or into the
account before it is sent for clearing.
(c) by committing to that client, either at the time or earlier, that he may draw the

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cheque before it is cleared
(d) by approving a current overdraft in avowed reduction of the check

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(e) by providing cash for the cheque while it is in for collection.
Collecting Banker as an Agent - When a collecting banker credits a check to the
customer’s account after a drawee’s banker pays the money, he acts as the customer’s

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agent. He will then be permitted to collect the amount of the check.

Conversion by the Collecting Banker - A banker is frequently charged with

incorrectly converting checks to which his customer has no or a defective title. It refers

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to an improper or morally wrong interference (i.e., use, sale, invading, or taking) with
another person’s property that is inconsistent with the owner’s right of possession.
Negotiable instruments fall under the category of ‘property,’ so a banker may be held

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liable for conversion if he receives cheques for a client who lacks a title or has a faulty
instrument title.
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Statutory Protection to Collecting Bank - The collection banker is protected under
Section 131 of the Negotiable Instruments Act as follows:

Section 131: Non-liability of a banker receiving payment of a cheque: A banker who

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has accepted money for the customer of a cheque crossed in particular or expressly
for himself in reasonable care and without fault shall not incur any liability for the true
owner of the cheque in the event that the title to the cheque appears to be faulty, solely
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on the ground that he has received such payment..

Duties of the Collecting Bank

Section 131 of the Negotiable Instruments Act, which provides immunity to the
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collecting bank, specifies that the bank must not have been negligent, among other
conditions. To demonstrate that it has not been careless, the bank must demonstrate
that it has taken all of the steps that would be expected of a responsible banker in order
to obtain a cheque. Over time, these safeguards have evolved based on practises and
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judicial declarations as duties imposed on bankers, for which the bank can be held
liable for failure to comply due to negligence.
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The Responsibilities are as follows:

Obligation to open an account with references and sufficient documentary
evidence: Today’s banker understands all too well that the requirement to open an
account only after properly identifying the new account holder is highly unlikely without
an introduction. The need for a good customer introduction is to keep crooks and
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fraudsters out of accounts where they can collect forged cheques or other tools. As
an added precaution, the RBI has insisted on obtaining photographs of the customer
as well as sufficient documentary evidence for constitution and address when opening
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 Principles and Practices of Banking 141

accounts. To identify the referee when the referee is not identified or to identify the
Notes

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referee in absentia: Because practise bankers in India often require the introduction
of an existing bank customer, especially when the branch is new, this is not always
possible. Clients are expected to obtain references from locals or current bankers in

in
these cases. In such a case, the banker must request confirmation from the referee that
the person with a newly opened account is genuine.

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Obligations Concerning Crossings and Special Crossings: It is the banking officer’s
responsibility to ensure that the check is clearly crossed and to deny collection if the
check is given to another banker. Similarly, when the check is deposited into a specific
account, the credit of the check makes him liable for negligence without the need for

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any additional inquiries.

Obligation to inspect the instruments for obvious flaws: The instrument presented
for collection may occasionally send a notice to the banker that the customer who

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submitted the instrument is either committing a breach of trust or mismanaging money
belonging to someone else. If a banker fails to heed the warning issued by a prudent
banker, he may be held liable for negligence.

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Obligation to know the status of the customer’s account: The collecting banker is
required to know the status of the customer as well as the various transactions that
have occurred in the customer’s account. It will be the banker’s responsibility to take
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the necessary precautions if any amounts arrive in the account that are unlikely to be
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received by him, as well as when collecting such cheques.

Duties & Responsibilities of Collecting Bankers:

Acting as an agent: When a banker collects an instrument, whether for credit to
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a customer’s account or for himself, he acts as the customer’s agent. As an agent, he

must generally take the same steps and precautions to protect his client’s interests that
a prudent man would take to protect his own.
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Examining the instruments: The name of the holder, the branch name, the date, the
amount in world and figure, any cutting without signature, and any material alteration
must be carefully examined. Checking the endorsement: Bankers must examine the
instrument to ensure that it has been properly endorsed.
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Providing the instrument on time: It is the collecting bank’s responsibility to present

the instrument to the paying bank on time.

Putting the money in the payee’s account: It is the collecting banks’ responsibility
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to collect and credit the proceeds of the instruments to the appropriate/correct account.

Dishonor notice and return of instruments: If any instrument is dishonoured by the

paying bank, the customer should be notified on the business day following the receipt
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of the unpaid instruments.

Obtaining Banker’s Insurance

According to Section 131 of the Negotiable Instruments Act, a collecting banker
(c

is not liable to the true owner of a cheque or a banker’s draught if his title to the
instrument proves defective, provided the cheque or draught was crossed generally or
specially to himself and collected in good faith and without negligence. The collecting

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 142 Principles and Practices of Banking

banker is entitled to the above-mentioned statutory protection only if the following

Notes

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conditions are met:

●● The cheque he collected is a crossed cheque

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●● He collected such crossed cheque only as an agent for his customer and not as a
holder for value
●● He collected such crossed cheque in good faith and without negligence.

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●● Opening of A/C without satisfactory references/introduction.
●● Crediting the proceeds of a cheque to an irregularly endorsed endorsee.

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●● Crediting a cheque’s proceeds to the personal accounts of directors, partners, or
employees when the cheque is payable to the company.
●● Crediting the proceeds of a charge to the official’s personal name when they are

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payable to a government agency, autonomous body, or corporation.
●● Crediting the amount of a cheque drawn by an agent on behalf of its principal in
the personal A/C.

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●● When the customer depositing the cheque has limited means and the cheque
deposited unexpectedly is for a large sum, and the banker credits the proceeds
without making a proper inquiry.
●●
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Cheques drawn by customers are frequently dishonoured, and such accounts are
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credited with the proceeds of collecting cheques without proper investigation.
●● If the crossed cheque is collected and credited to the other account, the proceeds
are credited to the other account.
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A collecting banker’s rights are as follows: the banker must present the cheque
to the paying banker for encashment within a reasonable time. What constitutes
reasonable time is determined by the facts of each case. According to standard
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practise, the collecting banker should present cheques received from customers for
collection at least the following or next day after receiving them. Any unreasonable
delay in collection would make the banker liable to the customer for any losses incurred
as a result of the delay.
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If the cheque presented in clearing is realised, the proceeds of the realised cheque
should be credited to the customer’s account as soon as possible.

If a cheque sent for collection is dishonoured by the drawee bank, the collecting
bank must return the cheque to the customer within a reasonable time frame so that
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the customer can recover the amount of the cheque from the parties liable for it. If the
collecting banker fails to send the notice of cheque dishonour to the customer within a
reasonable time and the customer suffers a loss as a result of the failure to send the
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notice, the collecting banker is obligated to compensate the customer.

2.1.6 Remittance
The term “remittance” is derived from the word “remit,” which means “to send
(c

back.” Money that is sent or transferred to another party, usually overseas, is referred to
as remittance. Wire transfers, electronic payment systems, mail, draughts, and cheques
are all options for remittances. Remittances can be used for any type of payment,
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 Principles and Practices of Banking 143

including business invoices or other obligations such as personal transfers to family and
Notes

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friends.

Workers’ or migrant remittances occur when migrants send home a portion of their

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earnings in the form of cash or goods to support their families. They have grown rapidly
in recent years and are now the primary source of foreign income for many developing
economies.

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The exact size of remittance flows is difficult to estimate because many take
place through unofficial channels. International migrant remittances are expected to
reach $596 billion in 2017, with $450 billion going to developing economies. These are

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recorded in the balance of payments; an international technical group is reviewing how
they should be recorded.

Unrecorded flows through informal channels are thought to be at least 50% greater

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than recorded flows. Remittances are not only large, but they are also distributed
more evenly among developing economies than capital flows, including foreign direct
investment. Remittances are especially important for low-income countries, accounting
for nearly 4% of GDP, compared to about 1.5 percent of GDP in middle-income

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countries.

A typical remittance transaction occurs in three stages:

◌◌ r
The migrant sender pays the remittance to the sending agent in cash, check,
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money order, credit card, debit card, or debit instruction sent via e-mail,
phone, or Internet.
◌◌ The sending agency directs its agent in the recipient’s country to deliver the
funds.
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◌◌ The payment is made to the beneficiary by the paying agent.

In most cases, there is no real-time funds transfer for agent settlement; the balance
owed by the sending agent to the paying agent is settled on a regular basis through a
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commercial bank. Informal remittances are sometimes settled through the exchange of
goods.

A fee charged by the sending agent, typically paid by the sender, and a currency-
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conversion fee for delivery of local currency to the beneficiary in another country are
among the costs of a remittance transaction. To account for unexpected exchange-rate
movements, some smaller operators charge the beneficiary a fee to collect remittances.
Furthermore, remittance agents (particularly banks) may earn an indirect fee in the form
of interest (or “float”) by investing funds prior to delivering them to the beneficiary. In
m

countries with high overnight interest rates, the float can be significant.

Remittances are usually transfers from one person to another or from one
)A

household to another. They are tailored to the recipients’ specific needs, and thus help
to alleviate poverty. In general, cross-country analyses show that remittances have
reduced the population’s proportion of poor people (Adams and Page 2003, 2005;
Gupta, Pattillo, and Wagh 2009).

According to World Bank research based on household surveys, international

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remittances helped reduce poverty by nearly 11 percentage points in Uganda, 6

percentage points in Bangladesh, and 5 percentage points in Ghana. Remittances have

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 144 Principles and Practices of Banking

been attributed to between a fifth and half of Nepal’s 11 percent reduction in poverty
Notes

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between 1995 and 2004, a period of political conflict. In poorer households, remittances
can be used to buy basic consumption goods, housing, and children’s education
and health care. They may provide capital for small businesses and entrepreneurial

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activities in wealthier households. They contribute to the payment of imports and the
service of external debt; in some countries, banks have raised overseas financing by
using future remittances as collateral.

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More Stable than Capital Flows
Remittance flows are more stable than capital flows, and they are countercyclical,

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increasing during economic downturns or after natural disasters when private capital
flows are decreasing. They are frequently an economic lifeline to the poor in countries
affected by political conflict. According to the World Bank, they accounted for
approximately 31 percent of GDP in Haiti in 2017, and more than 70 percent of GDP in

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some areas of Somalia in 2006.

During the financial crisis, remittances from source countries such as the United

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States and Western European countries proved to be resilient. Migrants’ incomes were
impacted by the crisis, but they attempted to compensate by reducing consumption
and rental expenditures. Those affected by the crisis found work in other fields. While
the crisis reduced new immigration flows, it also discouraged return migration because
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migrants were afraid of being denied re-entry into the host country.
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Thus, even during the global financial crisis, the number of migrants—and thus
remittances—continued to rise, and even more so in recent years in the face of conflicts
and natural disasters such as hurricanes and earthquakes.
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There may be fees associated with remittances. Countries that receive migrant
remittances incur costs if the emigrating workers are highly skilled or if their departure
causes labour shortages. Furthermore, if remittances are large, the recipient country’s
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real exchange rate may rise, making its economy less competitive on a global scale.

Some argue that remittances reduce recipients’ incentives to work, slowing

economic growth. Others argue that the negative relationship observed in some
empirical studies between remittances and growth may simply reflect the influence of
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growth on remittances rather than vice versa. Remittances also have human costs.
Migrants may make significant sacrifices, such as separation from family, and take risks
in order to find work in another country. And they may have to work extremely hard in
order to save enough money to send remittances.
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High Transaction Costs

Transaction costs rarely affect large remittances (for trade, investment, or aid):
)A

they are typically small as a percentage of the principal amount, and major international
banks are eager to compete for large-value remittances. However, for smaller
remittances—say, less than $200, which is common for poor migrants—fees typically
average 7 percent and can be as high as 15–20 percent in smaller migration corridors.
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Reduced transaction costs would benefit recipient families. Here’s how it works:

First, the fee should be a low fixed amount rather than a percentage because the
cost of remittance services is independent of the amount of principal. The true cost of a
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 Principles and Practices of Banking 145

remittance transaction, including labour, technology, networks, and rent, is estimated to

Notes

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be significantly lower than the current fee level.

Second, competition would drive down prices. New market participants can be

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encouraged by harmonising and lowering bond and capital requirements, as well
as avoiding excessive regulation (such as requiring full banking licences for money
transfer operators). Since the 9/11 terrorist attacks on the World Trade Center, money

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service businesses have faced intense scrutiny for money laundering or terrorism
financing, making it difficult for them to maintain accounts with their correspondent
banks, forcing many in the United States to close. Regulations are necessary, but
they should not make it difficult for legitimate money service businesses to maintain

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correspondent banking accounts. A risk-based regulatory approach—checking only
suspicious transactions and exempting small transactions under $1,000 from identity
requirements, for example—can reduce costs and facilitate flows.

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Fees have been reduced due to competition in the US–Mexico corridor, where
remittance fees fell more than 50% from more than $26 (to send $300) in 1999
to around $12 in 2005, and have since levelled off at around 5% for $200 in the first

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half of 2017. In order to attract customers for their deposit and loan products, some
commercial banks offer free remittance services. In addition, new remittance tools
based on cell phones, smart cards, or the Internet have emerged in some countries.

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Third, nonexclusive collaborations between providers and existing postal and retail
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networks would aid in the expansion of remittance services without requiring large
investments to develop payment networks.

Fourth, poor migrants may be given greater access to banks that charge lower
interest rates. Allowing origin-country banks to operate overseas; providing identification
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cards (such as the Mexican matricula consular) accepted by banks to open accounts;
and facilitating participation of microfinance institutions and credit unions in the
remittance market are all ways that both sending and receiving countries can improve
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banking access for migrants.

Boosting Flows
Governments will occasionally offer incentives to increase remittance flows and
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direct them to productive uses. However, such policies may be more problematic than
efforts to increase access to financial services or lower transaction costs. Tax breaks
may encourage remittances, but they may also encourage tax evasion. Matching-fund
programmes to attract remittances from migrant associations may divert funds away
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from other local funding priorities, while efforts to channel remittances to investment
have been unsuccessful. Remittances are essentially private funds that should be
treated similarly to other sources of household income. Efforts to increase savings and
)A

improve expenditure allocation should be achieved through improvements in the overall

investment climate, rather than by focusing on remittances.

Remittance Types
Since we’ve learned what remittance is and its role in a country’s economic and
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infrastructure development, let’s look at the various types of remittance based on the
transaction process. Remittances are classified into two types based on the same
criteria:
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 146 Principles and Practices of Banking

◌◌ Remittances inward
Notes

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◌◌ Remittances Outward
Inward Transfers: The transfer of funds from one account to another, either

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domestically or internationally, is referred to as inward remittance. To understand inward
remittance, consider the fact that most families have children living abroad, either
for work or study, and when they send money back home, it is referred to as inward

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remittance for the family at home. Similarly, when parents send money to their children,
it is considered inward remittance.

Outward Remittance: Outward remittance is the transfer of funds outside of

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the country or overseas. For example, if parents transfer funds from their account to
their children’s foreign account in order to support them, this is considered outward
remittance. Outward remittances apply to countries that send money, whereas inward
remittances apply to countries that receive money.

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2.2 Relationship

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2.2.1 Banker - Customer
The relationship between the banker and the customer is a legal one that begins

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with the formation of a contract. When a person opens a bank account and the banker
accepts the account, it binds the banker and the customer in a contractual relationship.
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A bank customer is someone who has a bank account and uses the bank’s services.
More types of banker and customer relationships are created as a result of the
contractual relationship between the bank and the customer.
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The terms “bank” and “customer” are both related to the bank. A banker is
someone who works in the banking industry, and a bank customer is someone who
works with the bank, either by depositing money or taking out a loan. The relationship
between a banker and a customer can take many forms because it is entirely
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dependent on the activities, products, and services offered by the banker to the
customer. Despite the fact that the relationship is entirely based on contact, trust is an
essential component of the relationship between bankers and customers.
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The Banking Regulations Act 1949 defines a bank as a financial institution in

Section 5 (b). According to the section, “the bank accepts, lends, or invests money
from the public, repayable on demand or otherwise, and withdraws money through
online, cheques, draughts, or any other means.” It is a licenced institution that accepts
m

customer deposits and makes loans.

The bank’s primary function is to accept deposits and make loans. The bank
encourages people to save their money in bank accounts so that they can earn interest
)A

on it. This money is used by the bank to make interest-bearing loans to deserving
individuals. In other words, the bank acts as a go-between for two people, one of
whom wants to save money and the other of whom requires money. This process also
assists the bank in making a profit and establishing a relationship between the banker
and the customer. This process creates different rights and duties for bankers against
(c

customers, as well as rights and duties for customers against banks, which strengthens
the banker-customer relationship.

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 Principles and Practices of Banking 147

Relationship Classification
Notes

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The relationship between the banker and the customer is critical. A bank’s
relationship with its customers can be divided into two types: general relationships and

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special relationships.

A. General Relationship - According to Section 5(b) of the Banking Regulation Act, the
bank’s business is accepting deposits for lending. As a result, the relationship formed

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by these two main activities is known as General Relationship.
1. Debtor and Creditor: When a ‘customer’ opens a bank account, he completes
and signs the account opening form. He agrees/contracts with the bank by

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signing the form. When a customer deposits funds into his account, the bank
becomes a debtor to the customer and the customer becomes a creditor
to the bank. The money deposited by the customer becomes the bank’s
property, and the bank is free to use it as it sees fit. The bank is not required

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to inform the depositor of the disposition of funds deposited by him. The bank
provides no security to the depositor, who is also the debtor. The bank has
borrowed money, and the banker will only pay when the depositor demands it.

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The bank’s position differs significantly from that of ordinary debtors. When a
bank issues a Demand Draft, Mail / Telegraphic Transfer, it becomes a debtor
because it owns money to the payee/beneficiary.
2.
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Creditor and Debtor: The most important activity of a bank is lending money.
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Banks use the funds they raise to fund lending operations. A customer who
borrows money from a bank contributes money to the bank. The banker is the
creditor in any loan/advances account, and the customer is the debtor. When
a person deposits money with the bank, the relationship reverses when he
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borrows money from the bank. Before using the credit facility, the borrower
signs documents and provides security to the bank.
B. Special Relationship - In addition to these two activities, banks engage in the others
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listed in Section 6 of the Banking Regulation Act. Banks provide a variety of services
in addition to opening a deposit/loan account, which broadens and complicates the
relationship. Depending on the nature of the transaction and the type of services
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provided, the banker may act as a bailee, trustee, principal, agent, lessor, custodian,
and so on.
1. Trustee and Beneficiary (Bank as Trustee and Customer as Beneficiary):
According to Section 3 of the Indian Trust Act 1882, a “trust” is an obligation
attached to the ownership of property and arising from a confidence reposed
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in and accepted by the owner, or declared and accepted by him, for the
benefit of another, or of another and the owner. As a result, the trustee holds
property on behalf of a beneficiary.
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A banker-customer relationship is a special contract in the case of a trust.

When a person entrusts valuable items to another person with the intent
that such items will be returned to the keeper on demand, the relationship is
transformed into that of a trustee and trustier. Customers who keep valuables
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or securities with the bank for safekeeping or deposit money for a specific
purpose (Escrow accounts) have the banker act as a trustee. Banks charge
fees for storing valuables in their vaults.

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 148 Principles and Practices of Banking

2. Bailee and Bailor (Bank-Bailee and Customer-Bailor): Section 148 of the

Notes

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Indian Contract Act of 1872 defines the terms “Bailment,” “Bailor,” and
“Bailee.” A “bailment” is the delivery of goods by one person to another for
some purpose, with the agreement that when the purpose is completed,

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the goods will be returned or otherwise disposed of in accordance with the
directions of the person delivering them. The person who delivers the goods is
referred to as the “bailor.” The person to whom they are delivered is referred

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to as the “bailee.”
Banks secure their advances by acquiring tangible assets. Physical
possession of securities goods (Pledge), valuables, bonds, and so on is

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taken in some cases. When a bank takes physical possession of securities,
it becomes a bailee, and the customer becomes a bailor. Banks also act as
Bailees and keep their customers’ articles, valuables, securities, and so on in

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Safe Custody. As a bailee, the bank is responsible for the goods bailed.
3. Lessee and Lessor (Bank-Lessee and Customer-Lessee): The terms
lease, Lessor, lessee, premium, and rent are defined in Section 105 of
the ‘Transfer of Property Act 1882.’ According to the section, “a lease of

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immovable property is a transfer of a right to enjoy such property for a specific
time, express or implied, or in perpetuity, in consideration of a price paid or
promised, or of money, a share of crops, service, or any other thing of value,
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to be rendered to the transferor on specified occasions by the transferee, who
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accepts the transfer on such terms.”
Lessor, lessee, premium, and rent are all defined as follows:

(1) The transferor is referred to as the lessor

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(2) the transferee is referred to as the lessee

(3) the price is referred to as the premium
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(4) the money, share, service, or other thing to be rendered is referred to as the
rent.
Safe deposit boxes are an ancillary service provided by banks to their customers.
The bank agrees with the customer while providing a Safe Deposit Vault/locker facility
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to their customers. The agreement is referred to as a “Memorandum of letting,” and it is

subject to stamp duty.

The bank’s relationship with the customer is analogous to that of a lessor and
lessee. Banks lease (hire lockers to their customers) their immovable property and give
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the customer the right to enjoy such property during the specified period, i.e. during
office/banking hours, and charge rentals. If the locker holder fails to pay the rent, the
bank has the right to break open the locker. Banks accept no liability or responsibility for
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any damage to the contents of the locker. Banks do not insure the contents of customer
lockers.

4. Agent and Principal (Bank-Agent and Customer-Principal): Section 182 of

the Indian Contract Act of 1872 defines “an agent” as a person employed
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to perform any act for another or to represent another in dealings with

third parties. The person for whom such an act is performed or who is so
represented is referred to as “the Principal.”

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 Principles and Practices of Banking 149

Thus, an agent is a person who acts for and on behalf of the principal and
Notes

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under the latter’s express or implied authority, and the acts performed under
such authority are binding on his principal, and the principal is liable to the
party for the agent’s actions.

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Banks collect cheques, bills, and make payments to various authorities on
behalf of their customers, such as rent, phone bills, insurance premiums, and

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so on. Banks also follow the standing instructions provided by their customers.
In all of these cases, the bank acts as the customer’s agent and charges for
these services. The Act agent is entitled to charges under the Indian contract.
There are no fees for collecting local cheques through the clearing house.

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Charges are only applied when a cheque is returned to the clearinghouse.
5. Indemnity Holder and Indemnifier (Bank-Indemnify and Customer-Indemnify):
The definition of indemnity is “security or protection against a loss or other

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financial burden.” Indemnity is defined as follows in Section 124 of the Indian
Contract Act of 1872. A “contract of indemnity” is a contract in which one party
promises to save the other from loss caused by the promisor’s contract or the
conduct of any other person. Section 124 of the Indian Contract Act of 1872

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defines the right of indemnity-holder.
An indemnity is a person’s obligation to provide compensation for a specific
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loss suffered by another person. In banking, the relationship occurs in
transactions such as issuing duplicate demand draughts, TDRs, deceased
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account payments, and so on. In that case, the indemnifier will compensate
any loss caused by the incorrect or excessive payment. In these cases, the
bank serves as an Indemnity Holder (Promisee), while the customer serves as
the Indemnifier (Promisor).
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6. Hypothecator and Hypothecatee (Bank-Hypothecatee and Customer-

Hypothecatee): A customer and a banker can have a Hypothecator and
Hypothecatee relationship. This occurs when a customer hypothecates certain
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movable or immovable property or assets with the banker in order to obtain a

loan. In this case, the customer assumed the role of Hypothecator, while the
Banker assumed the role of Hypothecatee.
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7. Pledger and Pledgee (Bank-Pledgee or Pawnee and Customer-Pledger Or

Pawnor): The relationship between a customer and a banker can be described
as a Pledger and Pledgee relationship. This occurs when a customer pledges
(promises) certain assets or security to the bank in order to obtain a loan. The
customer becomes the Pledger or Pawnor in this case, and the bank becomes
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the Pledgee or Pawnee. The assets or security will remain with the bank
under this agreement until the customer repays the loan.
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8. Mortgagor and Mortgagee (Bank-Mortgagor and Customer-Mortgagor):

According to section 58 of the Transfer of Property Act 1882, a mortgage
is the transfer of an interest in specific immovable property to secure the
payment of money advanced or to be advanced by loan, an existing or future
debt, or the performance of an engagement that may give rise to a pecuniary
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liability. The mortgagor only has an interest in the property, not ownership.
The person who transfers an interest in a property is known as a mortgagor,
and the person who receives the transfer is known as a mortgagee. In this

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 150 Principles and Practices of Banking

instance, the customer became the mortgagor and the banker became the
Notes

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mortgagee.
9. As a Custodian: A custodian is someone who looks after something. Banks

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are legally responsible for their customers’ securities. When you open a D-Mat
account, your bank becomes a custodian.
10. As a Guarantor: Banks provide guarantees on behalf of their customers

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and put themselves in their shoes. A guarantee is a type of conditional
contract. According to Section 31 of the Indian Contract Act, a guarantee is
a “contingent contract.” A contingent contract is a contract to do or not do

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something depending on whether or not some event, collateral to the contract,
occurs or does not occur.
11. Advisor and Client (Bank-Adviser and Customer-Client): When a customer
invests in securities, the banker serves as an advisor. The advice can be

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given either officially or informally. When giving advice, the banker must
exercise extreme caution. In this case, the banker is referred to as an Advisor,
and the customer is referred to as a Client.

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Relationship Termination Between a Banker and a Customer:
As a result, the banker-customer relationship is a transaction relationship. The
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relationship between a bank and a customer ends on the following events: (a) the
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customer’s death, insolvency, or lunacy (b) the customer closing the account i.e.
voluntary termination (c) the company’s liquidation (d) the bank closing the account
after giving due notice (e) the completion of the contract or the specific transaction (f)
lends to the borrower (g) invests the money so collected by way of deposits
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2.2.2 KYC
KYC (Know Your Customer) is now an important component in the fight against
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financial crime and money laundering, and customer identification is the most important
aspect because it is the first step in performing better in the subsequent stages of the
process.
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The global landscape of anti-money laundering (AML) and counter-terrorism

financing (CFT) raises enormous stakes for financial institutions. International
regulations influenced by standards such as The Financial Action Task Force (FATF)
are now incorporated into national laws, encompassing strong directives such as AML 4
and 5 as well as preventive measures such as “KYC” for client identification.
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KYC stands for Know Your Customer and, in some cases, Know Your Client. KYC,
or KYC check, is the required process of identifying and verifying the client’s identity
when opening an account and on a regular basis. In other words, banks must ensure
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that their customers are who they claim to be. If a client fails to meet the minimum
KYC requirements, banks may refuse to open an account or terminate a business
relationship.

KYC’s Importance
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KYC procedures defined by banks include all actions required to ensure their
customers are genuine, as well as assess and monitor risks. These client-onboarding

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 Principles and Practices of Banking 151

procedures aid in the prevention and detection of money laundering, terrorism

Notes

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financing, and other forms of illegal corruption.

The KYC process consists of ID card verification, face verification, document

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verification (such as utility bills as proof of address), and biometric verification. To
reduce fraud, banks must follow KYC and anti-money laundering regulations. Banks are
responsible for KYC compliance. In the event of noncompliance, severe penalties may

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be imposed.

Over the last ten years (2008-2018), fines totaling USD26 billion have been levied
in the United States, Europe, the Middle East, and Asia Pacific for noncompliance with

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AML, KYC, and sanctions-fines – not to mention the reputational damage that has gone
unmeasured.

KYC documentation

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KYC checks are performed using an independent and trustworthy source of
documents, data, or information. Each client must provide credentials to prove their
identity and address. The United States Financial Crimes Enforcement Network

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(FinCEN) added a new requirement in May 2018 for banks to verify the identity of
natural persons of legal entity customers who own, control, and profit from businesses
when those organisations open accounts.
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Bottom line: When a corporation opens a new account, it must provide Social
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Security numbers as well as copies of photo IDs and passports for its employees, board
members, and shareholders.

eKYC
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In India, Electronic Know Your Customer (eKYC) is a process in which the

customer’s identity and address are electronically verified using Aadhaar authentication.
Aadhaar is the national biometric eID scheme of India. Capturing information from IDs
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(OCR mode), extracting digital data from government-issued smart IDs (with a chip)
with a physical presence, or using certified digital identities and facial recognition for
online identity verification are all examples of eKYC.
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Directive Against Money Laundering

In Europe, the fourth Anti-Money Laundering Directive (AMLD4) went into effect
in June 2017, bringing with it a new set of rules to help financial institutions protect
themselves against the risks of money laundering and terrorism financing. The
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enhanced version of the fifth AML directive (AMLD5), which went into effect on January
10, 2020, presented new challenges for financial institutions:

◌◌ Increase your understanding of customers, beneficial owners of legal entities,

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and their financial dealings in order to reduce risk.

◌◌ Increased Customer Due Diligence (CDD)
◌◌ Control customer identity and data sharing with central administration
◌◌ EU member states must put the directive into effect within two years.
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 152 Principles and Practices of Banking

Measures for Know Your Customer (KYC) and Customer Due Diligence
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The KYC policy is a framework that banks and financial institutions must follow in
order to identify customers. Its origins can be traced back to Title III of the Patriot Act of

in
2001, which provided a variety of tools to combat terrorist activity.

To ensure compliance with international anti-money laundering and terrorist

financing regulations, strengthened When enrolling a new customer, Know Your

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Customer procedures must be implemented in the first stage of any business
relationship.

Banks’ KYC policies typically include the four key elements listed below:

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◌◌ Customer Policy
◌◌ Customer Identification Procedures (data collection, identification, verification,
and checking of politically exposed persons/sanctions lists) aka Customer

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Identification Program (CIP)
◌◌ Risk evaluation and management (due diligence, part of the KYC process)
◌◌ Constant monitoring and documentation

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This entails verifying a customer’s identity using documents such as a national ID
document and advanced document verification software.

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From visual identification to digital verification
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For some, this is still primarily a paper check with KYC forms to complete. Others
define it as a digital process that includes verifying the authenticity of an identity
document or even going so far as to authenticate the document holder through
additional biometric checks such as facial or fingerprint checks.
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A digital ID verification process allows a bank to automatically capture customer

demographic data, which can then be integrated into enterprise systems such as CRM
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to:

◌◌ Streamline the customer onboarding process

◌◌ Conduct additional due diligence and risk assessment
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◌◌ Check for PEPs (Politically Exposed Persons)

In addition, financial institutions must keep records on transactions and information
obtained through Customer Due Diligence measures. Based on materiality and risk,
these requirements should apply to all new and existing customers.
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Innovative approaches to KYC verification

In November 2018, the Federal Reserve and other US agencies issued a joint
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declaration encouraging some banks to become more sophisticated in their approaches

to detecting suspicious activity and experimenting with artificial intelligence and digital
identity technologies.

Earlier this year, the European Supervisory Authorities promoted new solutions
to specific compliance challenges. They advocate for the continuation of a common
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approach to ensure consistent standards across the EU.

They anticipate various types of control, such as “a built-in computer application

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 Principles and Practices of Banking 153

that automatically identifies and verifies a person from a digital image or a video source
Notes

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(facial biometrics)” or “a built-in security feature that can detect images that are or have
been tampered with (e.g., facial morphing), causing such images to appear pixelated or
blurred.”

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Indian point of view

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KYC, or ‘know your customer,’ is a mandatory verification procedure used by
financial institutions to reduce illegal activity. Since 2004, the Reserve Bank of India has
made it illegal for individuals to open a bank account, trading account, or demat account
without first completing the KYC procedure.

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The KYC process is required for any type of financial transaction. After completing
the KYC verification process, you must provide information about your identity, address,
and financial history to the financial institution that conducted the test. This can help the

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bank know that the money you chose to invest in was not used for illegal purposes.

A number of documents are required for the KYC verification process, which can
be completed in a matter of minutes or hours. These documents are as follows:

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List of KYC documents: Depending on the type of KYC, the required documents
must be submitted as hard or scanned copies. KYC requires two types of documents:

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proof of identity and proof of address, which can overlap but generally vary. The
following documents are required:
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For Identity Verification
●● The UID, or unique identification number, that is associated with an Aadhar card.
You can also use your voter identification, passport, or driver’s licence.
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●● Your PAN card, complete with a photograph.

●● An essential document containing the applicant’s photograph. This must be issued
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by either the state or federal governments.

●● A government-issued identification card issued by a scheduled commercial bank, a
public-sector undertaking, or any other public financial institution.
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●● Finally, identity cards issued by your college, if it is affiliated with universities, or

any identification document provided by professional bodies such as the ICWAI,
ICAI, Bar Council, ICSI, and so on.
●● A credit or debit card issued by a bank to an individual that bears the individual’s
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name and address.

●● Voter’s card/Passport/Driving License/Registered Sale Agreement or Lease on
residence/Maintenance bill of the flat is acceptable as proof of address.
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●● Your electricity or gas bill, telephone bill, and water consumption bill are all valid.
These bills must be no older than three months.
●● A self-declaration provided by supreme or high court judges provides the applicant
with a new address, which may be required if the applicant is convicted of any
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reason.

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 154 Principles and Practices of Banking

●● Address proof for KYC can also be issued by any of the following entities: bank
Notes

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managers of Scheduled co-operative banks/scheduled commercial banks/gazetted
officers/Multinational Foreign Banks/Notary public/Documents issued by any
Statutory Authority or government/any representatives elected to the Legislative

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Assembly or Parliament.
●● The Power of Attorney given to the Custodians by the FII/sub-account with the

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registered address must be taken for any sub-account or FII.
●● Address proof in the name of your spouse is also acceptable for KYC.

KYC Verification Types

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KYC verification processes are classified into two types. They are both equally
authentic, and it is a matter of personal preference whether one prefers one over the
other.

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KYC based on Aadhaar: The first type of KYC verification is defined as an online
verification process, which is extremely convenient for those who have access to
broadband or the internet. For this type of KYC, you must upload a scanned copy of

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your original Aadhar card. If you want to invest in a mutual fund, you can only do so with
Aadhar-based KYC up to 50,000 per year.

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KYC performed in-person: In-person KYC verification, on the other hand, is done
offline. You can do this by visiting a KYC kiosk or mutual fund house and authenticating
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your identity using Aadhar biometrics. You can also contact the KYC registration agency
and request that an executive come to your home or office to perform this verification.

2.3 Negotiable Instrument

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In India, the Negotiable Instruments Act was passed in 1881. Prior to its enactment,
the provisions of the English Negotiable Instruments Act applied in India, and the
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current Act is based on the English Act with some modifications. Except for the state of
Jammu and Kashmir, it covers the entire country of India. The provisions of Sections 31
and 32 of the Reserve Bank of India Act, 1934 govern the operation of the Act.

Section 31 of the Reserve Bank of India Act states that no person in India,
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other than the Bank or the Central Government as expressly authorised by this Act,
shall draw, accept, make, or issue any bill of exchange, hundi, promissory note, or
engagement for the payment of money payable to bearer on demand. This Section also
states that no one, other than the RBI or the Central Government, may make or issue a
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promissory note that is payable on demand or after a certain period of time.

Section 32 of the Reserve Bank of India Act makes the issuance of such bills or
notes punishable by a fine up to the face value of the instrument. These provisions
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have the following effect or consequences:

1. A promissory note, whether payable on demand or after a certain period of time,

cannot be made payable to the bearer.
2. A bill of exchange cannot be made payable to the bearer on demand, but it can be
(c

made payable to the bearer after a specified period of time.

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 Principles and Practices of Banking 155

3. However, a cheque drawn on a person’s account with a banker, even if it is a bill of

Notes

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exchange payable to bearer or demand, can be drawn on a person’s account with a
banker.

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2.3.1 Protection Available
“Negotiable instrument” means a promissory note, bill of exchange, or cheque

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payable either to order or to bearer, whether the words “order” or “bearer” appear on the
instrument or not, according to Section 13 (a) of the Act. According to Justice Willis, “a
negotiable instrument is one in which the property is acquired by anyone who takes it
bonafide and for value notwithstanding any defects of title in the person from whom he

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took it.”

Thus, a negotiable instrument is a written document that creates a right in favour

of someone and is freely transferable. Although the Act only mentions these three

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instruments (such as a promissory note, a bill of exchange, and a cheque), it does not
preclude the addition of any other instrument that meets the following two negotiability
conditions:

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1. The instrument should be freely transferable (by delivery or endorsement and
delivery) according to trade custom.
2.
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The person who obtains it in good faith and for a fair price should receive it free of all
defects and be entitled to recover the instrument’s money in his own name.
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As a result, documents such as bearer share warrants, bearer debentures, and
dividend warrants are negotiable instruments. Money orders and ostal orders, deposit
receipts, share certificates, bills of lading, dock warrants, and so on, on the other hand,
are not negotiable instruments. Despite the fact that they are transferable by delivery
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and endorsements, they cannot provide a better title to a bona fide transferee for a
higher value than the transferor has.
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Bankers’ Liability for Collecting and Paying

Collecting Bankers’ Responsibility – Section 131 of The Negotiable Instrument Acts
of 1881 states that “a banker who has in good faith and without negligence received
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payment for a customer of a cheque crossed generally or especially to him shall not, in
case the title to the cheque proves defective, incur any liability to the true owner of the
cheque solely by reason of having received such payment.”

The protection afforded to collecting bankers under Section 131 of the NI Acts 1881
m

is available only if the following conditions are met by the collecting banker.

1. The check should have been crossed to the bank, in general or specifically.
2. The bank should have collected such a cheque as an agent for collection rather than
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as a holder for a value.

3. The proceeds of the collected cheque are credited only to the account of the payee
or, if the endorsement on the instrument is regular, to the account of the endorsee.
4. The collecting banker must have acted honestly. In this case, ‘good faith’ means that
(c

the banker had no reasonable grounds to believe that the customer was not entitled
to receive payment of the amount specified.

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 156 Principles and Practices of Banking

5. The collecting banker should not have acted carelessly. ‘Without negligence’ means
Notes

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that the account of the customer on whose behalf the cheque is collected is opened
in accordance with KYC norms, such as verification of identity and address proof
before opening the account.

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6. The collecting banker who received payment based on an electronic image of a
truncated cheque must have verified the apparent genuineness of the cheque in his

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possession with due diligence and ordinary care to ensure the instrument’s prima
facie genuineness.

Responsibilities of a Banker

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Sections 85(1), 85(2), and 128 of the Negotiable Instruments Act provide statutory
protection to paying bankers when they make payments of order cheque, bearer
cheque, or crossed cheque in that order.

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Cheque payment for order
Section -85(1) of the Northern Ireland Acts 1881 states that “where a cheque

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payable to order purports to be endorsed by or on behalf of the payee, the drawee is
discharged by payment in due course.” The above section protects a paying banker
if he has made payment of an order cheque in due course (within the meaning of

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sec.10 of the Northern Ireland Act) and if the proceeds are credited to the account of an
endorsee if and only if
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Payment by bearer check
According to Section -85(2) of the N.I.Acts, “where a cheque is originally expressed
to be payable to bearer, the drawee is discharged by payment in due course to the
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bearer thereof, notwithstanding any endorsement whether in full or blank appearing

thereon and notwithstanding any such endorsement purporting to restrict or exclude
further negotiation.”
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The preceding section states that a cheque that is ‘once a bearer, always a bearer’
(which means if a cheque is originally drawn as a bearer cheque remains always bearer
irrespective of any endorsements on the back of the instrument). As a result, banks are
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not required to verify the regularity of any endorsement on the back of the cheque, and
they are not liable if they pay an uncrossed bearer cheque to a bearer in due course.

‘Crossed cheque’ payment

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According to Section -128 of the Northern Ireland Acts of 1881, “where the banker
on whom a crossed cheque is drawn has paid the same in due course, the banker
paying the cheque and (in case such cheque has come into the hands of the payee)
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the drawer thereof shall respectively be entitled to the same rights, and be placed in
the same position, as if the amount of the cheque had been paid to and received by the
true owner thereof.”

To be eligible for protection under related NI acts, the paying banker of a crossed
cheque must meet the following conditions.
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1. Payment must be made in a timely manner.

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 Principles and Practices of Banking 157

2. When a cheque is crossed in general, the banker on whom it is drawn must pay it to
Notes

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a banker.
3. Where a cheque is specially crossed, the banker on whom it is drawn shall not pay

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it to anyone other than the banker to whom the cheque is crossed or his agent for
collection.
If a paying banker makes a cheque payment, he is not entitled to the following

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statutory protections:

a) Materially altered, or the drawer’s signature is forged, or payment is made

with a crossed cheque with an irregular endorsement.

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b) If he pays a crossed cheque to someone other than the banker, he is liable for
the loss to the true owner of the cheque.

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Banker who Collects
A collecting banker is the person who collects the proceeds of a cheque on behalf
of the customer. Even if a banker collects the proceeds of a cheque for the customer

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solely as a matter of service, the Negotiable Instruments Act of 1881 inflicts statutory
obligation. This is clear from Section 126 of the Negotiable Instruments Act, which
states that a cheque with a “general crossing” shall not be paid to anyone other than

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the banker, and a cheque with a “special crossing” shall not be paid to anyone other
than the banker to whom it is crossed. As a result, a paying banker must pay a crossed
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cheque only to a banker, indicating that the cheque should be collected by another
banker.

According to Section 131 of the Negotiable Instruments Act of 1881, “A banker who
has received payment for a customer of a cheque crossed generally or specifically to
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himself in good faith and without negligence shall not incur any liability to the true owner
of the cheque by reason of only having received such payment.
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Explanation: A banker receives payment of a crossed cheque for a customer under

this section even if he credits his customer’s account with the amount of the cheque
before receiving payment.”

The following are the fundamentals of claiming protection under Section 131 of the
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Negotiable Instruments Act of 1881:

i) The collecting banker must have acted in good faith and without error. The
term “acted in good faith” refers to an act that is done honestly. The plea of
good faith can be defeated on the basis of unruliness, which indicates a lack
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of proper care and attention.

(ii) The banker should have accumulated a crossed cheque.
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(iii) The proceeds should have been collected for a customer, i.e. someone who
has an account with him.
(iv) That the collecting banker acted as the customer’s agent. If he became the
holder for value, the protection provided by Section 131 of the Negotiable
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Instruments Act of 1881 is lost.

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 158 Principles and Practices of Banking

Paying Banker Protection (Sections 10, 85 and 128)

Notes

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The banker may disregard any endorsement on a cheque that was originally
articulated by the drawer himself to be payable to the bearer. In due course, he will be

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released by payment.

The Negotiable Instruments Act states in Section 85 that “where a cheque

payable to order purports to be endorsed by or on behalf of the payee, the banker

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is discharged by payment in due course.” He can debit the customer’s account with
the amount even if the endorsement is later discovered to be forged, or if the payee’s
agent without authority endorsed it on the payee’s behalf.” It should be noted that the

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payee includes the endorsee. This safeguard is approved because a banker cannot be
expected to know the signatures of every person on the planet. He has no right to see
the signatures of his own customers.

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As a result, forgery of the drawer’s signature will not usually defend the banker, but
even in this case, the banker may debit the customer’s account if it can demonstrate
that the forgery was familiarly connected with the customer’s laxity and was the
adjacent cause of loss.

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The following are the duties and responsibilities of a collecting banker:

1. Due care and diligence in cheque collection.

2. r
Issuing a dishonourable notice.
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3. Collection agent.
4. Payment of the proceeds to the customer
5. Bills of exchange collection
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1. Due Care and Diligence in Cheque Collection: The collecting banker is required to
exercise due care and diligence in collecting cheques presented to him. If a cheque
is entrusted to the banker for collection, he must show it to the drawee banker within
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a reasonable time frame. According to Section 84 of the Negotiable Instruments Act

of 1881, “Whereas a cheque is not presented for payment within a reasonable time
of its issue, and the drawer or person in whose account it is drawn had the right,
as between himself and the banker, to have the cheque paid and suffers actual
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damage, that is to say, to the extent to which such drawee suffers actual damage, he
is discharged to the extent of such damage, that is to say, to the extent to which
The customer may suffer loss if a collecting banker fails to present the cheque for
collection through the proper channel within a reasonable time. If the collecting
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banker and the paying banker work for the same bank or if the collecting branch
is also the drawee branch, the collecting banker must present the cheque by the
next business day. If the cheque is drawn on a bank in another location, it must be
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presented on the day it is received.

2. Serving Notice of Dishonour: When a cheque is dishonoured, the collecting banker
is required to notify his customer within a reasonable time frame. It should be noted
that when a cheque is returned for confirmation of endorsement, notification must be
(c

sent to the customer. If he fails to provide such notice, the collecting banker will be
liable to the customer for any loss incurred as a result of such failure.

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 Principles and Practices of Banking 159

The return of a cheque by the drawee banker for confirmation of endorsement is not
Notes

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referred to as dishonour. However, in this case, the customer must be notified. In the
absence of such a notice, the collecting banker will be liable for the loss if the cheque
is returned for the second time and the customer suffers a loss.

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3. Collection Agent: If a cheque is drawn in a location where the banker is not a member
of the clearing-house, he may employ another banker who is a member of the

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clearing-house to collect the cheque. In this case, the banker acts as a substituted
agent. “Whereas an agent, holding express or implied authority to name another
person to act in the business of the agency, has accordingly named another person,
such a person is a substituted agent,” Section 194 of the Indian Contract Act, 1872

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states. Such an agent shall be considered the agent of a principal for the portion of
the work entrusted to him.”
4. Remittance of Proceeds to the Customer: If a collecting banker has realised the

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cheque, he must pay the proceeds to the customer in accordance with his (the
customer’s) instructions. Generally, the amount is credited to the customer’s account
upon his written request, and the proceeds may be remitted to him via demand
draught. In such cases, if the customer gives his banker instructions, the draught

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may be forwarded. As a result, the principal-agent relationship is terminated, and a
new debtor-creditor relationship is established.
5. r
Bills of Exchange Collection: A banker is not required by law to collect bills of
exchange for its customers. However, most banks provide such a service to their
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customers. A banker should examine the depositor’s title when collecting bills as the
statutory protection under Section 131 of the Negotiable Instruments Act, 1881.
As a result, the collecting banker must carefully examine his customer’s title to the
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bill. If a new customer arrives, the banker should extend this facility to him along with a
reliable reference.
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2.4 Others

2.4.1 Endorsement
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A bank endorsement is a guarantee issued by a bank confirming that it will honour

a check or other negotiable instrument issued by one of its customers, such as a
banker’s acceptance. This assures any third party that the bank will back the obligations
of the instrument’s creator if the creator is unable to make payment.
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Bank endorsements are common in international trade, where the parties are
usually unfamiliar with one another. Banks act as a go-between, assuring the recipient
of good funds. In the case of a banker’s acceptance, for example, a bank endorsement
is the equivalent of a guarantee. A banking institution will generally not provide a
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banker’s acceptance unless there is a reasonable likelihood that the funds will be
available as specified.

The term endorsement is defined in Section 15 of the Negotiable Instruments Act

1881 as follows: When the maker or holder of a negotiable instrument signs it, other
(c

than as such maker, for the purpose of negotiation, on the back or face thereof or on a
slip of paper annexed thereto, or so signs a stamped paper intended to be completed

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 160 Principles and Practices of Banking

as a negotiable instrument, he is said to have endorsed the same and is called the
Notes

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endorser.

Endorsement is defined as “writing on the back of the instrument.” However, it

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is defined as “writing a person’s name on the back of the instrument or on any paper
attached to it for the purpose of negotiation” under the Negotiable Instruments Act.

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An Endorser and an Endorsee
An act of endorsement is primarily initiated by two people: the Endorser and the
Endorsee.

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The endorsee is the person to whom the instrument is being endorsed. While the
person making the endorsement is referred to as the endorser.

The Requisites of Valid Endorsement

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The following are the requirements for a valid endorsement:

●● The endorsement must be made on the back or face of the instrument, and if no

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space is available, it must be made on a separate piece of paper attached to it.
●● The endorsement must be done in ink; any endorsement done in pencil or with a
rubber stamp is deemed invalid.
●●
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The stranger cannot endorse; it must be done by the maker or holder of the
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instrument.
●● It must be signed by the endorser.
●● It must be completed by the delivery of the instrument
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●● The endorsement must be of the entire bill; a partial endorsement is not valid.

Instrument Endorsement
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The holder of a negotiable instrument may sign his or her name on the back of the
instrument, replicating the transfer of title or ownership of that negotiable instrument;
this process is known as an endorsement. An endorsement can be accomplished by
putting another person or entity in a favourable position. As a result, we can say that
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an endorsement facilitates the transfer of property to another individual or legal entity.

In this context, we will learn about the various types of instrument endorsement done in
the legal world.
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Endorsement Types
There are two kinds of endorsements:

●● The Blank Endorsement

)A

●● The Complete Endorsement

According to Section 16 of the Negotiable Instrument Act of 1881, if the endorser
simply signs his name, the underwriting is presumed to be clear, and if he adds
a heading to pay the sum referenced in the instrument to, or to the request for, a
(c

predetermined individual, the Endorsement is presumed to be in full, and the individual

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 Principles and Practices of Banking 161

so determined is known as the endorsee of the instrument. There are a few different
Notes

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types that are well-known but not widely known, which are listed below.

There are six different types of endorsement. These are applicable for banking

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endorsement and various types of endorsement cheques:

◌◌ General Endorsement or Blank Endorsement

◌◌ Full or Special Endorsement.

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◌◌ Conditional Endorsement.
◌◌ Restrictive Endorsement.

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◌◌ Partial Endorsement.
Blank or General Endorsement: A blank or general endorsement is one in which
the endorser writes his or her name only on the instrument and does not write the name
of anyone to whom or whose request the payment is to be made.

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Endorsement (Full) or Endorsement (Special): A special Endorsement or full
Endorsement occurs when the endorser, in addition to his mark, notices the name of

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the individual to whom or whose request the payment is to be made. Endorsement
adds a heading to the individual named as the endorsee of the instrument, who now
becomes its payee qualified to sue for the money owed on the instrument.

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Conditional Endorsement: A conditional endorsement is an arrangement that
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produces results based on the occurrence of a specified event, or not something else.
The endorser of a disputed instrument may, by express words in the Endorsement,
reject his own risk subsequently, or make such obligation or the privilege of the
endorsee to get the sum due consequently rely on the occurrence of a predetermined
occasion, albeit such occasion may never occur. When an endorser limits his risk and
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then becomes the holder of the instrument, all intermediate endorsers are obligated to
him.
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Restrictive Endorsement: Restrictive Endorsement attempts to eliminate the

primary characteristics of a Negotiable Instrument and seals its future debatability.
This may appear to be somewhat unusual, but the endorsee is particularly within his
rights if he so signs that the resulting move is limited. This eliminates the possibility
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of unapproved individuals obtaining payment through misrepresentation or falsification

and losing their money.

Partial Endorsement: An endorsement is considered partial when the endorser

indicates that only a portion of the sum payable will be moved to the endorsee. In
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layman’s terms, halfway underwriting is support that allows a portion of the sum
payable to be transferred to the endorsee.

Facultative Endorsement: Facultative Endorsement is a type of underwriting

)A

in which the endorser defers some right to which he is entitled. For example, if the
endorsee is disrespectful to the endorser, his inability to pull out will usually vindicate
the endorser from his risk.

2.4.2 Forged Instruments

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When forgery occurs in the signature of the drawer, signature of the endorser,
and alteration in the name of the payee, alteration in amount, alteration in date, etc.

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 162 Principles and Practices of Banking

validated by forged signature, an instrument (negotiable instrument such as cheque/bill

Notes

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of exchange/promissory note) is called forged instrument.

A forged instrument is meaningless to the drawer/endorser whose signature is

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forged because the holder of such instruments is not legally protected. Forgery is void
from the start and gives the holders no rights. As a result, the transferee will be unable
to collect payment from the parties to the bill, cheque, and promissory note.

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If a transferee receives payment by mistake, that payment can be reclaimed
from him or her. For example, when a forged cheque is paid by the drawee bank, it is
deemed payment without the customer’s actual mandate. The paying bank is obligated

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to make up the customer’s loss. Similarly, a bank that collected the cheque on the basis
of a forged endorsement will be held liable and may be required to return the proceeds
collected.

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Endorsement Fraud
We cannot negotiate an instrument that has been fully endorsed unless it is signed
by the person to whom or whose order the instrument is payable. This is due to the

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fact that the endorsee obtains title solely through his endorsement. As a result, if an
instrument is negotiated using a forged endorsement, the endorsee acquires no title
even if he is a purchaser for value and in good faith, because the endorsement is void.
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No title is conveyed by forgery. However, if the instrument is a bearer instrument or
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has been endorsed in blank, it can be negotiated by mere delivery, and the holder’s title
is independent of the forged endorsement. He can also seek payment from any of the
instrument’s parties.

For example, “Pay A or order” is written on a bill. A signs it in the blank, and it is
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given to B, who simply delivers it to C. C forges B’s signature and passes it on to D.

In this case, D, as the holder, derives his title not from a forged endorsement of
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B, but from a genuine endorsement of A. As a result, despite the intervening forged

endorsement, he can seek payment from any of the parties.

2.4.3 Bouncing of Cheque

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In certain circumstances, the bank may refuse to pay a cheque or dishonour a

cheque; in such cases, the cheque will bounce. When a cheque is dishonoured due to
insufficient funds in a customer’s account, the cheque bounces and action can be taken
under Section 138 of The Negotiable Instruments Act.
m

A cheque can bounce for a variety of reasons, but if it bounces due to insufficient
funds in the drawer’s account, it is an offence under the Act. The bank must reject the
cheque presented for payment and issue a return memo citing insufficient funds as the
)A

reason. In this case, the payee of the cheque can send a cheque bounce notice to the
drawer, demanding that the cheque amount be paid.

New Cheque Bounce Policy

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Customers whose financial activities rely heavily on cheques, or who intend to

use cheques, will be required to maintain a minimum bank balance, according to a
notice issued by the Reserve Bank of India (RBI) in early August 2021. The cheque

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will bounce if this minimum balance is not maintained. In addition, the customer who
Notes

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issued the cheque may be charged a penalty fee. In addition to these changes, the RBI
announced that the National Automated Clearing House (NACH) would be operational
24 hours a day, seven days a week.

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All national and private banks are affected by these changes. The rule change was
implemented to speed up and smooth out the clearing of cheques. Because the new

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rule ensures that NACH is operational every day of the week, Sundays will also be a
day when the entity can process and clear a cheque.

Cheque Bounce Circumstances

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The following are the various situations that result in a cheque bounce:

Insufficient account balance – If there is insufficient balance in the drawer’s

account to pay the cheque, the bank will reject the cheque and return it to the payee

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with a memo stating that there are insufficient funds to pay the cheque amount.

Cheque validity has expired – Once issued, the cheque must be presented for

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payment within three months. If the cheque is not presented to the bank within three
months, it will expire. If an expired cheque is presented to a bank, it will bounce.

Overwriting – If the drawer’s signature, cheque amount, or any other statement is

overwritten on the cheque, the cheque bounces. r
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Damaged cheque – If a cheque is damaged or disfigured, and the details are not
visible, or the cheque has marks or stains, it will bounce.

Signature mismatch – The cheque will bounce if the drawer’s signature is unclear,
missing, or does not match the one in the bank’s database.
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Mismatch of amounts or digits – The cheque will bounce if the amount stated in
words and figures does not match.
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Remedies for Cheque Bounce

Resubmission of cheque: If a cheque bounces due to overwriting, a mismatch in
signature, a mismatch in the figures and words of the cheque amount, or a damaged
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cheque, the payee can request that the drawer resubmit the cheque. If the drawer
refuses to submit another cheque, the payee may file a civil action against the drawer to
recover the cheque amount owed to him rather than the cheque bounce.

Section 138 of the Negotiable Instruments Act provides for a Cheque Bounce
m

Notice.

When a cheque bounces due to insufficient funds in the drawers’ account to make
the cheque amount payment, a cheque bounce notice is issued under Section 138
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of the Negotiable Instruments Act. If the cheque bounces for any reason other than
insufficient funds, no cheque bounce notice will be issued, and the payee may request
that the cheque be resubmitted.

Cheque Bounce Notice Issuance

(c

When a cheque bounces due to insufficient funds, the first step is to demand
payment by issuing a cheque bounce notice in writing via postal service under the

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 164 Principles and Practices of Banking

Negotiable Instruments Act. Within 30 days of receiving notification from the bank and
Notes

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the bounced cheque, the payee may issue a cheque bounce notice stating that the
bank is unable to make the cheque payment due to insufficient funds.

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Following the issuance of the cheque bounce notice, the payee must give the
drawer 15 days from the date of receipt of the cheque bounce notice to pay the cheque
amount. If the drawer does not reimburse the cheque amount even after the 15-day

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period has expired, the payee may file a lawsuit against the drawer within 30 days of
the expiration of the 15-day period.

A cheque bounce notice, on the other hand, cannot be issued if the cheque was

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issued as a donation, gift, or any other legally enforceable obligation. To be an offence
under the Act, the cheque must be issued to discharge a legally enforceable liability or
debt.

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Following the Issuance of a Cheque Bounce Notice, Follow the Procedure
The payee can file a lawsuit against the drawer after 15 days of receiving the
cheque bounce notice. Section 138 of the Act requires the payee to file a complaint.

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Cheque bounce is a criminal offence under Section 138 of the Act, for which the payee
may file a criminal suit. The payee must file a complaint against the cheque bounce with
the Magistrate within 30 days of the cheque bounce notice expiring.
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Magistrate’s Jurisdiction for Filing a Cheque Bounce Suit
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The payee may file a complaint with the Magistrate in any of the following locations:

●● The location of the cheque.

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●● The location where the cheque was presented for payment.

●● The location where the payment had to be made.
●● Where the cheque was returned unpaid; and • Where the demand notice was
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served.
If the cheque bounce suit is filed in a metropolitan city, the complaint must be filed
with the Metropolitan Magistrate. If the cheque bounce suit is filed in another city, the
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complaint must be filed with the Judicial Magistrate.

Cheque Bounce Suit Process

The following is the procedure for filing a cheque bounce suit:
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●● Filing a complaint with the Magistrate after the drawer has had 15 days from the
date of receipt of the cheque bounce notice.
●● The payee/complainant must appear in court and provide case details. If the
)A

Magistrate is satisfied with the complainant’s statement, he will summon the

drawer to appear in court. The drawer will appear and either accept or deny the
complainant’s facts. If the drawer refuses to accept the complaint, the court will
proceed with the criminal trial. The drawer/accused will file his statement, and both
sides’ evidence and arguments will be presented to the court. If the court finds the
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drawer guilty of the offence of cheque bounce, the court will enter a judgement of

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 Principles and Practices of Banking 165

conviction against the drawer. Cheque bounce is punishable by imprisonment for

Notes

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no more than two years or a fine of up to twice the amount of the cheque, or both.
●● A civil suit can also be filed against the drawer to force payment of the cheque

in
amount. In the event of the filing of a civil suit, the payee is not permitted to issue a
cheque bounce notice. Only a legal notice can be issued by the payee in order to
recover the amount.

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●● Cheque bounce is a criminal offence under Section 138 of the Act that provides
criminal punishment for cheque bounce due to insufficient funds. The civil suit for
recovery, on the other hand, does not punish the drawer and only seeks to recover

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the amount of the cheque bounce.
●● The company can be served with a cheque bounce notice. Under Section 148 of
the Act, a criminal suit can be filed against a company if it issues a cheque that
bounces due to insufficient funds. When a criminal suit is filed under Section 148

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of the Act, the company and its directors will be held accountable for the offence of
cheque bounce.
●● However, if the drawer pays the cheque amount to the payee within 15 days of

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receiving the cheque bounce notice, he commits no office and no legal action can
be taken against him for cheque bounce under Section 138 of the Act.

How to Handle a Cheque Bounce Case r

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To avoid further legal proceedings, the first step would be to respond to the legal
notice with your defence or pay the cheque amount. However, before responding, you
should consult with a legal practitioner who specialises in cheque bounce. If the cheque
amount is paid at the outset, the problem will be resolved right away.
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There is no set format for responding to a legal notice, but make sure to include the
following topics in your response:
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◌◌ Address the legal notice response to the drawee’s lawyer.

◌◌ A description of yourself, as well as your name and address.
◌◌ Issue facts: date of issue, cheque-return memo, and so on.
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◌◌ A refutation of the allegations levelled against you.

◌◌ Refrain from admitting to any allegation made against you in the notice.
◌◌ Any complaints against the cheque’s drawee.
◌◌ A summary of your defence to the allegations in the legal notice for check
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bounce.
◌◌ Any response to a legal notice must be sent on the letterhead of a lawyer.
Failure to respond to the legal notice or pay the cheque amount within 15 days may
)A

prompt the drawee to file a legal complaint with the court, launching legal proceedings
against you.

Summary
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●● Since the onset of the financial and sovereign debt crises, the importance of
the financial sector has grown. The sector has presented world economies with

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 166 Principles and Practices of Banking

significant challenges in understanding the dimensions of operations, delivery, and

Notes

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regulations in the banking industry.
●● The role of the banking sector in an economy has been identified around the

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world on the basis of providing financial resources, particularly to capital-intensive
sectors such as infrastructure, automobiles, iron and steel, and industrial and high-
growth sectors such as pharmaceuticals and health care. Nonetheless, banks bear

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the additional burden of implementing the government’s social agenda.
●● The growth experience of India—the world’s tenth largest economy in terms of
nominal GDP and third largest in terms of purchasing power parity—has been well

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documented in the literature. The Indian financial system is primarily composed of
the banking sector, and its role has been observed ranging from financing large-
scale projects to providing finance and related services to the country’s masses.
●● The sector has seen key reforms such as granting operational autonomy to public

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sector banks (PSBs), reducing public ownership in PSBs by allowing them to raise
capital from the equity market up to 49% of paid-up capital, transparent norms
for entry of Indian private sector, foreign and joint venture banks and insurance

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companies, and permission for foreign investment in the financial sector in the
form of foreign direct investment (FDI).
●● The Indian banking industry is taking shape in terms of the implementation of
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innovative banking models such as payments and small finance banks, as well as
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increased promotion of private banks.
●● While learning from global regulatory bodies and keeping the domestic problem
of the Indian banking industry in mind, the urgent need of the hour is to maintain
proper checks and balances on banking transactions, especially in recent times
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as the Indian economy undertakes innovative reforms to maintain its growth

trajectory.
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Glossary
●● KYC based on Aadhaar: The first type of KYC verification is defined as an online
verification process, which is extremely convenient for those who have access to
broadband or the internet. For this type of KYC, you must upload a scanned copy
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of your original Aadhar card. If you want to invest in a mutual fund, you can only do
so with Aadhar-based KYC up to 50,000 per year.
●● KYC performed in-person: In-person KYC verification, on the other hand, is
done offline. You can do this by visiting a KYC kiosk or mutual fund house and
m

authenticating your identity using Aadhar biometrics. You can also contact the KYC
registration agency and request that an executive come to your home or office to
perform this verification.
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●● eKYC: In India, Electronic Know Your Customer (eKYC) is a process in which

the customer’s identity and address are electronically verified using Aadhaar
authentication.
●● Agent and Principal (Bank-Agent and Customer-Principal): Section 182 of the
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Indian Contract Act of 1872 defines “an agent” as a person employed to perform
any act for another or to represent another in dealings with third parties. The

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 Principles and Practices of Banking 167

person for whom such an act is performed or who is so represented is referred to

Notes

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as “the Principal.”
●● Lessee and Lessor (Bank-Lessee and Customer-Lessee): The terms lease,

in
Lessor, lessee, premium, and rent are defined in Section 105 of the ‘Transfer of
Property Act 1882.’ According to the section, “a lease of immovable property is a
transfer of a right to enjoy such property for a specific time, express or implied, or

nl
in perpetuity, in consideration of a price paid or promised, or of money, a share
of crops, service, or any other thing of value, to be rendered to the transferor on
specified occasions by the transferee, who accepts the transfer on such terms.”

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●● Inward Transfers: The transfer of funds from one account to another, either
domestically or internationally, is referred to as inward remittance.
●● Outward Remittance: Outward remittance is the transfer of funds outside of the
country or overseas.

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●● Collecting Banker as an Agent - When a collecting banker credits a check to
the customer’s account after a drawee’s banker pays the money, he acts as the
customer’s agent. He will then be permitted to collect the amount of the check.

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●● Collecting banker: A Collecting banker is someone who works on behalf of a
customer to collect cheques, draughts, bills, pay orders, traveller cheques, letters

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of credit, dividends, debenture interest, and so on.
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●● Stale Cheques: When a cheque is presented three months after the date it bears,
the banker may refuse to make payment.
●● Power of Attorney: A power of attorney (POA) is a written instruction that allows
one person to act on behalf of another. That is, the agent may perform any lawful
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act or series of lawful acts on behalf of the principal person.

●● Venture capitalist: A venture is a concept in which an entrepreneur deals with a
new high-risk project. Venture capital is the availability of funds for high-risk
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projects. These are high-risk, high-reward ventures. After calculating the risk, the
bank will provide capital for such projects in exchange for higher returns.
●● Retail banking: Retail banking, also known as consumer banking or personal
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banking, is financial services provided to the general public. Retail banking allows
the average customer to manage their money, obtain credit, and deposit funds in a
secure manner.

Check Your Understanding

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1. According to .................. of the Negotiable Investment Act, a bank draught is an

order to pay money drawn by one office to the bank upon other offices of the same
bank for a sum of money payable to order on demand.
)A

(a) Section 85 (A)

(b) Section 80 (A)
(c) Section 82 (A)
(c

(d) Section 83 (A)

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 168 Principles and Practices of Banking

2. ................ refers to the transfer of funds from one account of the same bank to
Notes

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another account of the same bank in a different location.
(a) Mail transfer

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(b) Wire transfer
(c) RTGS transfer

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(d) NEFT transfer
3. ...................... is abbreviated as RTGS.
(a) Real Time Gross Settlement

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(b) Real Time Settlement
(c) Real Settlement Time

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(d) Gross Settlement in Real Time
4. A .................... is a prepaid fixed amount that works like cash and can be used to
purchase goods or services while travelling.

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(a) traveller’s cheque
(b) bankers cheque
(c) sureity cheque r
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(d) demand draft
5. ............... is a social security scheme in which retired and superannuated employees
receive a lump sum payment.
(a) Pension
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(b) Social security

(c) Old age pension
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(d) VRS
6. .................. is a financial service in which all services are provided, beginning with
the sale of goods and services and ending with the collection of receivables.
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(a) Factoring
(b) Banking
(c) Financial market
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(d) Financial banking

7. The primary goal of ............. is to collect investments from a large number of investors
and depositors and then diversify the capital.
)A

(a) mutual funds

(b) financial funds
(c) savings funds
(c

(d) current funds

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 Principles and Practices of Banking 169

8. A resident Indian can be appointed as a mandate holder by a Non-Resident Indian

Notes

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(NRI) who has an .................account.
(a) NRE/NRO

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(b) NRI/NRO
(c) NRI/NRE

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(d) NR/NE
9. A ............ is a simple letter of authority signed by a constituent that authorises the
bank to allow a specific named person (agent) to operate the account on his or her

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behalf.
(a) mandate
(b) requisition

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(c) forwarding letter
(d) covering letter

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10. A .................. (POA) is a written instruction that allows one person to act on behalf of
another.
(a) power of attorney
(b) power for attorney r
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(c) power against attorney
(d) power in favour of attorney
11. .............. of the Negotiable Instruments Act, which provides immunity to the collecting
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bank, specifies that the bank must not have been negligent, among other conditions.
(a) Section 131
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(b) Section 130 A

(c) Section 141
(d) Section 130
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12. According to .............. of the Banking Regulation Act, the bank’s business is accepting
deposits for lending.
(a) Section 5(b)
(b) Section 6(b)
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(c) Section 15(b)

(d) Section 10(b)
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13. According to Section 3 of the .............., a “trust” is an obligation attached to the

ownership of property and arising from a confidence reposed in and accepted by the
owner, or declared and accepted by him, for the benefit of another, or of another and
the owner.
(c

(a) Indian Trust Act 1882

(b) Indian Trust Act 1885

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 170 Principles and Practices of Banking

(c) Indian Trust Act 1883

Notes

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(d) Indian Trust Act 1884
14. The ............. is a framework that banks and financial institutions must follow in order

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to identify customers.
(a) KYC policy

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(b) KC policy
(c) YC policy
(d) Banking policy

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15. ................... of the Reserve Bank of India Act states that no person in India, other than
the Bank or the Central Government as expressly authorised by this Act, shall draw,
accept, make, or issue any bill of exchange, hundi, promissory note, or engagement

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for the payment of money payable to bearer on demand.
(a) Section 31
(b) Section 41

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(c) Section 30
(d) Section 40
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16. ................ of The Negotiable Instrument Acts of 1881 states that “a banker who has
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in good faith and without negligence received payment for a customer of a cheque
crossed generally or especially to him shall not, in case the title to the cheque proves
defective, incur any liability to the true owner of the cheque solely by reason of
having received such payment.”
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(a) Section 131

(b) Section 141
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(c) Section 151

(d) Section 133

Exercise
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1. What are the different types of bank deposits?

2. What is model locker agreement?
3. What are ancillary services of banks?
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4. Define the term mandate and power of attorney from banking perspective.
5. What is a paying and collecting banker?
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6. Define remittance.
7. Define paying banker protection.
8. What is a bank endorsement?
9. What is bouncing of cheque?
(c

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 Principles and Practices of Banking 171

Learning Activities
Notes

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1. Discuss the importance of KYC in today’s banking sector.
2. Discuss Negotiable Instruments Act and its application in the banking sector.

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Check Your Understanding - Answers
1. Section 85 (A)

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2. Mail transfer
3. Real Time Gross Settlement

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4. traveller’s cheque
5. Pension
6. Factoring

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7. mutual funds
8. NRE/NRO

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9. Mandate
10. power of attorney
11. Section 131
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12. Section 5(b)
13. Indian Trust Act 1882
14. KYC policy
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15. Section 31
16. Section 131
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Further Readings and Bibliography

1. Introduction to Banking, Barbara Casu (Author), Claudia Girardone (Author),
Prof Philip Molyneux (Author)
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2. BANKING LAW AND PRACTICE, THE INSTITUTE OF COMPANY

SECRETARIES OF INDIA
3. Banking an Overview, Allen N. Berger, Philip Molyneux and John O. S. Wilson
4. FUNDAMENTALS OF BANKING 1 – BANKING AND FINANCE 1, Dr. Girija
m

Shankar , Vivek Datar

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(c

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 172 Principles and Practices of Banking

Module - III: Asset Products and Different Committee

Notes

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Recommendations

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Learning Objectives:
●● NPA Management - DRT/DRAT, SARF AESI Act 2002, Competition Act 2005
●● Credit Appraisal Mechanism

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●● Financial inclusions - PMJDY Agriculture, SMEs, SHGs, SSIs, Microfinancing
●● Banking products & services - Credit Cards, Personal Loans, Consumer Loans

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●● Banking reports - Nachiket Mor Committee Report
●● Payment Banks and Small Banks
●● Banking - Business Correspondence

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●● Calculating base rate - Introduction and Calculations and Prime Lending Rate
●● Treasury management

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Introduction
Effective corporate governance is essential for the banking sector and the
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economy as a whole to function properly. Banks play an important role in the economy
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by channelling funds from savers and depositors into activities that support business
and drive economic growth.

Banks’ safety and soundness are critical to financial stability, and how they conduct
their business is therefore critical to economic health. Governance flaws at banks that
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play a significant role in the financial system can cause problems to spread throughout
the banking sector and the economy as a whole.

The primary goal of corporate governance should be to safeguard stakeholders’

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interests in accordance with public interest on a long-term basis. Shareholders’ interests

would be secondary to depositors’ interests among stakeholders, particularly in retail
banks.
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Corporate governance governs how a bank’s board and senior management carry
out its business and affairs, including how they:

◌◌ Set the bank’s strategy and objectives

◌◌ Select and oversee personnel
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◌◌ Operate the bank’s business on a day-to-day basis

◌◌ Protect depositors’ interests, meet shareholder obligations, and take into
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account the interests of other recognised stakeholders

3.1 Credit Recommendation

A credit review, also known as account monitoring or an account review inquiry, is
a periodic evaluation of an individual’s or business’ credit profile. Credit reviews may be
(c

conducted by creditors such as banks, financial institutions, credit bureaus, settlement

companies, and credit counsellors. To be eligible for a loan or to pay for goods and

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 Principles and Practices of Banking 173

services over an extended period of time, businesses and individuals must undergo a
Notes

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credit review.

3.1.1 Tandon Committee

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In 1974, a study group was formed under the chairmanship of Mr. P. L. Tandon
to develop guidelines for commercial banks for the follow-up and supervision of bank

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credit in order to ensure proper end-use of funds. The Tandon Committee Report on
Working Capital was the name given to the group’s report, which was submitted in
August 1975. Its main recommendations concern inventory and receivables standards,

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lending approaches, credit styles, follow-ups, and information systems.

It was a watershed moment in India’s banking history. With the Reserve Bank of
India’s acceptance of major recommendations, a new era of lending in India began.

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Recommendations of the Tandon Committee
The committee encouraged banks to shift away from traditional methods of
security-oriented lending and toward need-based lending. The committee stated that a

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well-functioning business enterprise, not collateral, is the best security for a bank loan.

The Tandon committee made the following major recommendations:

●● r
A rational assessment of the borrower’s need-based credit based on their
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business plans.
●● Bank credit would only supplement the borrower’s resources rather than replace
them, i.e. banks would not finance 100% of the borrower’s working capital
requirement.
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●● The bank should ensure proper end use of bank credit by closely monitoring the
borrower’s business and imposing financial discipline on them.
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●● Borrowers would be able to obtain working capital finance based on industry-

specific norms (prescribed first by the Tandon Committee and then by the Reserve
Bank of India) for holding various current assets, such as raw materials, stores,
and other items used in the manufacturing process.
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o In-Process Stock.
o Completed goods
o Receivables (accounts receivable).
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●● Credit would be made available to borrowers in various components such as

cash credit, bills purchased and discounted working capital, term loan, and so on,
depending on the nature of the holding of various current assets.
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●● In order to facilitate a close watch under operation of borrowers, banks would

require them to submit data regarding their business and financial operations, for
both the past and future periods, at regular intervals.
Initially, the Norms Tandon committee proposed norms for holding various current
(c

assets for fifteen different industries. Many of these standards were revised, and the
few that remained were expanded to cover nearly all of the country’s major industries.

The following are the rules for holding various current assets:
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 174 Principles and Practices of Banking

●● Raw materials for a certain number of months’ consumption. They include stores
Notes

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and other items used in the manufacturing process.
●● Stock-in-process, which represents the cost of production over a number of

in
months.
●● Finished goods and accounts receivable as a number of months’ cost of sales and
sales. These figures only represent average levels. Individual items of finished

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goods and receivables may exceed the indicated norms for different periods as
long as the overall average level of finished goods and receivables does not
exceed the amounts determined by the norm.

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●● Spare parts inventory was not included in the standards. In terms of money,
these were thought to be a minor portion of total operating expenses. Banks were
expected to evaluate the need for spares on a case-by-case basis. They should,
however, keep a close eye on spares if they exceed 5% of total inventories.

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●● The norms were based on the average level of holding of a specific current
asset, rather than on individual items within a group. For example, if an industry’s
receivables holding norm was two months and a unit met this norm by dividing

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annual sales by average receivables, the unit would not be asked to delete some
of the accounts receivable that had been held for more than two months.

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The Tandon committee, in establishing the rules for holding various current assets,
made it abundantly clear that it was opposed to rigidity and straightjacketing. On the
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one hand, the committee stated that norms should be regarded as the outer limits for
holding various current assets, but they should not be regarded as entitlements to
hold current assets up to this level. If a borrower has previously managed with less, he
should continue to do so. The committee, on the other hand, believed that some leeway
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should be allowed in cases where the need for re-examination was justified.

The committee anticipated that there might be deviations from norms in the
following situations.
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●● Raw material receipts, including imports, are grouped together.

●● Production halts due to power outages, strikes, or other unavoidable
circumstances.
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●● Delays or bottlenecks in transportation.

●● Stockpiling of finished goods due to a lack of shipping space for exports or other
sales disruptions.
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●● Stockpiling of finished goods, such as machinery, due to the failure of the

purchaser for whom these were specifically designed and manufactured.
●● The need to cover the entire or a substantial portion of the raw material
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requirement for a specific export contract with a short duration.

While allowing the above exceptions, the committee noted that the deviations
should be for known and specific circumstances and situations, and should only be
allowed for a limited period to tide over a borrowing unit’s temporary difficulty. When
(c

conditions return to normal, returns to norms would be automatic.

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 Principles and Practices of Banking 175

3.1.2 Chore Committee

Notes

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In March 1979, the Reserve Bank of India appointed another committee, chaired by
Shri K.B. Chore, to review the workings of the cash credit system in recent years, with

in
particular reference to the gap between sanctioned limits and the extent to which they
were used, and to suggest alternative types of credit facilities that would ensure greater
credit discipline. The Committee’s key recommendations are as follows:

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●● All borrowers with working capital credit limits of Rs. 50 lacs and above must
provide quarterly statements in the prescribed format to the banks.
●● Banks should conduct a periodic review of limits of Rs. 10 lacs and higher.

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●● Banks must not divide cash credit accounts into demand loan and cash credit
components.
●● If a borrower fails to submit quarterly returns on time, banks may charge 1% penal

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interest on the total amount outstanding for the period of default. • Banks should
discourage the issuance of temporary limits by charging 1% interest above the
normal rate on these limits.

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●● Wherever possible, banks should set separate credit limits for peak and non-peak
periods.
●●
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Banks should take steps to convert cash credit limits into bill limits for the purpose
of financing sales.
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Characteristics of the Chore Committee: The following were the characteristics of
the RBI guidelines issued in December 1980:

(a) Accounts’ Annual Revenue: Given that the cash credit system cannot be
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completely replaced by another lending system, the RBI saw the need to
streamline the system with regular periodical reviews of limits in order to verify
the continued viability of borrowers and assess the need-based character of
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their limits.
All scheduled banks are required to review borrowers’ accounts with working
capital limits of Rs. 10 lakhs or more at least once a year. If the borrower’s
limit exceeds Rs. 50 lakhs, he must submit a quarterly statement for this
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purpose.
(b) Account Bifurcation: The RBI revoked previous directives issued to scheduled
banks requiring them to divide cash credit accounts into demand loan and
cash credit components and charge differential interest rates. If the accounts
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have already been divided, the differential rates are to be eliminated with
immediate effect.
)A

3.1.3 Nayak Committee

The Reserve Bank of India (RBI) established the P J Nayak Committee, officially
known as the Committee to Review Governance of Boards of Banks in India, to review
the governance of Indian bank boards. The Committee was formed in January of 2014.
(c

P J Nayak, the former CEO and Chairman of Axis Bank, presided over the Committee.

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 176 Principles and Practices of Banking

P J Nayak Committee Goals

Notes

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●● To review the regulatory compliance requirements of the country’s bank boards in
order to determine what can be rationalised and where requirements need to be

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strengthened.
●● To investigate the operations of bank boards, including whether adequate time is
allotted to strategy issues, governance, growth, and risk management.

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●● Examine the RBI’s regulatory guidelines for bank ownership, ownership
concentration, and board concentration.

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●● Investigate the board’s compensation.
●● Investigate possible conflicts of interest in board representation, as well as the
representation on the boards of banks.

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●● Research any other issues concerning the operation and governance of bank
boards.

Purpose of forming the P J Nayak Committee

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●● The government owns more than half of the shares in nationalised banks,
giving it majority voting rights. As a result, the government can intervene in the
boards of such banks and appoint ineffective people to them. That is, members’
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appointments may not always be based on merit. This will result in overall
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efficiency as well as scams like the Syndicate Bank scam.

Recommendations of the PJ Nayak Committee

●● Repeal the Bank Nationalisation Acts of 1970 and 1980, as well as the SBI Act and
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SBI Subsidiaries Act. This is due to the fact that these acts require the government
to own more than 50% of the banks.
●● Following the repeal of the aforementioned acts, the government should establish
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a Bank Investment Company (BIC) as a holding company or core investment

company.
●● The government will transfer its ownership of the banks to this BIC. As a result,
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the BIC would become the parent holding company for all of these national banks,
which would then become subsidiaries of the BIC. As a result, all PSBs (public
sector banks) would be reclassified as ‘limited’ banks. BIC will be self-governing,
with the authority to appoint the Board of Directors and make other policy
decisions. To perform the functions of the BIC until the BIC is formed, a temporary
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body called the Bank Boards Bureau (BBB) will be formed. BBB will be dissolved
once BIC is formed. The BBB will provide advice on board appointments, as well
as the chairman and other executive directors of banks.
)A

3.2 Principles of Lending

Banks and financial institutions across the country are required to follow certain
rules and adhere to a few lending principles. The Reserve Bank of India has drafted a
(c

memo for the implementation of bank lending principles across the country.

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 Principles and Practices of Banking 177

3.2.1 Introduction
Notes

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The Reserve Bank of India outlined the Fair Practices Code for Lenders.

●● According to the principles of bank lending, banks must provide a timeline within

in
which loans of up to Rs. 2 lakh will be disposed of, as well as acknowledgement
for the receipt of loan applications. Not only that, but they must also provide an
appropriate reason in writing if a loan application for up to Rs. 2 lakh is rejected.

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●● Lenders must conduct a proper credit assessment on the borrower. They must
exercise due diligence.

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●● The lender must communicate credit limits, terms, and conditions to the borrower
and obtain written approval from the borrower.
●● The rules require lenders to deposit loan proceeds into their loan accounts on a
timely basis. The borrower must be informed of all terms and conditions, changes

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(if any), interest rates, and so on.
●● The lender should not engage in any type of discrimination based on gender,
caste, or religion.

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●● Lenders should not resort to undue harassment to recover loans, such as
bothering borrowers at odd hours, using muscle power to recover loans, and so
on.
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These are the basic lending principles that banks must adhere to when engaging in
loan-related activities.

Lending principles followed by banks are as follows:

1. Liquidity: Liquidity is an important principle in bank lending. Banks only lend for short
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periods of time because they are lending public money that depositors can withdraw
at any time. As a result, they make loans on the security of such assets that are
easily marketable and convertible into cash at short notice.
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In its investment portfolio, a bank selects securities that have sufficient liquidity. It is
critical because, if the bank requires cash to meet the urgent needs of its customers,
it must be able to sell some of the securities on very short notice without significantly
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affecting their market prices. Certain securities, such as central, state, and local
government bonds, can be easily sold without affecting their market prices.
This category also includes the shares and debentures of large industrial corporations.
Ordinary firms’ shares and debentures, on the other hand, are not easily marketable
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without lowering their market prices. As a result, banks should invest in government
securities, as well as shares and debentures of reputable industrial firms.
2. Security: The safety of funds Another principle of lending is lent. Safety implies that
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the borrower should be able to repay the loan and interest on time and at regular
intervals without default. The loan’s repayment is determined by the nature of the
security, the borrower’s character, his ability to repay, and his financial situation.
Bank investments, like all other investments, are risky. However, the degree of
risk varies depending on the type of security. Central government securities are
(c

more secure than state and local government securities. And the securities of
state governments and local governments are more secure than those of industrial

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 178 Principles and Practices of Banking

concerns. This is because the central government’s resources are far greater than
Notes

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those of the states and local governments, and the latter are far greater than those
of industrial concerns.

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Indeed, the shares and debentures of industrial concerns are linked to their
earnings, which can fluctuate with the country’s business activity. When investing in
government securities, the bank should consider the governments’ ability to repay

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their debts. Political stability, peace, and security are required.
Investing in the securities of a government with a large tax revenue and a high
borrowing capacity is a very safe bet. The same is true for the securities of a wealthy

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municipality or local government, as well as the state government of a prosperous
region. As a result, when making investments, the bank should select securities,
shares, and debentures from governments, local governments, and industrial
concerns that adhere to the principle of safety.

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Thus, from the bank’s perspective, the nature of security is the most important
consideration when making a loan. Even so, it must consider the borrower’s
creditworthiness, which is determined by his character, ability to repay, and financial

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situation. Above all, the safety of bank funds is dependent on the technical feasibility
and economic viability of the project for which the loan is advanced.
3. Diversity: A commercial bank’s investment portfolio should be diverse. It should not
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invest its excess funds in a single type of security, but rather in a variety of securities.
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It should select shares and debentures from various industries located throughout
the country. The same principle should be applied to state and local governments.
Diversification seeks to reduce the risk of a bank’s investment portfolio.
The principle of diversity also applies to the granting of loans to various types of
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firms, industries, businesses, and trades. A bank should follow the adage, “Don’t put
all your eggs in one basket.” It should spread its risks by lending to various trades
and industries in various parts of the country.
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4. Stability: Another important principle of a bank’s investment policy should be to

invest in stocks and securities with high price stability. The bank cannot afford any
loss in the value of its securities. As a result, it should invest its funds in the stocks of
reputable companies where the possibility of a price decline is remote.
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Interest rates on government bonds and corporate debentures are fixed. Their value
fluctuates in response to changes in the market interest rate. However, the bank is
forced to liquidate a portion of them in order to meet its cash-in-hand requirements
during the financial crisis. Otherwise, they run to their full term of 10 years or more,
m

and changes in the market rate of interest have little effect on them. As a result, bank
investments in debentures and bonds are more stable than investments in company
stock.
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Profitability is the guiding principle for a bank’s investment decisions. It must make a
profit. As a result, it should invest in such securities that ensure a fair and consistent
return on investment. The earning capacity of securities and shares is determined by
the interest rate, dividend rate, and tax benefits.
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The majority of government securities issued by the federal, state, and local
governments are exempt from taxation. The bank should invest more in such

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 Principles and Practices of Banking 179

securities rather than shares of new companies, which are also tax-exempt. This is
Notes

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due to the fact that stock in new companies is not a safe investment.

3.2.2 Working Capital and Term Loans

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Banks and other financial institutions now provide a diverse range of loan products
from which customers can choose. You name it, they have it: personal loans, business

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loans, professional loans, education loans, loan against property, and so on. These
offerings are further customised to meet the needs of individual customers.

And when it comes to business, the need for finance is unavoidable. Many small

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and medium-sized enterprises (SMEs) frequently require ready funds to conduct or
expand their operations. There are several options available to them, the most popular
of which are term loans and working capital loans.

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Difference between Term Loans and Working Capital Loans
Term loans and working capital loans are products that cater to the funding needs
of enterprises and are a popular option among businesses in need of finance. A term

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loan is one in which funds are made available for a set period of time, typically ranging
from one to ten years (or even more in some cases). A working capital loan is one
that business owners take out to cover any short-term financial needs or sudden cash
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crunch, as well as to help them keep their day-to-day operations running. The money or
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funds used to run daily business operations and associated expenses is referred to as
working capital.

Loans for Working Capital

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Working capital is a critical source of funding for businesses. For them, working
capital is the immediate cash they receive to cover the day-to-day expenses of
the business. Working capital is typically required when a company needs to pay its
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monthly rent, pay its employees’ salaries, or cover some seasonal demands that have
arisen at the last minute. The assistance they receive from external funding sources
allows them to get back on track and continue their work. A working capital loan is one
type of working capital assistance that you can obtain.
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Term Loans
Term loans, as the name implies, are loans that last for a longer period of time,
ranging from one to ten years. These term loans are used when you need funds for
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larger investments, business expansion, or the purchase of new machinery or tools.

These loans typically involve larger sums of money than working capital loans, and as a
result, they are paid off over a longer period of time.
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Distinctions between a Term Loan and a Working Capital Loan

Working capital loans are typically used to meet immediate cash needs or short-
term needs. Term loans are typically used by business owners for long-term needs or
extended periods of time. HDFC Bank provides Term Loans with terms ranging from
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one to five years.

A term loan is typically used for things like business expansion plans, the purchase

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 180 Principles and Practices of Banking

of equipment/machinery, or the renovation of office premises. Working capital loans,

Notes

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on the other hand, are typically used to bridge the gap between cash shortages and
working capital requirements.

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Ease of obtaining a loan: A working capital loan is easier to obtain than a term loan
for those with good credit.

Repayment: Because a working capital loan is a short-term funding option, it has

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a very flexible repayment period/tenure. Term loans, on the other hand, have longer
repayment terms.

Amount: Because term loans are for larger sums, the repayment period is longer.

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Working capital loans are typically smaller in size than term loan limits and are
calculated based on business turnover.

Interest rates: Although working capital loans are easier to obtain, they have higher

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interest rates due to their shorter repayment terms, whereas term loans have lower
interest rates.

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3.2.3 Appraisal Techniques
You may have heard the term ‘credit appraisal’ when discussing personal loans or
reading about loans in general. Credit appraisal is the process of thoroughly evaluating
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a specific loan application or proposal in order to determine the loan applicant’s
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repayment ability. A credit appraisal is performed by a lender primarily to ensure that the
money that the bank lends to its customers is repaid.

Whether an applicant applies as an individual or as a corporate entity, a lender

always conducts a thorough and systematic credit evaluation process. Before making
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a loan to an entity, the credit appraisal process appraises or evaluates management,

market, technical, and financial elements.
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No lender approves or sanctions a loan application without first evaluating it. A

credit appraisal is required by a lender to ensure that the borrower can repay the entire
loan amount on time and without missing any payment deadlines. This is critical for a
bank because it determines the bank’s interest income and capital. Borrower repayment
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behaviour has a direct impact on the bank’s performance.

Before approving a personal loan or any other loan application, both banks and
non-banking financial corporations (NBFCs) use credit appraisal procedures. Each
lender will have their own methods for performing credit appraisals. A lender will use
m

certain norms, rules, and standards to determine a loan applicant’s creditworthiness. If

a borrower has excellent credit, there is a good chance that the bank will approve his or
her loan application. A credit appraisal is performed to reduce the risk of loan default.
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In the context of loans and credit, creditworthiness broadly refers to a person’s

financial character. When a person applies for a loan, the lender will look at this
financial character to see how the applicant handles debt.

The lender will run a credit check on the borrower. This will include examining
(c

his or her repayment behaviour, the time it takes to pay different equated monthly
instalments (EMIs), how a borrower has handled his or her various debt obligations,
and so on.

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 Principles and Practices of Banking 181

Credit Rating
Notes

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A credit analysis must be performed to determine a borrower’s creditworthiness.
A lender will evaluate a borrower’s credit score in addition to his or her credit history.

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A credit score is a numerical value assigned to a borrower based on his or her credit
history. Credit bureaus provide this score by evaluating a person’s full repayment
behaviour and assigning a score. It will be based on credit bureaus’ credit reports. As

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a result, if a person wishes to apply for a personal loan, a car loan, or any other type of
loan, he or she should ensure that their credit score is good. In India, a loan applicant’s
credit score should ideally be 750 or higher.

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In India, CIBIL is the leading credit bureau in charge of monitoring your credit
behaviour and preparing a credit report that includes information about your credit
score. You can get an idea of your credit history by looking at your CIBIL report.

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Factors Considered During the Credit Appraisal Process
The following important factors are typically checked and evaluated during a
lender’s credit appraisal process:

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◌◌ Income
◌◌ Age
◌◌ Repayment ability r
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◌◌ Work experience
◌◌ Current and previous loans
◌◌ Employment nature
◌◌ Other monthly expenses
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◌◌ Future liabilities
◌◌ Previous loan records
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◌◌ Tax history
◌◌ Financing pattern
◌◌ Assets owned
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How Does a Lender Determine a Borrower’s Eligibility Using Credit Appraisal?

A lender will typically compare your loan amount, income, EMIs, repayment
capacity, and overall expenses to determine whether or not you are eligible for a
personal loan or any other loan. In general, banks and NBFCs look at certain ratios
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to determine loan eligibility. Some of the ratios that can be used in the credit appraisal
process are as follows:

Fixed obligation to income ratio (FOIR): This ratio refers to how one manages his
)A

or her debts and how frequently they are repaid. It is the ratio of a person’s monthly
loan obligations and other expenses to their monthly income. The bank will determine
whether a certain portion of your income is sufficient to cover your EMIs for the loan you
have applied for as well as your other liabilities. If the ratio is higher than the lender’s
predetermined threshold, the application may be denied.
(c

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 182 Principles and Practices of Banking

Installment to income ratio (IIR): This ratio compares your loan’s equated monthly
Notes

e
instalments (EMIs) to your monthly income. It will show you how much money you will
need to take out of your paycheck to pay your personal loan EMI.

in
Ratio of loan to cost: This ratio indicates the maximum amount that a specific
borrower is permitted to borrow. This will be determined by the cost of the car if you
take out a car loan and the cost of the house if you take out a home loan. The amount

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of a personal loan will be determined by your individual needs. Typically, the ratio will be
between 70 and 90 percent of the cost of the car or house.

Credit Appraisal for Organizational Project Financing

O
If a company approaches a lender for project financing or a loan, the lender must
consider the financial, technical, commercial, market, and managerial aspects of the
organisation.

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To evaluate financial aspects under credit appraisal, the bank must examine the
organization’s costs, expenses, and estimated revenues in order to determine whether
the company will be able to repay the loan without difficulty.

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To evaluate technical aspects of a company, the bank must first assess the nature
of the business as well as the borrower’s industry or sector. The lender will have to
scrutinise the company’s raw materials, capital, labour, transportation, and sales plans,
among other things. r
ve
To assess the borrower’s market, the bank must consider both demand and supply.
If the demand-supply gap is large, the lender will benefit greatly. This is because it
indicates that the company will have good sales and thus be able to repay the loan
quickly.
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Before making a loan to an organisation, the bank must also evaluate its
managerial aspects. The bank should be aware of the company’s goals, plans, and
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commitment to the project. The lender should observe the organization’s management
style and methods of dealing with subordinates.

During the credit appraisal process, banks will consider both financial and non-
financial factors to determine the borrower’s creditworthiness.
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The intensity of the credit appraisal will be determined by the loan amount and the
loan’s purpose. According to these factors, the appraisal process for both individuals
and entities can be simple or complex.
m

3.3 Credit Monitoring

Credit monitoring is the monitoring of a person’s credit history for any changes or
)A

suspicious activity. A credit monitoring service will display an individual’s credit report
and provide them with new information such as new credit inquiries, accounts, and
so on. The individual can also check to see if the information is genuine. Individuals
can also use credit monitoring to keep an eye on their credit score and track it, giving
them the option to be aware of their credit history before applying for loans and
(c

mortgages. When it comes to delinquency, the monitoring process takes many steps
to ensure negligent loans within the parameters of the credit policy followed. The credit
management section will ensure that the loans are collected.
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 Principles and Practices of Banking 183

3.3.1 Introduction
Notes

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CRISIL’s innovative solutions help many of the world’s systemically important
financial institutions meet the ever-changing challenges of credit risk monitoring.

in
Staying informed, especially when it comes to finances, is truly empowering. Monitoring
your credit report for inconsistencies is not only important, but also required. Credit
monitoring could be the answer to staying on top of your credit history.

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Credit monitoring is the process of staying on top of your credit history by being
notified of any unusual changes or transactions that may have occurred through any
of your accounts. This reduces the possibility of fraud and misuse of confidential

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information by unscrupulous elements, as well as credit card theft. If you have
previously been a victim of cheating, using these services is a wise decision. It is also
a useful tool for keeping track of your credit score if you intend to apply for a Personal
Loan in the future.

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Services for Credit Monitoring
The report received varies depending on the company and what you choose.

si
However, your credit monitoring service can provide you with information such as new
accounts opened in your name, hard inquiries for a loan or other credit products on your
report, name and other changes to your report, and so on.
r
Please keep in mind that credit monitoring services may not be the best option for
ve
everyone.

The following points explain why credit monitoring is necessary:

Assist in comprehending Identity Theft: Identity theft is a serious problem that has a
ni

significant impact on a person’s credit score. This is where credit monitoring comes in,
notifying you of any suspicious activity that could indicate fraud. This, in turn, allows you
to take appropriate action by notifying the appropriate authorities, preventing damage
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and maintaining a healthy credit score.

Aids in the management of your finances: Even a few points in your credit score
can affect your loan eligibility, the interest rates you can obtain, and so on. Credit
monitoring will notify you if your credit score changes. Being alert in time allows you to
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reconsider and correct your spending habits.

Credit should be monitored. Inquiries received on your behalf: Credit monitoring

services enable you to personalise updates and receive information that is most
relevant to you. For example, if you have previously been a victim of theft, you can
m

choose to receive notifications whenever there is a suspicious transaction on your credit

card.
)A

Aids in the Detection of Fraudulent Transactions: If a credit card is stolen or

hacked, the details of any suspicious transactions made with it are also monitored by
these agencies, who then notify the cardholder.

The Advantages of Credit Monitoring

(c

●● Credit monitoring has numerous advantages.

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 184 Principles and Practices of Banking

●● It sends individuals reports if there are any changes in their history, as well as your
Notes

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score and report.
●● The possibility of credit fraud and identity theft is reduced with credit monitoring.

in
●● Individuals receive alerts about important activities such as credit history, credit
inquires, delinquency, public records, and even any other negative information.
Credit Information Bureau India Limited, or CIBIL, is the most important player

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in the finance industry. They were founded in August 2000 and assist many financial
institutions in providing loans to customers as well as managing their businesses. CIBIL
is the country’s credit monitor; they keep records of an individual’s financial transaction

O
history pertaining to loans, credit cards, and so on from the country’s many banks
and lending institutions. With this information, they generate reports pertaining to the
individual’s financial transaction history, known as a Credit Information Report, which
also provides the individual with a score. Because CIBIL has assessed the individual’s

ty
repayment capacity, many banks and financial institutions will be willing to make a loan
of any kind to him or her.

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Credit Monitoring Limitations
Although credit monitoring can assist in detecting signs of potential fraud, it
cannot prevent fraud on its own. Monitoring alone will not protect your data, prevent
r
someone from opening fake accounts, applying for credit in your name, or do much
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else. Aside from credit monitoring services, one should be extremely cautious with
sensitive information such as card numbers, bank account numbers, passwords, mobile
numbers, OTPs, and so on. Never leave your passwords out for others to find, always
use secure two-factor authentication to complete transactions, and be cautious with
ni

your credit cards. In the event of a loss, contact your bank immediately to have the card
hotlisted.

3.4 NPA Management

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NPA Management tool is a banking solution that assists lending institutions in

managing the large documentation and compliance component that comes with
managing NPAs and putting an end to NPA manipulations.
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3.4.1 Introduction
Unresolved NPAs are posing a significant challenge to banks all over the world.
One of the few consequences of rising NPA levels is a deterioration in the banks’ credit
m

rating and credibility. Keeping it under control and recovering delinquent loans has
become one of the most important tasks for sustaining profitability.
)A

Non-performing assets, or NPAs, are like a cancer worm that has been slowly and
steadily destroying India’s banking system. NPAs are bad loans with banks or other
financial institutions that have been overdue for a long time in terms of interest and/or
principal. This period is usually 90 days or longer. Banks, like any other business, must
make a profit, but NPAs eat into that margin.
(c

The Reserve Bank of India (RBI) defines NPA in greater detail. According to the
RBI Master Circular on Non-Performing Assets, “an asset, including a leased asset,

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 Principles and Practices of Banking 185

becomes non-performing when it ceases to generate income for the bank.” A non-
Notes

e
performing asset (NPA) is a loan or advance in which:

●● Interest and/or principal payments remain overdue for more than 90 days in the

in
case of a term loan
●● The account remains ‘out of order’ in the case of an Overdraft/Cash Credit (OD/
CC)

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●● The bill remains overdue for more than 90 days in the case of bills purchased and
discounted

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●● The principal or interest payment remains overdue for two crop seasons for short
term loans,

NPA Varieties

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Substandard NPAs are those that have been overdue for less than or equal to 12
months.

Doubtful NPA: NPAs that have remained in the substandard category for a period

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of 12 months or less.

Loss Assets: This occurs when an NPA has been identified as a loss by the bank,

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an internal or external auditor, or during an inspection by the Reserve Bank of India
(RBI), but the loan has not been completely forgiven.
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Provisioning Guidelines
The RBI has mandated that all banks set aside a certain amount for bad assets,
also known as non-performing assets (NPAs). They differ depending on the NPA
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category as follows:

●● 10% of allowances for the total unpaid amount without making any budget for
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securities or other government guarantee cover.

●● The NPA in the substandard category would have another 10% cover, for a total of
20% on the outstanding amount.
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●● The provisional requirement for unsecured or doubtful NPA is 100%.

Factors that contribute to NPAs

●● Banks lending to individuals, corporations, and other entities that are not
creditworthy and pose high risks.
m

●● Banks are not reducing their losses by understanding their bank’s sufficiency on
capital and loan loss reserves at any given time
)A

●● Company promoters are redirecting their funds elsewhere

●● Banks are attempting to fund non-viable projects.
Public Sector Banks began to experience acute capital shortages and losses in
the early 1990s. The targets set for their operations did not reflect the greatest need
(c

for these corporate goals; the banks had very little autonomy in pricing their products,
offering products to preferred sectors, or spending money for their own profits. For
example, due to political pressure, banks were forced to lend to a priority sector, namely

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 186 Principles and Practices of Banking

agriculture; inadequate means for commercial banks to collect and distribute credit
Notes

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information.

Efficient recovery from evasive and overdue borrowers was hampered by flaws in

in
the existing debt recovery process, ineffective legal provisions on and bankruptcy, and
issues with foreclosure and the execution of court orders.

●● It reduces the bank’s profits

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●● It has an impact on the bank’s capital adequacy.
●● As a result, banks become averse to making loans and take zero percent risk. As

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a result, no new credit is created.
●● Banks begin to focus on credit risk management rather than making the bank
more profitable

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●● Funds become more expensive as a result of NPA.

NPA’s Current Situation

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1) The RBI anticipates that bank asset values will decline by September 2020.
2) According to the RBI’s Financial Stability Report, the gross NPA ratio for commercial
banks could worsen to 9.9 percent by September 2020, up from 9.3 percent in the
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first half of the fiscal year.
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3) Furthermore, gross non-performing assets (NPAs) for public sector banks may rise
to 13.2 percent by September 2020, up from 12.7 percent in September 2019.
4) Given the current COVID-19 pandemic, the latest projections would be even worse,
as the Indian economy, like the global economy, would experience a slowdown.
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Corrective Action Plan to Stop Rising NPAs

Banks must anticipate nonpayment and report it to the Central Repository of
U

Information on Large Credits as soon as possible (CRILC).

Before a loan account becomes an NPA, Non-Banking Finance Companies

(NBFCs) must identify emerging stress in the account by establishing a sub-asset
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category called ‘Special Mention Accounts’ (SMA).

Preventive Actions
●● Considering a person’s or corporation’s Credit Information Bureau (India) Limited
m

(CIBIL) score before lending.

●● Make a compromise or use a variety of settlement options.
●● Use alternative dispute resolution mechanisms, such as Lok Adalats and Debt
)A

Recovery Tribunals, to settle debts more quickly.

●● Actively disseminate information about defaulters.
●● Strict action must be taken against large NPAs.
(c

●● Employ an Asset Reconstruction Company.

●● Legal reforms, such as the Insolvency and Bankruptcy Code, have already taken
place.
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 Principles and Practices of Banking 187

●● Restructuring of Corporate Debt (CDR).

Notes

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●● Develop guidelines for wilful defaults and fund diversion.
●● Special Mention Accounts – Extra Care at the Operating Level

in
RBI’s Most Recent Measures
The main proposals are as follows:

nl
●● A lender’s committee with strict timelines for a resolution plan must be formed as
soon as possible.

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●● Lenders must be given incentives to agree to collectively and quickly plan– if a
resolution plan is already in place, then regulatory treatment must be improved;
if no agreement can be reached, then accelerated provisioning must be
implemented.

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●● Improving the current restructuring process: large-value restructurings must be
evaluated independently, with a focus on viable plans and a fair sharing of losses
(and future potential upside) between promoters and creditors.

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●● Future borrowing from lenders for non-cooperative borrowers must be made more
expensive in resolution.
●●
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Asset sales must be treated more liberally by regulators.
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●● If a loss is fully disclosed, lenders must be permitted to spread their losses on sale
over a two-year period.
●● If takeout financing/refinancing is made available over a longer period of time, it
will not be construed as restructuring.
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●● Leveraged buyouts must be permitted when specialised entities acquire ‘stressed

companies.’
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●● Steps must be taken to improve the operation of Asset Reconstruction Companies.

●● Sector-specific companies and private equity firms must be assisted in playing an
active role in the distressed asset market.
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Formation of a Joint Lenders’ Forum: If an account is reported to the Central

Repository of Information on Large Credits (CRILC) as SMA-2, all lenders should form
a lenders’ committee called the Joint Lenders’ Forum (JLF) under a convener and frame
a joint Corrective Action Plan (CAP) to resolve the stress in the account as soon as
possible. This would also include: Rectification; Restructuring; and Asset Recovery.
m

Scheme of Settlement
Banks are free to design and implement their own policies for loan recovery and
)A

write-offs, as well as incorporate compromise and negotiate settlements with the

approval of their boards. Debts as small as Rs. 1 lakh can now be brought before the
National Company Law Tribunal following the implementation of the Insolvency and
Bankruptcy Code of 2016 (IBC) (NCLT).
(c

Lok Adalats (Local Adalats): They can handle small NPAs up to Rs. 20 lakhs. They
guarantee a quick recovery and also have a cloak of authority. Lok Adalats are not

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 188 Principles and Practices of Banking

harsh, there are no defaulters, and they are a cheaper and easier way of resolving loan
Notes

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disputes.

Under the IBC, the NCLT and the National Company Law Appellate Tribunal

in
(NCALT) have replaced the Board of Industrial and Financial Reconstruction (BIFR) and
the Appellate Authority for Industrial and Financial Reconstruction (AAIFR). This was
done because the BIFR was unable to meet its goal of preventing sick industries. Under

nl
the IBC, not only financial creditors, but also operational creditors, can file a liquidation
application with the NCLT. In addition, the IBC requires that the entire resolution
process, including litigation, be completed within 330 days.

O
NPA sale to other banks: An NPA can only be sold to another bank if it has been an
NPA in the selling bank’s books for more than two years. Furthermore, the NPA must be
held in the purchasing bank for a period of at least 15 months before it can be sold to
other banks. However, it cannot be sold to the bank that sold the NPA in the first place.

ty
3.4.2 DRT/DRAT
A strong banking system is an indicator of a country’s economic development.

si
Banks play an important role in the Indian financial system. The backbone of the
financial sector is an efficient and vibrant banking system. Banks’ primary functions are
to accept public deposits and to lend to underserved sectors. Furthermore, commercial
r
banks and cooperative credit institutions play an important role in the country’s rural
ve
economy.

Commercial banks and other financial institutions can obtain refinancing from
development banks such as NABARD, SIDBI, NHB, and EXIM Bank. As the country’s
central bank, the Reserve Bank of India serves as a regulator, supervisor, and facilitator
ni

of the Indian banking system. In India, banks are classified as follows:

i) Reserve Bank of India [RBI]

U

(ii) Commercial Banks [Scheduled and Non-Scheduled Banks]. [Public Sector

Banks, Private Sector Banks, Foreign Banks, Local Area Banks, Regional
Rural Banks]
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(iii) Development Banks [National Bank for Agriculture and Rural Development
(NABARD), Small Industries Development Bank of India (SIDBI), Export-
Import Bank of India (EXIM Bank), & National Housing Bank (NHB)]
(iv) Co-Operative Banks [Short Term Credit Institutions, Long Term Credit
Institutions
m

Both the government and the RBI have all major powers over banks, including
the authority to open new banks and branches, licence banking companies, manage
)A

banking companies, and form boards of directors. These have the final say on board
director rights as well as bank shareholder rights. The government and the RBI have
authority over CRR and SLR, cash currency management, liquidation, amalgamation
and mergers, advances, monetary and credit policy, and so on. In a nutshell, the
government and the RBI have complete supervision and control over the financial
(c

system.

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 Principles and Practices of Banking 189

The RBI Act of 1935, the Banking Regulation Act of 1949, and the Prevention of
Notes

e
Money Laundering Act of 2002 establish a regulatory framework and compliance
requirements. Other legal statutes governing banking affairs in India include the
Companies Act, 1956, the Negotiable Instruments Act, 1881, the Indian Contract Act,

in
1872, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (DRT
Act), the Securitisation and Resconstruction of Financial Assets and Enforcement
of Security Interest Act, 2002 [SARFAESI Act], the Law of Limitation, Bankers’ Book

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Evidence Act, 1891, the Consumer Protection Act, 1986.

The Government of India established Debts Recovery Tribunals under an Act of

Parliament (Act 51 of 1993) for the expeditious adjudication and recovery of debts owed

O
to banks and financial institutions. When a bank or financial institution needs to recover
a debt from another person, it files an Original Application (OA) with the Tribunal. The
DRTs operate in accordance with the Recovery of Debts Due to Banks and Financial

ty
Institutions Act of 1993 and the Debts Recovery Tribunal (Procedure) Rules of 1993.

The provisions of the Recovery of Debts Due to Banks and Financial Institutions
Act, 1993, do not apply where the amount of debt owed to a bank or financial institution

si
or a consortium of banks or financial institutions is less than ten lakh rupees or such
other amount, not less than one lakh rupees, as the Central Government may specify
by notification. The Court fee payable under Rule 7 of the Debts Recovery Tribunal

r
(Procedure) Rules, 1993 is Rs.12,000/- where the amount of debt due is less than
Rs.10.00 lakhs, Rs.12,000 plus Rs.1000 for each one lakh of debt due or part thereof
ve
in excess of Rs.10.00 lakhs, up to a maximum of Rs.1,50,000/- where the amount of
debt due is greater than Rs.10.00 lakhs. The Court fee for a Review Application is half
of the fee paid for the OA. The filing fee for an Interlocutory Application (IA) is Rs.250.
The filing fee for a Vakalatnama is Rs.5/-. The Court fees are Rs.12,000/- if the amount
ni

appealed against is less than Rs.10 lakhs, Rs.20,000/- if the amount appealed against
is between Rs.10 and Rs.30 lakhs, and Rs.30,000/- if the amount appealed against is
greater than Rs.30 lakhs.
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3.4.3 SARF AESI Act 2002

The SARFAESI Act, also known as the Securitisation and Reconstruction of
ity

Financial Assets and Enforcement of Security Interest Act, was enacted in 2002 with
the intention of enabling banks to recover non-performing assets (NPAs) without the
intervention of a court.

The existing legal framework governing banking laws frequently fails to meet
m

the ever-changing needs of the financial sector. The formation of the SARFAESI Act
compensated for the lack of a strong law. The SARFAESI Act of 2002 has greatly aided
in the recovery of defaulted loans and the reduction of non-performing assets (NPAs) in
banks and other financial institutions.
)A

The Central Government established the Narasimham Committee and the

Andhyarujina Committee to examine the overall reforms in the banking sector and to
determine changes in the current legal system for banks.
(c

These committees proposed new legislation for securitization and empowering

financial institutions to hold securities and sell them in due course without the
intervention of a court, and the recommendations became the SARFAESI Act.

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 190 Principles and Practices of Banking

Sarfaesi Act, 2002, and its application

Notes

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◌◌ The SARFAESI Act authorises Indian banks and financial institutions to sell or
auction the assets/properties of credit defaulters without the intervention of the

in
courts.
◌◌ The SARFAESI Act also establishes a Central Registry of Securitisation Asset
Reconstruction and Security Interest (CERSAI). CERSAI is a completely

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online security interest registry. CERSAI was established to combat frauds in
which multiple loans are obtained from different banks using the same assets
as collateral.

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◌◌ According to the most recent amendment to the Sarfaesi Act, 2002, it is “an
act regulating the securitization and reconstruction of various financial assets
and the enforcement of security interests, as well as providing for a central
database of security interests that are specifically created on the rights of

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property, and for those matters connected with or incidental thereto.”

This SARFAESI Act addresses the following issues:

si
◌◌ The Reserve Bank of India registers and regulates Asset Reconstruction
Companies (ARCs) (RBI).
◌◌ Facilitating the securitization of various financial assets of financial institutions
r
and banks, with or without the benefit of underlying securities.
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◌◌ Promoting the seamless transferability of financial assets through the use of
ARC for acquiring financial assets of financial institutions and banks through
the issuance of bonds or debentures or some other security that acts as a
debenture.
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◌◌ The SARFAESI Act is also in charge of entrusting the Asset Reconstruction

Companies (ARCs) with raising funds by issuing security receipts to a group
of qualified buyers.
U

◌◌ Facilitating the overall reconstruction of several acquired financial assets while

exercising necessary powers for enforcing securities, changing management,
or any other power proposed to be conferred on financial institutions and
banks.
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◌◌ Defining a ‘security interest’ as a type of security that includes mortgages and

changes on immovable properties given in exchange for timely repayment of
any financial assistance provided by any financial institution or bank.
◌◌ The SARFAESI Act allows the borrower’s account to be classified as a non-
m

performing asset in accordance with the various directions given or guidelines

issued by the Reserve Bank of India (RBI) from time to time.
◌◌ The officers authorised would exercise the various rights of a secured
)A

creditor on this specific behalf in accordance with the rules set by the Central
Government of India.
◌◌ The Central Government of India may establish or cause the establishment
of a Central Registry for the purpose of registering transactions relating to
(c

securitization, asset reconstruction, and the creation of a security interest.

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 Principles and Practices of Banking 191

◌◌ An appeal to the relevant Debts Recovery Tribunal against the action of any
Notes

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financial institution or bank, followed by a second appeal to the Appellate
Debts Recovery Tribunal.

in
◌◌ Non-application of various legislation to security interests in agricultural lands,
loans less than Rs. 1 lakh, and cases where the borrower repays 80 percent
of the loan.

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◌◌ The SARFAESI Act paves the way for the proposed legislation to be applied to
financial institutions and banks, as well as giving the Central Government the
authority to extend the legislation’s application to financial companies in the
non-banking sector and other entities.

O
The 2002 SARFAESI Act’s Goals
The following are the primary goals of the Sarfaesi Act of 2002:

ty
●● Quick or efficient recovery of non-performing assets (NPAs) of financial institutions
and banks.
●● Allows financial institutions and banks to auction off residential and commercial

si
properties when a borrower defaults on his or her loan and fails to repay it.

The SARFAESI Act was enacted in 2002.

The SARFAESI Act of 2002 was enacted to: r
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●● Regulate the securitization and reconstruction of financial assets
●● Enforce the security interest for
●● Matters connected with or incidental thereto.
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The SARFAESI Act was extended to the entire country of India. The Sarfaesi act
2002 rules are in effect for amending the four laws listed below:
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●● The 2002 Act on the Reconstruction and Securitization of Financial Assets and the
Enforcement of Security Interests.
●● The collection of debts owed to the Banks and Financial Institutions Act of 1993
(RDDBFI).
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●● The Depositories Act of 1996, as well as any matters related to or incidental to it.
●● The Indian Stamp Act of 1899.
Why is the Sarfaesi Act of 2002 significant?
m

Cooperative banks were initially excluded from the definition of banks to which the
SARFAESI Act applied. A major notification was issued in 2003 to bring cooperative
banks into the class of banks eligible to use the SARFAESI Act. The Indian government
)A

amended this Act in 2013 to include cooperative banks formally under the definition of
banks eligible to use this Act.

Following that, petitions were filed challenging the notification’s authority as well as
Parliament’s power to amend the SARFAESI Act, 2002. The Supreme Court resolved
(c

this particular matter on May 5, 2002, by ruling in favour of the operational cooperative
banks and invoking the SARFAESI Act. This action has greatly aided cooperative banks

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 192 Principles and Practices of Banking

in avoiding excessive delays in recovering bad loans that are involved in civil courts and
Notes

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cooperative tribunals.

With significant deposits from retail investors, the Indian Banking System now has

in
1,544 urban cooperative banks and 96,248 rural cooperative banks. Given their size,
timely recovery of default loans is critical for the smooth operation of cooperative banks.

To summarise, the RBI registers and regulates securitization and reconstruction

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companies in accordance with the Sarfaesi Act 2002. These companies are permitted
to raise funds by issuing security receipts to qualified institutional buyers (QIBs),
allowing banks and Fls to take possession of securities provided for financial assistance

O
and sell or lease them in order to take over management in the event of a default.

3.4.4 Competition Act 2005

ty
According to Articles 38 and 39 of the Indian Constitution, the State shall strive
to promote the welfare of the people by securing and protecting, as effectively as
possible, a social order in which justice – social, economic, and political – shall inform
all institutions of national life, and the State shall, in particular, direct its policy towards

si
securing:

(a) That ownership and control of the community’s material resources are
r
distributed in such a way that
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As a result, for the reasons discussed above, Parliament passed the MRTP Act
first, followed by the Competition Act to promote equitable distribution of wealth and
economic power. The Union Legislature enacted the Competition Act, and there is
no corresponding law at the state/provincial level. The reason for enacting the new
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law is stated in the Statement of the Objects and Reasons to the Competition Act as
follows: “In the pursuit of globalisation, India has responded by opening up its economy,
removing controls, and restoring to liberalisation.”
U

The Competition Act’s goal can be deduced from its preamble, which reads: “An
act to provide, in view of the country’s economic development, for the establishment of
a Commission to prevent practises having an adverse effect on competition, to promote
and sustain competition in markets, to protect the interests of consumers, and to ensure
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freedom of trade carried on by other participants in markets, in India...”

The Competition Act, like most competition laws around the world, is written in
broad strokes and is not limited to regulating commercial acts of private parties.
m

(A) Anticompetitive agreements (section 3 of the Act) are prohibited or regulated

by the Competition Act.
(B) Abuse of a dominant position (under Section 4 of the Act)
)A

(C) Combinations (sections 5 and 6 of the Act).

As a quasi-judicial body, the CCI is bound by the rule of law principles and the
doctrine of precedents when making decisions. According to the Competition Act, the
Commission is duly empowered to receive documents and testimonials as evidence
(c

and is thus well suited to adjudicate disputes before it on the basis of material adduced
by parties and by applying the principles of evidentiary proof set forth in the Evidence

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 Principles and Practices of Banking 193

Act. This is significant because, unlike in the United States, a civil suit for anti-
Notes

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competitive practises cannot be brought. In addition, intent in cartel-like behaviour does
not exempt the case from the CCI’s jurisdiction. Furthermore, the scope of investigation
of the Federal Trade Commission (FTC) and the Department of Justice (DOJ) differ

in
slightly; however, in India, all anticompetitive practises cases can only be investigated
by the CCI.

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Section 27 of the Act specifies the penalties for violations of Sections 3 and 4 of the
Competition Act. The CCI may issue a “cease and desist” order or levy a penalty not to
exceed “10% of the average turnover during the preceding three years” from the date of
order. In cartel cases, CCI may levy a penalty of up to 10% of the total turnover or three

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times the amount of profit derived from the cartel agreement. In cases of ‘contravention
by companies,’ CCI may proceed against and punish any person who was in charge of
the company at the time of the violation, unless that person can show that the violation

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was committed ‘without his knowledge’ or that he exercised ‘all due diligence to prevent
the violation.’

Section 43 A states that if a combination is not notified, the Commission may

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levy a penalty of 1% of the combination’s total assets or turnover. Section 42A of the
Competition Act provides for compensation in the event of a violation of a CCI order.
This section states that a person may apply to the Competition Appellate Tribunal

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for compensation from an enterprise for any loss or damage suffered as a result of
violating the CCI’s directions under sections 27, 28, 32, 33, and 41 of the Competition
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Act.

3.5 Priority Sector Lending

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The Reserve Bank of India decides to allocate funds to predetermined priority

sectors of the economy that may require credit and financial assistance, particularly in
cases where a lack of PSL will result in heavy losses to sector participants in some
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cases. Priority Industries The RBI acts as a lender to banks, urging them to allocate
funds to specific sectors of the economy such as agriculture and related activities,
education, housing, and food for the poorer population.

A PSL initiative’s goal is to provide credit to the most vulnerable members of

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society, as opposed to funding only profitable sectors or spaces that are solely
important to economic growth. All priority sectors can easily access financial assistance,
such as applying for loans that banks are required to make available at a lower interest
rate.
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Agriculture (including microfinancing groups like SHGs, JLGs, individual farmers,

and other institutions dedicated to individuals working in the sector), micro, small and
medium scale enterprises (MSMEs) and SSIs, Educational and Small Scale Industrial
)A

loans, Housing loans, and other micro credit finances are among the priority sectors
under the policy.

When banks exceed their PSL targets and require additional funding to fund priority
sectors, they can only issue PSL certificates (PSLCs) up to the amount banks are
(c

permitted to lend in that sector. These certificates are available for trading on the RBI’s
e-Kuber platform.

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 194 Principles and Practices of Banking

Highlights of Priority Sector Lending (PSL)

Notes

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●● The RBI sought to channel funds for the startup sector in 2020.
●● When first implemented, only public sector banks were required to focus on the

in
development of predetermined priority sectors; however, private and foreign banks
are now required to provide adequate care and credit as well.
●● The trading of PSLCs is similar to the workings of the money market, where

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issuing these certificates will assist banks in raising funds. Surplus banks may be
rewarded in the process, and banks facing a cash shortage may be able to finance
their short-term needs..

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3.5.1 Credit Appraisal Mechanism
You may have heard the term ‘credit appraisal’ when discussing personal loans or

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reading about loans in general. Credit appraisal is the process of thoroughly evaluating
a specific loan application or proposal in order to determine the loan applicant’s
repayment ability. A credit appraisal is performed by a lender primarily to ensure that the
money that the bank lends to its customers is repaid.

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Whether an applicant applies as an individual or as a corporate entity, a lender
always conducts a thorough and systematic credit evaluation process. Before making
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a loan to an entity, the credit appraisal process appraises or evaluates management,
market, technical, and financial elements.
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No lender approves or sanctions a loan application without first evaluating it. A
credit appraisal is required by a lender to ensure that the borrower can repay the entire
loan amount on time and without missing any payment deadlines. This is critical for a
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bank because it determines the bank’s interest income and capital. Borrower repayment
behaviour has a direct impact on the bank’s performance.

Before approving a personal loan or any other loan application, both banks and
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non-banking financial corporations (NBFCs) use credit appraisal procedures. Each

lender will have their own methods for performing credit appraisals. A lender will use
certain norms, rules, and standards to determine a loan applicant’s creditworthiness. If
a borrower has excellent credit, there is a good chance that the bank will approve his or
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her loan application. A credit appraisal is performed to reduce the risk of loan default.

How Does a Lender Determine an Individual Borrower’s Creditworthiness?

In the context of loans and credit, creditworthiness broadly refers to a person’s

m

financial character. When a person applies for a loan, the lender will look at this
financial character to see how the applicant handles debt.

The lender will run a credit check on the borrower. This will include examining
)A

his or her repayment behaviour, the time it takes to pay different equated monthly
instalments (EMIs), how a borrower has handled his or her various debt obligations,
and so on.

What exactly is a credit score?

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A credit analysis must be performed to determine a borrower’s creditworthiness.

A lender will evaluate a borrower’s credit score in addition to his or her credit history.

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 Principles and Practices of Banking 195

A credit score is a numerical value assigned to a borrower based on his or her credit
Notes

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history. Credit bureaus provide this score by evaluating a person’s full repayment
behaviour and assigning a score. It will be based on credit bureaus’ credit reports. As
a result, if a person wishes to apply for a personal loan, a car loan, or any other type of

in
loan, he or she should ensure that their credit score is good. In India, a loan applicant’s
credit score should ideally be 750 or higher.

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In India, CIBIL is the leading credit bureau in charge of monitoring your credit
behaviour and preparing a credit report that includes information about your credit
score. You can get an idea of your credit history by looking at your CIBIL report.

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If you have a high credit score, you can be confident that your loan application
will be approved, as long as you meet the other eligibility criteria set by your lender.
If your credit score is low, you can improve it by taking specific steps. When you take
good steps to improve your credit score, you increase your chances of getting your loan

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approved by the bank. To improve your credit score, you must be extremely financially
disciplined.

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Factors Considered During the Credit Appraisal Process
The following important factors are typically checked and evaluated during a
lender’s credit appraisal process:

◌◌ Income r
ve
◌◌ Age
◌◌ Repayment ability
◌◌ Work experience
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◌◌ Current and previous loans

◌◌ Nature of employment
◌◌ Other monthly expenses
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◌◌ Future liabilities
◌◌ Previous loan records
◌◌ Tax history
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◌◌ Financing pattern
How Does a Lender Determine a Borrower’s Eligibility Using Credit Appraisal?

A lender will typically compare your loan amount, income, EMIs, repayment
m

capacity, and overall expenses to determine whether or not you are eligible for a
personal loan or any other loan. In general, banks and NBFCs look at certain ratios
to determine loan eligibility. Some of the ratios that can be used in the credit appraisal
process are as follows:
)A

FOIR (fixed obligation to income ratio): This ratio refers to how a person manages
his or her debts and how frequently they repay their debts. It is the ratio of a person’s
monthly loan obligations and other expenses to their monthly income. The bank will
determine whether a certain portion of your income is sufficient to cover your EMIs for
(c

the loan you have applied for as well as your other liabilities. If the ratio is higher than
the lender’s predetermined threshold, the application may be denied.

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 196 Principles and Practices of Banking

Instalment to income ratio (IIR): This ratio compares your loan’s equated monthly
Notes

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instalments (EMIs) to your monthly income. It will show you how much money you will
need to take out of your pay check to pay your personal loan EMI.

in
Loan to cost ratio: This ratio indicates the maximum amount that a borrower is
permitted to borrow. This will be determined by the cost of the car if you take out a car
loan and the cost of the house if you take out a home loan. The amount of a personal

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loan will be determined by your individual needs. Typically, the ratio will be between 70
and 90 percent of the cost of the car or house.

Credit Appraisal for Organizational Project Financing

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If a company approaches a lender for project financing or a loan, the lender must
consider the financial, technical, commercial, market, and managerial aspects of the
organisation.

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To evaluate financial aspects under credit appraisal, the bank must examine the
organization’s costs, expenses, and estimated revenues in order to determine whether
the company will be able to repay the loan without difficulty.

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To evaluate technical aspects of a company, the bank must first assess the nature
of the business as well as the borrower’s industry or sector. The lender will have to
scrutinise the company’s raw materials, capital, labour, transportation, and sales plans,
among other things. r
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To assess the borrower’s market, the bank must consider both demand and supply.
If the demand-supply gap is large, the lender will benefit greatly. This is because it
indicates that the company will have good sales and thus be able to repay the loan
quickly.
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Before making a loan to an organisation, the bank must also evaluate its
managerial aspects. The bank should be aware of the company’s goals, plans, and
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commitment to the project. The lender should observe the organization’s management
style and methods of dealing with subordinates.

During the credit appraisal process, banks will consider both financial and non-
financial factors to determine the borrower’s creditworthiness.
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The intensity of the credit appraisal will be determined by the loan amount and the
loan’s purpose. According to these factors, the appraisal process for both individuals
and entities can be simple or complex.
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3.6 Financial Inclusions

Financial inclusion can be defined as the process of ensuring vulnerable groups,
)A

such as weaker sections and low-income groups, have access to financial services
and timely and adequate credit when needed at an affordable cost (The Committee on
Financial Inclusion, Chairman: Dr. C. Rangarajan).

Broadly defined, financial inclusion refers to universal access to a wide range of

(c

financial services at a reasonable cost. These include not only banking products, but
also insurance and equity products (The Committee on Financial Sector Reforms,
Chairman: Dr.Raghuram G. Rajan).

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 Principles and Practices of Banking 197

The goal of financial inclusion is to ensure the availability of financial services such
Notes

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as bank accounts for savings and transactional purposes, low-cost credit for productive,
personal, and other purposes, financial advisory services, insurance facilities (life and
non-life), and so on.

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3.6.1 PMJDY Agriculture

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The Indian government places a special emphasis on financial inclusion of citizens
because it is critical to poverty reduction. The exclusion of a large number of people
from financial services stifles our country’s growth. A financial empowerment scheme

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for citizens was desperately needed so that everyone could reap the benefits of growth
and development.

Globally, India is now regarded as a global agricultural superpower. In fact, 58

percent of the Indian population is employed in farming or agriculture, with 80 percent of

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them being small and marginal farmers.

Globally, India is now regarded as a global agricultural superpower. In fact, 58

percent of the Indian population is employed in farming or agriculture, with 80 percent of

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them being small and marginal farmers.

However, the agriculture sector only accounts for 20% of Indian GDP,
r
demonstrating the lack of financial inclusion of many small and marginal farmers in
the economic side of things. This was the impetus behind the creation of the Pradhan
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Mantri Jan Dhan Yojana, which aimed to assist farmers and other low-income
individuals in seamlessly integrating into the Indian economy. This was also a ploy to
educate and help close the digital divide by training farmers on how to use money or
bank accounts.
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PM Jan Dhan Yojana is being Launched

The Pradhan Mantri Jan Dhan Yojana was launched on August 28, 2014, and
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since then, it has reduced the number of villages in a 5-kilometer radius that do not
have access to bank accounts to just 256. Since its inception, the government has
credited these bank accounts with a total of 146230 crore rupees. It is also deeply
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intertwined with schemes such as the Atal pension scheme, PM Jeevan Jyoti Yojana,
which provides pension to people and assists them in obtaining insurance for an annual
insurance fee of Rs 330. So the pension that must be deposited and the insurance
charge that must be deducted are both deposited and deducted from the same zero
balance account that was created specifically for people with low-income wages, which
m

of course includes many small and marginal farmers.

According to finance professional and industry expert Devshree Shukla,

government schemes such as the Pradhan Mantri Jan Dhan Yojana actually created
)A

a platform for farmers to take initiative and go to banks in order to get their accounts
opened; this also helped them understand and put to use credit facilities such as the
Kisan Credit Card Schemes, which was impossible previously when they didn’t have
any card facility available.
(c

To assist households, the government deposited Rs. 500 per month into Woman
Jan Dhan bank accounts during Covid 19, amounting to a total of 30,945 crores rupees

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 198 Principles and Practices of Banking

in August 2021. Since the inception of this scheme, 43.4 crore bank accounts have
Notes

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been opened across India, with 85 percent of these accounts still active.

The timely deposit of money directly into these accounts created specifically for

in
small and marginal farmers has eliminated a lot of middlemen, ensuring that money
from various schemes is deposited in their account. It has also helped many farmers
get through the difficult period of Covid-19 by ensuring that money from various

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schemes such as the PM Kisan Samman Nidhi, among others, reaches their accounts
directly rather than being lost in transit.

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3.6.2 SMEs
For the first time, the world commemorated UN Micro, Small, and Medium
Enterprises (MSME) Day on June 27th, 2018, to pay tribute to the small businesses that
are the backbone of most economies worldwide, particularly in the developing world.

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The international body identified access to finance as one of the primary barriers to
MSME growth at the time. More than 90 percent of the 200 to 245 million and informal
enterprises that require credit but cannot obtain it are MSMEs. Given that India’s 51

si
million MSMEs face a $400 billion credit shortfall, many of these MSMEs are likely to be
Indian.

The Indian government has worked hard to mobilise credit and funding for this
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critical sector of the country’s economy, but conventional and legacy banks have proven
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inadequate. Today, India’s MSMEs and business owners believe that new-age digital
startups and alternative lending platforms are the most effective institutions for credit
disbursement.
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The difficulty
In the past, India’s MSMEs’ potential was limited due to a lack of access to the
funds needed to fuel their growth. For a variety of reasons, traditional lenders found it
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difficult to direct their funds to this sector. The two most significant reasons for MSMEs’
financial exclusion were a lack of a comprehensive credit score and a lengthy and
difficult loan application process.
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Most micro, small, and medium-sized enterprises (MSMEs) in India were and
continue to be primarily cash-based. In India, legacy lenders use credit ratings to
determine a loan applicant’s creditworthiness, and most MSMEs would be disqualified
due to a lack of extensive transactional history.
m

Even if an MSMEs has a good credit score, getting a loan can be difficult due to
the extensive documentation required, the repeated hassle of visiting bank offices,
filling out forms, dealing with paperwork, and long waiting periods. MSMEs were
a bad customer for most banks to lend to because the transaction size would be
)A

small, and they perceived the risk to be significantly higher for MSMEs than for larger
corporates. With no other options, Indian SMEs were forced to either stagnate or turn to
unscrupulous moneylenders who imposed crippling interest rates.

Alternative Lending Platforms are coming to The Rescue

(c

Nimble new-age startups identified a market gap and developed a technology-

driven solution that has made it easier for India’s MSMEs to access legitimate credit.

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 Principles and Practices of Banking 199

Today, several MSME founders and owners rely on these platforms for credit, with
Notes

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NBFCs accounting for more than 16 percent of MSMEs’ credit.

According to the ICRA, NBFC lending to MSMEs is expected to increase to 22-23

in
percent by March 2022. The amount of credit disbursed to MSMEs in India is increasing
as a result of these startups, despite the fact that public sector banks provided them
with 7% less credit between March 2017 and March 2018.

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These companies have overcome the credit gap by collecting data from other
sources and using cutting-edge AI-driven algorithms to create a credit score for
applicants, rather than relying on bureau and bank account-based credit scores. These

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credit scores are more comprehensive, offer a more detailed perspective, and are likely
to be significantly more accurate than current credit scores. These new-age lenders
have also made extensive use of regulatory developments such as Aadhaar and India
Stack, deploying e-KYC to streamline the application and approval process.

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The Advantages of Financial Inclusion for India’s SMEs
MSMEs having access to credit through these startups is a huge step forward,

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especially in light of how the Indian economy is embracing the e-commerce opportunity.
According to a Morgan Stanley report, India’s e-commerce market is expected to reach
$200 billion by 2026, growing at a rate of 30% per year. This incredible growth can be
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attributed in large part to greater adoption of technology by consumers in India’s tier
2 and tier 3 cities. Furthermore, according to a BCG report, by 2025, these cities will
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account for 45 percent of India’s consumption.

This is a fantastic opportunity for India’s MSMEs to grow and capture larger
portions of the consumer market. However, in order to effectively sell to this new
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customer base, these businesses will require capital to expand capacity, geographical
reach, and make the transition to the world of online commerce.

In its 74th Plenary, the United Nations General Assembly declared June 27th
U

as MSME Day to recognise the importance of MSMEs in achieving sustainable

development goals, promoting innovation, creativity, and sustainable work for all. With
alternate lending platforms in India providing the financial capital required to assist
India’s MSMEs in digitising and preparing for the future, they undoubtedly hold the key
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to the country’s bright economic future.

3.6.3 SHGs
Access to finance for the poor and vulnerable groups is required for poverty
m

reduction and social cohesion. This must become an essential component of our efforts
to promote inclusive growth. In fact, providing vulnerable groups with access to finance
is a form of economic empowerment. Financial inclusion refers to the provision of
)A

financial services at a low cost to large segments of the disadvantaged and low-income
populations.

Savings, credit, insurance, and remittance services are among the various
financial services available. The goal of financial inclusion is to broaden the scope of
(c

the organised financial system’s activities to include people with low incomes. The goal
of graduated credit must be to lift the poor from one level to another, allowing them to
escape poverty.

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 200 Principles and Practices of Banking

To achieve financial inclusion or to reach the unreached, the Reserve Bank of India
Notes

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has taken a number of steps, including:

i) No frill accounts

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ii) Overdraft in savings and bank accounts
iii) Business correspondent and business facilitator model

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iv) KCC/GCC guidelines
v) Liberalised branch expansion
vi) Liberalised ATM policy

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vii) introducing technology products and services
viii) Allowing RRBs/ Cooperative banks to sell insurance

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In rural areas, the Scheduled Tribes have the highest level of poverty (47.4
percent), followed by Scheduled Castes (42.3%), and Other Backward Classes
(OBC) (31.9%), compared to 33.8 percent for all social groups (Planning Commission,
Government of India, 2012). According to the results of an NSSO survey, 51.4 percent

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of farmer households are financially excluded from both formal and informal sources.
Only 27 percent of total farmer households have access to formal sources of credit, and
one-third of this group borrows from other non-formal sources. Approximately 36% of
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Scheduled Tribe (ST) farmer households are in debt, primarily to non-formal sources
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(Rangarajan, C. 2008). One of the Committee’s recommendations to achieve financial
inclusion is to “encourage SHGs in excluded regions.”

The Self Help Group (SHG) movement in India has grown to become the world’s
largest and most successful community-based poverty alleviation and empowerment
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programme. It is primarily a female-led movement. As some experts have noted, it is

a development innovation in and of itself. The SHG bank linkage programme (SBLP),
an India-invented programme, has proven to be one of the most effective community-
U

based microfinance programmes. In 1992-93, the SBLP started small, with 255 credit
linked groups and a loan amount of Rs. 29 lakh. Since then, the programme has grown
at an exponential rate. SHGs emerged as a mass movement across the country and
the world’s largest community-based microfinance model as a result of this process.
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According to NABARD’s microfinance report for March 2012, 79.6 lakh SHGs
have savings accounts in banks, with an estimated membership of 9.7 crores, and
an aggregate bank balance of Rs. 6,551 crores. Over 43.54 lakh SHGs have loan
accounts, with a total loan outstanding of Rs. 36,340 crores; however, regional
m

disparities in the growth of the SHG movement persist, with limited progress in the
eastern and western regions.
)A
(c

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 Principles and Practices of Banking 201

Notes

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Growth of SHG Bank linkage programme in India during the last three years:
According to the data, the number of SHG savings linked to banks increased from
2009-10 to 2011-12. The balance in SHGs’ SB accounts increased in 2010-11 but

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decreased in 2011-12. From 2009-10 to 2011-12, the number of SHGs credit linked with
banks decreased, but the amount of loan disbursed increased. The number of SHGs
with bank loans has decreased year on year, but the amount of loan outstanding has
increased. Furthermore, the amount of gross non-performing assets against SHGs has

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increased over the course of the period.

Number of SHG federations: In India, there are 1,66,742 SHG federations

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(APMAS, 2012) The total number of federations is 1,60,286 (96.1 percent) primary
federations, 6,358 (3.8 percent) secondary federations, and 98 (0.1 percent) tertiary
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federations. The formation of federations between different regions in the country
is growing unevenly, similar to the growth of SHGs in the country. The majority of the
primary and secondary federations are located in the country’s southern and eastern
regions (see table below).
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Credit linkage with banks by improving the quality of SHGs: According to an

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ENABLE network (2012) study, many SHGs are A-rated (42%), followed by B-rated
(36%), and C-rated (3%). (22 percent ). There are numerous issues concerning the
quality of SHGs, including:
)A

1) A limited focus on savings growth and need-based savings products.

2) There are still some SHGs that do not have a fixed meeting date/day and do
not hold regular meetings.
3) Poor bookkeeping quality iv) low incidence of leadership change v) high
(c

reliance on external funds

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 202 Principles and Practices of Banking

4) A lack of lending from internal funds, vii) a large amount of idle funds, and so
Notes

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on.
As a result, many SHGs do not have access to bank credit. Promoting institutions

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and banks should focus on strengthening SHGs because the quality of SHGs is linked
to credit linkage with banks and loan volume.

Financial inclusion as a topic for discussion at SHG/Federation meetings:

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The majority of SHGs have a financial agenda. It is mostly used for savings, loan
disbursement, and repayment. To promote financial literacy among SHG members and
their household members, SHGs should make financial inclusion a mandatory agenda

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item at SHG/federation meetings, which would aid in raising awareness about financial
inclusion among rural households.

Engagement of SHGs and federations in SHG promotion and strengthening: A

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number of SHGs have participated in the implementation of various government welfare
and development programmes and are increasingly addressing various social issues.
With their wealth of experience, many old SHGs and their federations, supported by
NGOs and the government, have formed new SHGs and revived defunct groups. The

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use of ‘Jankars’ and ‘Community Resource Persons’ from community to community
proved to be a cost effective method of scaling up and sustaining the SHG movement.
Older SHGs and SHG federations can play an important role in saturating villages with
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almost all poor households being members of SHGs. As a result, many poor people will
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be drawn into SHGs and will be able to obtain financial services from formal financial
institutions.

SHG bank credit linkages should be prioritised: In the majority of states and union
territories, less than half of SHGs are credit-linked to banks. Approximately 45 percent
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of SHGs do not have active bank loans. The typical loan amount is Rs. 1.44 lakh.
However, the percentage of SHGs credit linked to banks and the average loan amount
vary greatly across states. In states where the SHG programme is poorly implemented
U

and loans are small, promoters and bankers should focus on filling those gaps.

Bulk lending to federations: The majority of SHG federations in India are multi-
purpose federations that offer a variety of services including financial, livelihood,
and social services. Many federations provide financial services such as savings,
ity

loans, insurance, and remittance services, as well as acting as a bank’s business

correspondents and business facilitators. In terms of accessibility, federations are
closer to them than banks; additionally, there are numerous issues with the SHG-BL
programme. Bulk lending to federations is more appropriate in this context for reaching
m

the unreached and providing quality financial services to their member organisations
and members.

Need-based lending to promote livelihoods: According to many research studies,

)A

approximately 80-85 percent of SHGs disburse loans to their members on an equal

basis rather than based on need. Furthermore, banks base loan volume on the number
of linkages rather than credit plans submitted by SHGs. As a result, many people are
unable to apply for bank loans for productive purposes. SHGs, banks, and facilitating
agencies should promote livelihoods through need-based lending, which contributes to
(c

poverty reduction and inclusive growth in the country.

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 Principles and Practices of Banking 203

Skill development and loan utilisation and recovery monitoring: SHGs and
Notes

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federations can play a role in skill development and financial literacy by increasing their
members’ loan absorption capacity; additionally, they can play a monitoring role by
supervising whether their members are using loans for productive purposes or not.

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The loan absorption capacity or loan for income generation activity affects the
repayment rate, which in turn influences future credit access with banks.

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Linkages with line departments and institutions: In order to meet the needs of their
members, SHGs/federations should form alliances with various financial institutions and
service providers. Furthermore, a clear understanding of what a self-help group is, with

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its own mission and functions, is required in government, line departments, banks, and
microfinance institutions.

Adoption of technology by SHGs: To reach the unreached, a technology-based

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multichannel approach is required. Many innovations, such as handheld devices,
mobile phones, cards, and Micro-ATMs, are being implemented on a small scale in the
sector. These initiatives must be expanded to include the necessary infrastructure.

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SHGs and Federations can serve as Business Correspondents and Facilitators:
According to the Reserve Bank of India’s Jan 2006 guidelines, banks are permitted to
use two types of intermediaries to expand their reach: Business Correspondents (BCs)

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and Business Facilitators (BFs). According to the guidelines, while BCs may carry out
transactions on behalf of the bank as agents, BFs may refer clients, pursue the clients’
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proposals, and assist the bank in carrying out its transactions, but cannot transact on
the bank’s behalf.

According to numerous research studies, SHGs have resulted in positive changes

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at the household and village levels, particularly in men’s attitudes toward SHG
members and their activities. If SHG Federations allow them to act as BCs, they will
be successful in social mobilisation, raising awareness among villages about financial
literacy, opening accounts, promoting savings, accessing credit, repayment, recovery,
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and so on.

Another possibility is that SHG and SHG federation transactions are linked with
business correspondents, which has two implications: I it helps BC to sustain financially
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by increasing the volume of business, and ii) it allows SHGs to get quality services at
low cost at their doorstep by minimising costs such as travel expenses, lost time and
wages, improper use of funds, and so on.

Finally, if SHGs, SHG federations, promoters, banks, and other agencies work to
m

improve the quality of SHGs so that they can evolve as member-owned, managed, and
controlled institutions; and provide an environment in which to access quality services
from financial and non-financial agencies, SHGs will significantly contribute to achieving
)A

the goals of financial inclusion and inclusive growth.

3.6.4 SSIs
Small Scale Industries (SSI) are those in which manufacturing, production, and
(c

service delivery are done on a small or micro scale. These industries make a one-time
investment in machinery, plant, and equipment that does not exceed Rs.10 crore and
has an annual turnover of less than Rs.50 crore.

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 204 Principles and Practices of Banking

Previously, the Ministry of Small Scale Industries granted Small Scale Industries
Notes

e
(SSI) registration to industries that manufactured goods and provided services on a
small or micro-scale basis. However, after the government passed the MSME (Micro,
Small, and Medium Enterprises) Act in 2006, the small and micro-scale industries fell

in
under the purview of the MSME Act.

Following an amendment to the Government of India (Allocation of Business)

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Rules, 1961, the Ministries of Small Scale Industries and Agro and Rural Industries
merged on May 9, 2007, to form the Ministry of Micro, Small, and Medium Enterprises.
As a result, the SSIs fall under the purview of the Ministry of MSME.

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SSIs are currently classified as small or micro-scale industries based on the
turnover and investment limits set forth in the MSME Act, and they must obtain MSME
registration. The government currently provides many benefits to small scale industries
that have MSME registration.

ty
Small scale industries are essentially those that manufacture, produce, and provide
services using small machines and less manpower. These businesses must adhere to
the guidelines established by the Government of India.

si
SSIs are the lifeblood of the economy, particularly in developing countries such as
India. Because these industries are generally labor-intensive, they play an important

r
role in job creation. SSIs are an important sector of the economy, both financially and
socially, because they help with per capita income and resource utilisation.
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Small Scale Industries: What They Are and What They Do
A small scale industry is defined as an industrial undertaking in which the
investment in fixed assets in plant and machinery or equipment, whether owned outright
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or leased or hired out, does not exceed 10 crore for a manufacturing enterprise and
5 crore for a service enterprise. However, the investment limit is subject to change as
determined by the government.
U

According to the Micro, Small, and Medium Enterprises Development (MSMED)

Act of 2006, Micro, Small, and Medium Enterprises (MSME) are divided into two
categories:
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1. Manufacturing Enterprises: Entities engaged in the manufacturing or production

of goods pertaining to any industry specified in the first schedule to the Industries
(Development and Regulation) Act 1951, or employing plant and machinery in the
process of value addition to the final product having a distinct name, character, or
m

use. The Manufacturing Enterprise is defined by the amount of money invested in

plant and machinery.
2. Service Enterprises: These are businesses that provide or render services and are
)A

defined by their investment in equipment. Small, medium, and large scale industrial
units are generally classified based on their size, capital invested, and number of
human resources employed.
Different countries have defined small business in different ways; however,
(c

the definition changes over time. Small-scale industries in India, whether in the
manufacturing or service sectors, are classified into five categories:

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 Principles and Practices of Banking 205

1. Manufacturing industries: These units produce goods for direct consumption as well
Notes

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as for processing industries, such as khadi industries, food processing industries,
power looms, and so on.

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2. Ancillary industries: Ancillary industries manufacture parts and components for major
industries.
3. Service industries: Service industries are known for covering all light repairs shops

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that are required to keep mechanical equipment in good working order. These
industries rely entirely on machinery.
4. Feeder industries: These industries manufacture specialised products such as

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electroplating, casting, welding, and so on.
5. Mining or Quarries: These industries meet the demand for various types of stones
and minerals in the Indian and international markets.

ty
Small-scale industries, which produce a wide range of products ranging from
traditional to high-tech, are the second largest employer of human resources after
agriculture. Because it is labor-intensive, SSI plays an important role in the Indian

si
economy by creating jobs in both rural and urban areas. Despite fierce competition from
large industrial houses and inadequate government support, SSIs have played a critical
role in the growth of the Indian economy since independence.

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The following are some of the key roles that small-scale industries play in India.
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1. Creation of employment
2. Distribution of income in an equitable manner
3. Gathering of resources and entrepreneurial ability
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4. Industry dispersion on a regional scale

5. Improving Exports
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6. Promotes the expansion of large industries

7. Improved employer-employee relationships

Small-Scale Industry Performance

ity

Small-scale industries, which produce a wide range of products ranging from

traditional to high-tech, are the second largest employer of human resources after
agriculture. Because it is labor-intensive, SSI plays an important role in the Indian
economy by creating jobs in both rural and urban areas. Despite fierce competition from
m

large industrial houses and inadequate government support, SSIs have played a critical
role in the growth of the Indian economy since independence.

The following are some of the most important roles that small-scale industries play
)A

in India’s economic development.

1. Job creation: The fundamental problem confronting the Indian economy is the
escalating pressure of population on land, which necessitates the creation of massive
employment opportunities. This problem can be solved on a larger scale with the
(c

help of small-scale industries, which are labour intensive in nature and have shown
exceptional growth in the last decade.

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 206 Principles and Practices of Banking

2. Equitable distribution of income: Small-scale industries promote the equitable

Notes

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distribution of wealth and income within societies in economically positive and non-
politically turbulent ways, which is characterised primarily by greater concentration
of income and wealth in the organised sector while leaving the unorganised sector

in
underdeveloped.
3. Gathering of resources and entrepreneurial skill: Small scale industries can assemble

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an adequate amount of savings and entrepreneurial skill from semiurban and rural
areas, which remain unblemished from the clench of large scale industrial sector.
It also helps to improve social welfare in the country by identifying hidden talents
from the weaker section of society and investing intellectual skill in producing or

O
manufacturing commodities. Small-scale industry investment has increased over the
last decade.
4. Regional dispersion of industries: There has been a massive agglomeration of

ty
industries in a few metropolitan cities across India. People in search of work
migrate from semi-urban and rural areas to these developed metropolitan cities in
order to improve their standard of living, which has the negative consequences of
overcrowding, pollution, the formation of slums, and so on. Small scale industries

si
can overcome the Indian economy’s problem by utilising local resources in terms of
raw materials, investment, intellectual skill, and so on, resulting in the dispersion of
industries across the country and promoting balanced regional development.
5.
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Increased exports: Small-scale industries have seen tremendous growth in exports
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over the years. The value of SSI exports increased from 155 crores in 1971-72 to
124417 crores in 2004-05. The SSI units contribute approximately 40% of India’s
total export, assisting India in increasing its foreign exchange reserves and relieving
pressure on the country’s balance of payment.
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Contribution of Financial Institutions to Small-Scale Industries

Several critical inputs are required for the successful setup, maintenance, and
U

progression of any SSI unit, but the most important input is finance, both for investment
in fixed assets and for working capital. It is widely acknowledged that there is a need
for easy access to credit, as well as adequate and timely credit at a reasonable rate
of interest. Financial institutions in India have consistently been the primary source of
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long-term funds for the industrial sector; they offer a diverse range of financial products
and services to support various types of commercial activity.

This financial institution provides financial assistance to the industrial sector,

whether it is small, medium, or large, in order for it to establish and grow. Even
m

industries in backward areas benefit from these institutions, which help to reduce
regional imbalances. Financial institutions are divided into two types based on their
geographical coverage: national level institutions and state level institutions. They
)A

offer long and medium-term loans at reasonable interest rates on a national scale.
These financial institutions subscribe to corporate debenture issues, participate in the
underwriting of public stock offerings, guarantee loans and deferred payments, and so
on.
(c

State-level institutions, on the other hand, are primarily concerned with the
development of medium and small-scale enterprises, but they offer the same type

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 Principles and Practices of Banking 207

of financial assistance as national-level institutions. With the initiative of the union

Notes

e
government, a diverse range of financial institutions has been established at the
national level to cater to the diverse financial needs of entrepreneurs. The following are
some significant financial institutions that play an important role in business enrichment.

in
1. Indian Industrial Development Bank (IDBI)
2. India’s Industrial Finance Corporation Ltd. (IFCI Ltd)

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3. India’s Small Industries Development Bank (SIDBI)
4. The Industrial Investment Bank of India Ltd. (IIBI)

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5. The State Financial Corporation (SFCs)
6. Maharashtra State Financial Corporation is a state-owned financial
corporation in Maharashtra (MSFC)

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7. India’s Export-Import Bank

India’s Industrial Credit and Investment Corporation (ICICI)

si
The commercial banking sector’s greatest potential is in its relationship with Small
and Medium-sized Enterprises, where banks can be very influential through their
lending practises and by providing information with the help of the following schemes,
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Services, and Packages offered by various Financial Funding Agencies.
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Conclusion
The advancement and promotion of SSIs is critical for the development of the
Indian economy in order to achieve an equitable distribution of income and wealth,
economic self-sufficiency, and economic sustainability. To boost the SSI sector so that
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it can take its rightful place in the Indian economy’s growth mechanism, it is critical
to support MSMEs by educating them on how to make the best use of their inherent
capacity to be successful in both human and economic activity.
U

Capital is a critical component of any type of business activity; without adequate

capital, it is difficult to achieve the ultimate goal of the business and its establishment.
Thus, financial institutions play a critical role in rural alliance with the globalised world
ity

by assisting the rural population in the establishment of small businesses through

their various schemes and packages. Financial institutions have made significant
contributions in the last decade by providing finance and expertise services to these
small scale enterprises, but there is still much work to be done for better growth and
prosperity. It should be noted here that financial institutions work on the front lines of
m

society, attempting to diagnose the problems of new potential entrepreneurs.

3.6.5 Microfinancing
)A

Microfinance has played an important role in financial inclusion in India since its
inception, having been created to specifically serve the smaller and more overlooked
segments of society. In layman’s terms, microcredit is a small loan given to self-
employed rural residents to help them live better and improve their living conditions.
(c

Individuals seeking microcredit typically work as vegetable vendors, artisans, farmers,

rickshaw pullers, fishermen, and so on.

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 208 Principles and Practices of Banking

The basic idea behind microcredit is to provide economic inputs to people in rural
Notes

e
areas who want to get out of poverty. The fact that Microfinance Institutions (MFIs)
are one of the fastest growing segments in terms of reaching out to small borrowers
demonstrates the need for credit.

in
Credit to marginal and sub-marginal farmers and other small borrowers

Microfinance in India began with the Self-Help Group-Bank Linkage model, which

nl
was developed in 1992 by the National Bank for Agriculture and Rural Development
(NABARD) to connect the unorganised sector to the formal banking sector. This
industry has evolved over the last two decades and now accounts for more than 25% of

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the total addressable market in 2019.

Microfinance lenders aim to provide easy access to formal credit to customers who
need it the most and are not typically eligible for bank credit, thereby bringing inclusion

ty
to a large portion of the country’s rural and urban populations. The vast majority of
borrowers are women who are just above the poverty line and working to improve their
family’s living conditions.

si
The Economic Importance of Microfinance
Microfinance, which involves the provision of small loans and other financial
services to low-income groups, is a critical economic channel for facilitating financial
r
inclusion and assisting the poor in working their way out of poverty. It is argued that
ve
microfinance can help to achieve national policies aimed at poverty reduction, women’s
empowerment, assisting vulnerable groups, and raising living standards.

Over the last two decades, the journey to financial inclusion has been one of
intense effort and incremental experimentation. However, the quantum leap came with
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the launch of the Pradhan Mantri Jan Dhan Yojana (PMJDY) in 2014, which enabled the
achievement of the goal of providing bank accounts to adult population in almost every
household. Because of the reach of mobile phones and e-KYC (Know your customer),
U

these accounts are now available to those who have been included in the financial
services milieu.

The Reserve Bank of India has made sustained efforts to increase the penetration
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of formal financial services in unbanked areas, while maintaining its policy of ensuring
adequate credit flow to productive sectors of the economy and ensuring the availability
of banking services to all sections of the country’s population.

Until two decades ago, the lack of technology and infrastructure was a major
m

impediment to the expansion of banking services to remote areas of the country, which
included over 600,000 villages. The institutionalisation of the Business Correspondents
(BCs) framework has been a significant step toward improving access to banking
)A

services. For extending financial inclusion in geographically dispersed areas, the

Reserve Bank advocated a combination of “Brick and Mortar” structure and technology.
All of these measures have resulted in a significant increase in the number of banking
outlets in villages.

The establishment of new banking institutions (two new universal banks and ten
(c

small finance banks) has also aided the cause of financial inclusion in the country.
Given the close relationship between financial inclusion and payment systems, the

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 Principles and Practices of Banking 209

Reserve Bank has taken a number of steps, including encouraging the use of mobile
Notes

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banking, pre-paid instruments such as digital and mobile wallets, and so on.

Banks have been working hard for more than a decade to keep the momentum

in
going toward the goal of financial inclusion. Financial inclusion is becoming a priority
for banks, non-bank financial companies (NBFCs), financial technology companies
(FinTechs), and other financial institutions. Small Finance Banks have also been

nl
established to promote financial inclusion among migrant labour workforce, low-income
households, small businesses, and other unorganised sector entities.

When it comes to financial inclusion and microfinance, there are several channels

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available today, including universal banks, small finance banks, micro finance
institutions, BCs, and so on. As a country determined to achieve universal financial
inclusion at an affordable cost, this is a watershed moment, and we must seize it.

ty
The Reserve Bank has taken several innovative measures to facilitate the creation
of a conducive environment and increase the level of penetration of the banking
system to serve the unserved and underserved population in order to achieve the goal
of sustainable and inclusive economic growth. A co-origination model has also been

si
implemented for credit delivery to the priority sector, allowing scheduled commercial
banks (excluding Regional Rural Banks and Small Finance Banks) to co-originate loans
with non-deposit taking systemically important NBFCs. This is expected to increase
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lending to microenterprises, small and marginal farmers, Self Help Groups (SHGs), and
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other organisations.

In order to increase credit to the most vulnerable borrowers, the Reserve Bank
has also informed all Scheduled Commercial Banks (excluding Regional Rural Banks
and Small Finance Banks) that bank credit to registered NBFCs (other than MFIs) for
ni

onlending will be eligible for priority sector classification under respective categories,
subject to certain conditions.

Micro, Small, and Medium Enterprises (MSMEs) are an important part of the
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economy because of their contributions to job creation, innovation, exports, and

inclusive growth. In light of this, the Reserve Bank established a ‘Expert Committee
on Micro, Small and Medium Enterprises’ (Chairman: Shri U. K. Sinha) to identify
ity

causes and propose long-term solutions for the MSME sector’s economic and financial
sustainability. The Committee made a number of recommendations, including changes
to the legislative and institutional framework, access to finance, capacity building, and
new technological interventions for lending to the MSME sector. The recommendations
are currently being considered for implementation.
m

Since 2006, the Reserve Bank has taken a systematic and structured approach to
addressing financial inclusion issues by focusing on both the supply and demand sides.
With the increasing formalisation of financial services, we must now focus our efforts on
)A

the demand side, focusing on enhancing capabilities so that individuals in low-income

groups are able to not only avail the offered services, but also demand preferred
products and services that are suitable to their needs / choices.

MUDRA (Micro Units Development and Refinance Agency) is an example. While

(c

such a large-scale push would have lifted many people out of poverty, there has been
some concern about the rising level of non-performing assets among these borrowers.

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 210 Principles and Practices of Banking

Banks must focus on repayment capacity during the appraisal stage and closely
Notes

e
monitor loans throughout their life cycle.

The microfinance sector’s role and importance in our economy has also been

in
steadily growing. According to the Sa-Dhan Bharat Microfinance Report 2019,
MFIs operate in 29 Indian states, 5 union territories, and 570 districts. MFIs are also
expanding into newer territories in order to reduce concentration risk.

nl
Tailored products for providing credit to those without a credit score,
entrepreneurial and consumption credit, assistance, financial literacy, social event
credits, and insurance (life and nonlife) are all waiting to be tapped in scale and size. A

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few forays have been made, but they have yet to reach their full potential.

Financial inclusion, according to the Reserve Bank, is the “process of ensuring

access to appropriate financial products and services needed by all sections of society

ty
in general, and vulnerable groups such as weaker sections and low income groups
in particular, at an affordable cost in a fair and transparent manner by regulated,
mainstream institutional players.” We developed the National Strategy for Financial
Inclusion (NSFI) 2019-24. It outlines the Vision for making financial services available,

si
accessible, and affordable to all citizens in a secure and transparent manner, in order to
support inclusive and resilient multi stakeholder-led growth.

Microfinance’s Potential r
ve
With a large and growing working population, our country is undergoing a major
demographic shift. A sizable proportion aspires to enter the middle class with the help of
institutional credit. As a result, microfinance can play a significant role in meeting their
needs and achieving their objectives. Low-income people require credit for a variety of
ni

reasons, including emergency loans, consumer loans, business loans, working capital
loans, housing, and so on. In addition to credit, poor households would benefit from a
variety of financial services, such as savings, remittances, loans, micro-insurance, and
U

micro-pensions.

Technology is shaping the future of finance in today’s world. All of the key players
are leveraging technology to provide an efficient end-user experience. Improving the
accessibility of financial platforms through FinTech is critical in the Indian context. As
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a result, designing appropriate financial products that cater to specific needs of the
financially excluded population and provide services such as digital onboarding is
critical to achieving the goal of financial inclusion.

The goal of universal financial inclusion can only be achieved through collaborative
m

efforts between mainstream financial institutions and other players such as MFIs,
Fintech, and others who play complementary roles in championing this cause. As a
result, banks and NBFCs should investigate the possibility of establishing business
)A

collaboration among themselves as well as with FinTech firms, as this could be critical
in accelerating the agenda of financial inclusion through innovation.

In addition to incorporating emerging technology more quickly into their

businesses, microfinance entities may consider collaborating with FinTechs and other
(c

entities that can assist them in mining customer and transaction data, cross-selling
products, introducing new customer-centric products and services, and streamlining
operations. They will also have the opportunity and need to improve the digital literacy

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 Principles and Practices of Banking 211

of their customers, who are often uninformed and unaware, making them vulnerable to
Notes

e
fraud.

The Next Steps

in
Today, we are witnessing an explosion of data in several sectors of our economy
as a result of the growth of the internet and mobile phones. Similarly, in microfinance, a
wealth of formal and informal data is becoming available in the form of digital footprints

nl
left by low-income customers who use e-commerce platforms and the internet. Leading
banks and online lending companies use these digital footprints to lend to individuals as
well as micro and small businesses.

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Artificial intelligence (AI) and machine learning are also becoming more popular in
the Indian banking and financial services industries. It’s interesting to see how leading
e-commerce companies have partnered with banks and NBFCs to provide competitive

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working capital loans to their suppliers. The majority of the suppliers are micro and
small businesses.

The introduction of the Goods and Services Tax (GST), one of the world’s largest

si
and most significant tax reforms, is also contributing significantly to the formalisation of
the informal economy. Individuals engaged in proprietary businesses, micro and small
enterprises, have become more appealing clients for banks and NBFCs as a result of
r
a significantly improved digital footprint, reducing their reliance on informal sources of
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funds. Credit costs for micro and small businesses will also fall significantly as lending
shifts from collateral-based to cash flow-based.

While opening up a new world of possibilities, the use of technology in finance

comes with its own set of risks and challenges for regulators and supervisors.
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Recognizing these risks early and taking action to mitigate the associated
regulatory and supervisory challenges is critical to realising the full potential of these
developments. This necessitates a transparent, technological, and data-driven
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approach. Similarly, unsustainable credit growth, increased interconnectedness, pro-

cyclicality, and financial risks manifested by lower profitability can all lead to systemic
risks. Data confidentiality and consumer protection are also critical issues that must be
addressed.
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To Summarise
To summarise, the microfinance sector is undergoing a slew of changes as a result
of increased competition, rising public expectations, technological advancements, and
m

an evolving regulatory landscape. As a result, the sector is expected to expand beyond

microcredit in order to transform borrowers’ livelihoods. The banking and financial
services industry must continue to pursue the adoption of innovative, futuristic, and
high-impact business models while remaining mindful of technological transformation.
)A

The sector’s focus must be on Digital Microfinance.

Keeping in mind the need to increase transparency, address customer-centric

issues, and protect the interests of low-income customers, microfinance lenders must
prioritise their clients’ interests and fully implement the Code for Responsible Lending
(c

and the Code of Conduct. Resolving consumer complaints quickly and effectively
should be at the top of the priority list for MFIs and Self-Regulatory Organizations
(SROs).
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 212 Principles and Practices of Banking

To reduce concentration risk and serve a broader clientele base, microfinance

Notes

e
institutions must broaden their client outreach. From the standpoint of financial
inclusion, they should also conduct a critical review of their operations to ensure that
some of the regions do not remain underserved.

in
While the microfinance sector has grown quite well in recent quarters, we must be
mindful of the sector’s vulnerability to external developments, technological changes,

nl
event risks, and borrowers’ income inconsistencies. The increased use of technology
would create operational risks, as well as concerns about client data protection that
would need to be addressed.

O
Banks, NBFCs, and financial institutions are well-positioned to innovate in cutting-
edge technologies such as Artificial Intelligence (AI), machine learning, blockchain, and
so on. SIDBI could assist microfinance providers in this process, particularly with regard
to lending to micro and small businesses, in areas such as alternative credit scoring

ty
methods, predicting default probability, and so on.

With rapidly changing technology, SIDBI could also take the lead in hosting an
ecosystem within a well-defined regulatory sandbox to build an infrastructure that

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will reduce turnaround time and provide customer-centric products with robust risk
mitigation. This could also serve as a testing ground for cutting-edge products for micro-
entrepreneurs, as well as a vehicle for providing feedback to regulators.
r
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3.7 New Product and Services
The future of Indian banks appears to be not only exciting but also transformative.
By 2020, India’s banking sector could be the fifth largest in the world, and the
third largest by 2025. In the future, technology will make bank engagement more
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multidimensional, extending the time it takes to develop and expand banking services.
As technology and innovation advance in this day and age, banks are becoming more
advanced in order to provide better quality services to their customers at a faster pace.
U

Internet banking and mobile banking are two of the most prominent examples of
how technology is being used rapidly in the Indian banking sector to make banking
transactions convenient and easily accessible for all customers, even if they are in
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different locations. Indian banks’ innovation does not stop there; it also includes some
new concepts that have emerged, such as multi-channel, ATMs, credit cards, debit
cards, telephone/mobile banking, internet banking, call centres, and so on.

Following all of this innovation reform, the Indian banking sector has been
m

redefined from a mere financial intermediary to a variety of financial services operating

under one roof, much like a financial hypermarket. However, all of this technological
innovation has created intense competition among banks and has redefined the entire
)A

banking system. Banks are looking for new ways to attract and retain customers, as
well as gain a competitive advantage over their competitors.

3.7.1 Credit Cards

Plastic money is also referred to as polymer money. It is a catch-all term for all
(c

types of bank cards, including debit cards, credit cards, and smart cards. Furthermore,
it is one of the best alternatives to cash or currency because it is easy to carry and

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 Principles and Practices of Banking 213

handle, and it serves as the most convenient mode of payment for goods and services.
Notes

e
These cards were introduced in the 1950s and have now become an essential
source of payment, particularly during the demonetisation period in India, as well as
successfully reducing the risk of handling large amounts of cash.

in
Credit cards require cardholders to repay the borrowed funds, plus any applicable
interest, as well as any additional agreed-upon charges, in full by the billing date or over

nl
time. The Chase Sapphire Reserve is an example of a credit card.

In addition to the standard credit line, the credit card issuer may also provide
cardholders with a separate cash line of credit (LOC), which allows them to borrow

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money in the form of cash advances that can be accessed through bank tellers, ATMs,
or credit card convenience checks. When compared to transactions that access the
main credit line, such cash advances typically have different terms, such as no grace
period and higher interest rates. Borrowing limits are typically pre-set by issuers based

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on an individual’s credit rating. The vast majority of businesses allow customers to
make purchases using credit cards, which are still one of the most popular payment
methods for purchasing consumer goods and services today.

si
Credit cards have a higher annual percentage rate (APR) than other types of
consumer loans. Interest charges on any unpaid balances charged to the card are
typically imposed approximately one month after a purchase is made (except in cases
r
where a 0% APR introductory offer is in place for an initial period of time after account
ve
opening), unless previous unpaid balances were carried forward from a previous
month—in which case no grace period is granted for new charges.

Credit card companies are required by law to provide a grace period of at least
21 days before charging interest on purchases. That is why, whenever possible, paying
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off balances before the grace period expires is a good practise. It is also critical to
understand whether your issuer charges interest daily or monthly, as the former results
in higher interest charges for as long as the balance remains unpaid. This is especially
U

important to understand if you want to transfer a credit card balance to a card with a
lower interest rate. Switching from a monthly accrual card to a daily accrual card by
mistake may potentially negate the savings from the lower rate.
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Credit Card Types

Banks, credit unions, and other financial institutions issue the majority of major
credit cards, including Visa, Mastercard, Discover, and American Express. Many
credit cards entice customers with perks such as airline miles, hotel room rentals, gift
m

certificates to major retailers, and cash back on purchases. These credit cards are
commonly referred to as rewards credit cards.

To increase customer loyalty, many national retailers issue branded credit cards
)A

with the store’s name emblazoned on the front. Although qualifying for a store credit
card is typically easier than qualifying for a major credit card, store cards can only be
used to make purchases from the issuing retailer, which may offer cardholders perks
such as special discounts, promotional notices, or special sales. Some large retailers
also provide co-branded major Visa or Mastercard credit cards, which can be used
(c

anywhere, not just in retailer stores.

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 214 Principles and Practices of Banking

Secured credit cards are a type of credit card in which the cardholder pays a
Notes

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security deposit to secure the card. Such cards provide limited lines of credit equal to
the security deposits, which are frequently refunded after cardholders demonstrate
consistent and responsible card usage over time. Individuals with limited or poor credit

in
histories frequently apply for these cards.

A prepaid debit card, like a secured credit card, is a type of secured payment card

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in which the available funds match the money someone already has parked in a bank
account. Unsecured credit cards, on the other hand, do not require security deposits or
collateral. In comparison to secured cards, these cards typically offer higher credit limits
and lower interest rates.

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3.7.2 Personal Loans
Personal loans are unsecured loans in which the bank lends you money based

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on your creditworthiness and there is no need for security for the money borrowed.
Personal loans, on the other hand, have higher interest rates than other types of loans,
such as home loans or education loans, due to the amount of risk involved in lending

si
the money. The majority of banks provide personal loans ranging from Rs.50,000 to
Rs.15 lakh.

Personal Loans are being used by an increasing number of people to cover larger
r
expenses. One of the reasons for the significant increase in the growing popularity of
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Personal Loan is that it is an unsecured loan that does not require collateral and has a
quick processing time. A Personal Loan can be obtained from any bank or non-banking
financial institution of your choice. With the advent of financial institutions’ online
services, you can get the money within 48 hours.
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Advantages of Obtaining a Personal Loan

●● Unlike other types of loans, such as a home loan or a gold loan, which require
U

multiple documents, Personal Loans require only a few and the approval process
is quick.
●● With numerous financial institutions offering Personal Loan online services, the
loan amount is disbursed within a few hours provided the lender is convinced of
ity

your repayment capacity.

●● Another important feature of Personal Loan is that the lenders allow you to
choose your loan tenure. Personal loans typically have terms ranging from one
to five years. As a result, you can choose the loan term based on your repayment
m

capacity. You should choose a shorter loan term to save money on interest and
repay the loan faster.
What applications are there for it?
)A

It can be used for any personal financial need and will not be monitored by the
bank. It can be used to pay for home renovations, wedding expenses, a family vacation,
your child’s education, the latest electronic gadgets or home appliances, unexpected
medical expenses, or any other emergency.
(c

Personal loans can also be used to invest in a business, repair your car, pay for a
down payment on a new house, and so on.

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Criteria for Eligibility

Notes

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Although the general criteria differ from bank to bank, they generally include your
age, occupation, income, ability to repay the loan, and place of residence.

in
To qualify for a personal loan, you must have a steady source of income, whether
you are a salaried employee, a self-employed business owner, or a professional. An
individual’s eligibility is also influenced by his employer, credit history, and other factors.

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Disbursement of Loan Funds
It is usually disbursed within 7 working days of the loan application being submitted

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to the lender. Once approved, you will either receive an account payee cheque/draft for
the loan amount or the funds will be electronically deposited into your savings account.

The Maximum Amount you can Borrow

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The maximum amount you can borrow is determined by your income level,
profession, and the lender’s evaluation of your loan application. In general, lenders
approve loans based on their calculations, so that the EMI does not exceed 40% -

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50% of your monthly income. In addition, lenders consider whether you have any
outstanding debts when calculating the loan amount.

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If you own a business or work for yourself, the lender will base the loan amount on
the profits you earn and record on your profit and loss statement. If you are a salaried
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professional, the lender will calculate the loan amount based on your earnings and
other liabilities.

Maximum Loan Term

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It can range from one to five years, or from twelve to sixty months. Shorter or
longer tenures may be granted on a case-by-case basis, but this is uncommon.
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What factors do banks consider when determining the maximum loan amount?

Although loan sanctioning criteria vary by bank, some key factors determining the
maximum loan amount that can be sanctioned to you include your credit score, current
income level, and liabilities. A high credit score (closer to 900) indicates that you have
ity

properly serviced previous loans and/or credit card dues, leading lenders to believe you
are a safe borrower, resulting in a larger loan amount being sanctioned.

Your current income and liabilities (such as outstanding credit card balances,
unpaid loans, current EMIs, and so on) have a direct impact on your repayment
m

capacity. As a result, if you have a lower income or a large amount of unpaid credit card
bills or outstanding loan EMI, you will be approved for a lower personal loan amount
than those with a higher income or fewer financial liabilities.
)A

Rates
Personal loans have higher interest rates than secured ‘home and car’ loans
because they are unsecured. At the moment, many major banks and non-bank financial
(c

companies (NBFCs) offer such loans at interest rates as low as 11.49 percent. The
rate charged to a borrower, on the other hand, is determined by a number of factors,

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 216 Principles and Practices of Banking

including credit score, income level, loan amount and tenure, previous relationship
Notes

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(savings account, loans, or credit cards) with the lender, and so on.

An Additional fee is Required

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Aside from the interest payable on the principal amount, there is a non-refundable
fee associated with applying for a personal loan. To take care of any paperwork
that needs to be processed as part of the application process, the lender charges

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processing fees, which are typically 1-2 percent of the loan principal. If you have a long-
term relationship with the lender, he may waive this fee.

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Interest rates can be Fixed or Floating
The EMIs for a fixed rate personal loan remain constant. Because it uses the
reducing balance method of calculating interest payout on a personal loan, a floating

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rate means that the EMIs keep decreasing. Floating rates may be changed on a half-
yearly or annual basis under the new Marginal Cost of Funds-based Lending Rate
(MCLR) rules.

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Interest rate Reductions and a flat rate of Interest
As the name implies, in the former, the borrower only pays interest on the

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outstanding loan balance, i.e., the balance that remains outstanding after the principal
repayment has been deducted. The borrower pays interest on the entire loan balance
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throughout the loan term in a flat interest rate scenario. As a result, even though the
borrower makes periodic EMI payments, the interest payable does not decrease.

Personal Loan in Collaboration

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You can apply for a Personal Loan with your spouse or other family members such
as parents or siblings. One of the advantages of applying for a Personal Loan with a co-
borrower is that lenders will take both applicants’ income into account when determining
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the loan amount. This means you’ll be able to apply for a larger loan.

However, you should be aware that if the co-borrower has a poor credit history, the
lender may reject your loan application.
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Personal Loan Application Documents

Although the documentation required varies by lender, the following are some of
the essential documents you must submit with your application form:
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◌◌ Proof of income (pay stubs, bank statements, ITR forms)

◌◌ Proof of residence and identity
◌◌ A certified copy of your diplomas and licence (this is applicable only for self-
)A

employed applicants).

Charges for foreclosure

If you decide to pay off the loan before the end of the term, the lender may
(c

levy foreclosure fees as a penalty. This penalty is typically one to two percent of the
outstanding amount.

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The loan approval procedure

Notes

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The loan sanctioning officer makes the final decision, which is based on the criteria
specified by the bank/financial institution. The entire process can take anywhere from

in
48 hours to two weeks. Once all required documents are submitted and the verification
process is completed, the bank will disburse the loan, if approved, within seven working
days.

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Failure to pay scheduled EMIs
If you fail to make your scheduled EMIs and are unable to make future payments,

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the lender will first attempt to recover the outstanding balance through settlements and
recovery agents. If such attempts fail and your loan account is marked as a default,
the loan will appear as a default on your credit report, lowering your credit score and
making future loan and credit card approvals more difficult.

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Tax advantages
Although personal loans typically have no tax advantages, if you use them for

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home improvements or a down payment, you may be eligible for an I-T deduction under
Section 24. This tax benefit, however, is limited to only the interest and not the principal
amount. In order to claim a deduction, you must also provide proper receipts.

Offer for balance transfer

r
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In some cases, a lender will allow you to transfer the balance (amount still owed)
on your loan from your current lender to a new one. The new lender will pay off the
existing lender’s balance. You will owe the new lender payments plus any remaining
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interest on your loan at the end of the balance transfer process.

A balance transfer allows you to benefit from the lower interest rate offered by the
new lender; however, there may be fees such as a balance transfer fee, prepayment
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charges, and so on.

Credit report and credit score

Because a personal loan is an unsecured loan, your credit history is usually
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important in the approval process. In India, the three credit reporting agencies are
Equifax, Experian, and CIBIL TransUnion.

All three have partnerships with lenders and offer credit rating services to assist
lenders in evaluating prospective borrowers. Experian India provides credit information
m

services in collaboration with Union Bank of India, Sundaram Finance, Punjab National
Bank, Magna Finance, Indian Bank, Axis Bank, and Federal Bank.
)A

Equifax India has partnerships with the State Bank of India, the Union Bank of
India, Religare Finvest Limited, Kotak Mahindra Prime Ltd, and the Bank of Baroda.
Credit Bureau (India) Ltd (CIBIL) is the country’s first credit information company, and it
is a globally recognised credit reporting agency in collaboration with TransUnion.

All three keep detailed records of your credit history, including a repayment history
(c

for all of your credit card bills and any current or previous loans. Before approving your
loan, the prospective lender will double-check your repayment history.

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 218 Principles and Practices of Banking

A higher credit score indicates that you have a good loan track record. As a result,
Notes

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if your credit score is high (more than 750 in the case of CIBIL TransUnion), your
chances of being approved for a loan are greatly increased. Furthermore, by leveraging
your high credit score, you may be able to negotiate benefits such as a lower interest

in
rate, a larger loan amount, a waiver of processing fees, and so on.

Personal loans are classified into several types.

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Personal loans are very common in India. But did you know there are different
kinds of personal loans? Personal loans have grown from a risky business to a settled
space dominated by numerous lenders and borrowers over the last few years. Personal

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loans are available from a variety of financial institutions.

Personal loans accounted for approximately 96 percent of incremental non-food

credit in 2018, according to the Reserve Bank of India (RBI).

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The following are the various types of personal loans available in India:

Wedding Funding: Weddings are a very important occasion in India. They come

si
with a laundry list of costs. We all want this day to be very memorable (for ourselves
and our children), and there is nothing we wouldn’t do to make that happen. As a
result, many lenders have begun to offer personal loans for weddings, which assist us

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in making our special day memorable. Loans can be obtained by prospective brides,
grooms, or family members. The loan amount in this type of personal loan can be
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tailored to the individual’s needs.

Travel Loan: This is designed specifically for people who enjoy going on vacation.
They are known as travel/vacation/holiday loans, and they allow you to travel the world
while paying your bills later with holiday loans. In order to provide foolproof protection,
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this type of personal loan frequently includes travel insurance as an added benefit.

Home Renovation Loan: Taking out home loans to purchase real estate is
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common, but we rarely consider what happens when we need to renovate our homes.
We either postpone it because it is an expensive exercise, or we end up compromising
on several fronts to save money. As a result of identifying this need, home improvement
loans are offered, which assist us in covering repairing costs, purchasing new materials,
ity

laborer’s fees, and so on. This type of personal loan, which assists us in renovating our
home, has the added benefit of increasing the total economic value of the house in the
real estate market.

Pension Loan: Pension loans are available to retired military personnel. As a

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result, the standard eligibility criteria do not apply to this loan. In this type of personal
loan, some banks offer several times the amount of pension the pensioner would have
received in the month prior to submitting the loan application. Pension proof is required,
)A

according to the personal loan eligibility calculator. Pensioners are permitted to borrow
for any purpose, including medical bills or daily living expenses.

Education Loan: This is one of the most common types of personal loans and has
been around for a long time. In most cases, parents take out education loans, and their
children then take over and pay them off. Also known as school fee funding, such a loan
(c

can be used to pay one’s child’s tuition fees or a large academic requirement such as
going abroad.

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 Principles and Practices of Banking 219

Festival Loan: Lenders provide loans for festival celebrations, which can assist one
Notes

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in preparing for the festivities and hosting parties. This is a novel and distinctive type of
personal loan.

in
Appliances or Consumer Durable Loan: A Consumer Durable Loan is available for
the purchase of white goods.

Loans for Computers and Mobile Phones: Lenders provide computer loans as

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well as mobile phone loans for the purchase of computers and laptops. Some lenders
provide loan insurance in addition to the loan.

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3.7.3 Consumer Loans
A consumer loan is a loan given to a consumer to help them finance specific types
of expenses. A consumer loan, in other words, is any type of loan made to a consumer

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by a creditor. The loan can be secured (backed by the borrower’s assets) or unsecured
(not backed by the assets of the borrower).

Consumer Loan Types

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●● Mortgages: Used by consumers to finance the purchase of a home
●● Credit cards: Used by consumers to finance everyday purchases
●● r
Auto loans: Used by consumers to finance the purchase of a vehicle
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●● Student loans: Used by consumers to finance education
Consumer loans serve a variety of functions for qualified borrowers and are critical
in assisting them in financing their lives.
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Consumer Loans: Secured vs. Unsecured

Secured consumer loans are loans that have collateral backing them up (assets
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that are used to cover the loan in the event that the borrower defaults). Secured loans
typically provide the borrower with more funding, a longer repayment period, and a
lower interest rate. The lender’s risk is reduced because the loan is backed by assets.
For example, if the borrower defaults, the lender can take possession of collateralized
ity

assets and liquidate them to repay the outstanding amount.

Unsecured consumer loans are those that do not have collateral backing them
up. Unsecured loans typically provide the borrower with a limited amount of funding,
a shorter repayment period, and a higher interest rate. The lender faces increased
m

risk because the loan is not backed by assets. In the event of a borrower default, for
example, the lender may be unable to recover the outstanding loan amount.
)A

Interest Rates on Consumer Durable Loans

The interest rate on a consumer durable loan may differ between lenders. Some
key factors that may influence the interest rate charged by a lender include the cost of
the item being purchased (i.e. loan amount) as well as the individual applicant’s profile
such as credit score, employment type, desired tenure, and so on.
(c

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 220 Principles and Practices of Banking

Consumer Durable Loan Benefits

Notes

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The following are some key characteristics of a consumer durable loan:

●● Interest Rate: 0% by most lenders

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●● Loan Amount: From Rs. 10,000 to Rs. 15 lakh
●● Up to 100% financing on consumer durable goods

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●● No Cost EMI is available from leading banks and NBFCs
●● Repayment Tenure: From days to 36 months

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●● Loan Type: Both secured and unsecured
●● Simple documentation with quick disbursements
Leading Banks and Non-Banking Financial Companies (NBFCs) that provide

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Consumer Durable Loans

Apply for a Consumer Loan with one of these banks/NBFCs to take advantage of
the above-mentioned benefits.

si
●● SBI: No Cost EMI by most brands with loan amount up to Rs. 1 lakh
●● HDFC Bank: Get 100 percent financing on consumer durable products
●● r
Bajaj Finserv: Get up to 100 percent financing on your purchase at zero or low-
ve
interest rate
●● Tata Capital: 0 percent EMI facility available
●● IDFC First: No Cost EMI with loan amount from Rs. 25,000 to Rs. 5 lakh
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●● Fullerton India: Low EMIs for loans ranging from Rs. 11,000 to Rs. 30,000.

Criteria for Eligibility

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Most lenders (banks and non-bank financial companies) provide consumer durable
loans to both salaried and self-employed individuals. The criteria for a consumer
durable loan may differ depending on the applicant’s profile, repayment history, income,
loan amount, and so on. The following are the eligibility criteria that lenders require for
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consumer durable loans:

Individuals with a Salary:

◌◌ Age: Minimum 21 years and Maximum 65 years
m

◌◌ Minimum Monthly Income: Rs. 15,000

◌◌ Current Organization Experience: Minimum 1 year
)A

Professionals who are self-employed:

◌◌ Minimum Age: 21 years and Maximum Age: 68 years
◌◌ Minimum Income: Rs. 1.5 lakh
◌◌ Employment Stability: At least 2 years in the current business
(c

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 Principles and Practices of Banking 221

Loan Classifications
Notes

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A consumer durable loan is a type of credit that can be used to buy consumer
durable goods such as household appliances, electronic devices, and so on. Installment

in
loans are the most common type of consumer durable loan. This type of personal
loan differs from an EMI conversion using a credit/debit card in that no card is used to
complete the purchase or establish an installment-based payment plan.

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The following are the specifics of an instalment loan and its various subtypes:

Loans on instalments: These are the most common type of consumer durable
loans, and they are repaid in weekly, fortnightly, monthly, or bi-monthly instalments

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on a set schedule. The interest rate on these instalments may be fixed or variable.
Furthermore, security or collateral may or may not be required for these consumer
loans. Based on these distinguishing characteristics, instalment loans can be further

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classified as follows:

Fixed-rate consumer durable loan: The majority of consumer loans made available
to borrowers are fixed-rate loans, similar to the mechanism by which other personal

si
loan interest rates are calculated. As the name implies, the interest rate on these
consumer loans remains constant throughout the loan term.

Variable-rate consumer durable loan: The interest rate charged on the outstanding
r
balance in a variable rate consumer loan varies with changes in market interest rates.
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As a result, your interest payments will vary. However, the interest rate on these loans
is usually limited in terms of how high or low it can be.

Secured consumer durable loans: Secured loans are those that are collateralized
by assets. In India, secured consumer loans are typically secured by hypothecation
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of the item being purchased. Some banks also offer consumer durable loans secured
by other assets such as fixed deposits, RBI bonds, gold jewellery, LIC policies, and so
on. As a result, secured consumer durable loans typically have lower interest rates. If
U

you are unable to repay the loan for any reason, the lender has the right to seize your
collateral to compensate for their loss.

Consumer durable loans with no collateral: The most common are unsecured
consumer durable loans. The borrower is not required to provide anything. Unsecured
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loans may have higher interest rates than secured loans. However, the majority
of banks and financial institutions that provide consumer durable loans do so at
competitive rates comparable to personal loan interest rates. In some cases, such as
during festivals, you may even be eligible for special offers with no or low processing
m

fees and a 0% effective interest rate.

Fees and Surcharges

)A

Aside from interest charges, there may be other fees and charges that apply to a
consumer durable loan. Some of these are covered in greater detail below:

Processing Fees: Processing fees cover the administrative fees/charges

associated with the disbursement of a personal loan. The processing fee typically
(c

ranges between 0% and 6% of the loan amount sanctioned.

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 222 Principles and Practices of Banking

Late Payment Penalties: If you are late with your EMI payments, you must pay
Notes

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these charges (which are usually fixed) in addition to the owed EMI amount.

Cheque Bounce Charges: If you miss an EMI payment because the account linked

in
to the post-dated cheque is either depleted or closed, you must pay a cheque bounce
charge. It is usually a fixed fee of around Rs. 500.

Charges for Foreclosure/Prepayment: Prepayment entails paying an amount

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greater than the EMI amount. When you pay off a loan completely before the end of the
repayment term, this is referred to as foreclosure. This full prepayment usually comes
with some fees known as foreclosure/prepayment charges. These typically range

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between 0% and 6% of the principal amount prepaid, plus applicable taxes.

Factors Influencing the Interest Rate on Consumer Durable Loans

Though some lenders provide consumer durable loans with no interest, others do

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charge interest on these loans. The interest rate charged by a lender varies not only
depending on the financial institution, but also on the individual applicant’s profile. The
following are a few key factors that influence an individual’s interest rate:

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Credit Score: A credit score is a three-digit numeric summary of your credit report/
history that ranges from 300 to 900. A score closer to 900 (such as 750 or higher in the
case of a CIBIL score) makes it easier to obtain a consumer durable loan because it
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indicates higher creditworthiness. It also allows you to obtain it on better terms, such as
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a lower interest rate.

Loan Amount: Higher loan amounts usually result in a higher interest rate for the
applicant. This is due to the fact that larger loan amounts generally result in higher EMI
payouts, which increases the lender’s risk of default.
ni

Loan Tenure: Longer repayment terms are usually associated with higher interest
rates, and vice versa.
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Current Outstanding Debt: A higher rate of interest may be charged on consumer

loans if the applicant has a high level of existing debt, as this is perceived to increase
the lender’s risk of default.
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3.8 Others
In today’s banking environment, financial innovation is critical to a bank’s survival.
The significance of financial innovation is widely acknowledged. Numerous leading
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scholars, such as Miller (1986) and Merton (1992), have emphasised the importance of
products and services in the financial sector. Innovative ideas can be found in a variety
of industries and in a variety of forms.
)A

One of the most visible examples of innovation is product development, which is

widely used by banks nowadays. From the beginning of the financial transformation,
innovations have played a critical role in reducing financial exclusions and improving
the ways people receive banking services.
(c

3.8.1 Nachiket Mor Committee Report

On December 31, 2013, the Committee on Comprehensive Financial Services

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 Principles and Practices of Banking 223

for Small Businesses and Low-Income Households (Chairperson: Dr. Nachiket Mor)
Notes

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submitted its final report. On September 23, 2013, the Reserve Bank of India (RBI)
appointed the Committee to propose measures to achieve financial inclusion and
increased access to financial services. The Committee proposed the following goals for

in
January 1, 2016:

1. Provide an individual, full-service electronic bank account to each Indian resident

nl
over the age of 18
2. Establish widely distributed Electronic Payment Access Points that offer deposit and
withdrawal services at a reasonable cost.

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3. Provide each low-income household with convenient access to formally regulated
providers capable of providing suitable:
(a) Credit products

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(b) Investment and deposit products
(c) Insurance and risk management products at a reasonable price

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4. Provide every customer with the legally protected right to be offered suitable financial
services.

The Committee’s major recommendations are as follows:

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Widespread payment network and universal access to savings: The Committee
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recommended that when registering for an Aadhaar card, every resident receive a
Universal Electronic Bank Account. It suggested that the RBI prohibit banks from
refusing to open accounts and that Aadhaar be made the universal authentication
method. The Committee proposed the establishment of Payments Banks, the primary
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purpose of which will be to provide payments and deposit products to small businesses
and low-income households. These banks will be limited to a maximum balance of Rs
50,000 per customer and must have a minimum entry capital of Rs 50 crore.
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It also proposed the formation of Wholesale Banks, which would lend to

corporations and buy securitized retail and small-business loans. These banks will only
accept deposits of more than Rs 5 crore and will require a minimum of Rs 50 crore in
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entry capital.

Adequate access to affordable formal credit: The Committee proposed a number of

steps to help banks manage their credit exposures more effectively, including allowing
banks to purchase portfolio insurance. All loans, particularly kisan credit cards and
m

general credit cards, should be required to report information to credit bureaus on a

universal basis.

It also suggested that banks price farm loans based on risk and that any waivers
)A

be provided by the government through direct benefit transfer rather than interest
subsidies or loan waivers. The Committee proposed the establishment of a State
Finance Regulatory Commission, into which all state-level financial regulators would be
merged.
(c

It recommended that NonBanking Finance Companies (NBFCs)’ Non-Performing

Asset reporting provisions and other regulations be aligned with those of banks. It
also proposed measures to alleviate NBFC funding constraints, such as relaxation of

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 224 Principles and Practices of Banking

External Commercial Borrowings and equity investment rules. Furthermore, it proposed

Notes

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removing barriers to NBFC conversion into banks by including more sectors in the
Priority Sector Lending (PSL) classification.

in
Priority Sector Lending: The Committee proposed that bank investments in bonds
and equities, as well as the provision of guarantees to PSL beneficiaries, be counted
toward the banks’ PSL targets. It advocated for the removal of the cap on interest rates

nl
on loans at the base rate plus 8% per year. It also suggested that the PSL target be
increased from 40% to 50% of credit provided.

Concerns about customer protection: The Committee proposed that financial

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service providers be required to commit capital to customer protection risk. It proposed
that firms be held accountable for ensuring the suitability of products issued to
customers, and that the RBI develop regulations to that effect. It proposed establishing
a unified Financial Redress Agency (FRA) to handle customer complaints across all

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financial products in collaboration with their respective regulators.

3.8.2 Payment Banks and Small Banks

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In India, we come across various types of banks that have been licenced by
the RBI for a variety of purposes and to serve a variety of customers. Differentiated
banks are financial institutions that cater to a specific demographic group’s needs. To
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accelerate financial inclusion, Finance Minister Arun Jaitley stated in his most recent
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budget speech (July, 2014) that the RBI will establish a framework for licencing
Payments Banks/Small Banks and other differentiated banks.

These community banks, payment banks, and Small Banks are expected to meet
the credit and remittance needs of small businesses, the unorganised sector, low-
ni

income households, farmers, and migrant labourers.

The Reserve Bank of India (RBI) had already issued guidelines for Payments Bank
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licencing. The RBI has received 72 applications for Small Banks and 41 applications
for Payments Banks. (The deadline for submitting an application for a licence was
February 2nd, 2015.)

Telecom companies (such as Bharti – Airtel), large conglomerates (such as Birla

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Group, Reliance Group, and Future Group), mobile wallet providers, pre-paid card firms
such as ITzCash, the Department of Posts (India Post), micro finance companies, non-
banking finance companies (NBFCs), and others are among the applicants. (State Bank
of India, Reliance, and Bharti are collaborating with Kotak Mahindra Bank.)
m

Small-Scale Finance Institutions

Small finance banks are financial institutions that provide financial services to
)A

underserved and unbanked areas of the country. According to the Companies Act of
2013, they are incorporated as a public limited company. Like other commercial banks,
these institutions can engage in all basic banking activities, such as lending and
accepting deposits.

Small finance banks will be established with the goal of increasing financial
(c

inclusion through

(1) savings vehicles

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 Principles and Practices of Banking 225

(2) credit to small businesses, small and marginal farmers, micro and small
Notes

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industries, and other unorganised sector entities through high-tech, low-cost
operations.

in
SFBs were proposed by the NachiketMor committee on financial inclusion. Small
finance banks are unable to make large loans. It is not permitted to float subsidiaries or
trade in high-tech products.

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●● Ujjivan Small Finance Bank
●● Janalakshmi Small Finance Bank

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●● Equitas Small Finance Bank
●● A U Small Finance Bank
●● Capital Small Finance Bank

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●● ESAF Small Finance Bank
●● Utkarsh Small Finance Bank
●● Suryoday Small Finance Bank

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●● Fincare Small Finance Bank
Small finance banks are a type of specialty bank in India. Small finance banks
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are allowed to provide basic banking services like deposit acceptance and lending.
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The goal is to bring financial inclusion to sectors of the economy that are not currently
served by other banks, such as small businesses, small and marginal farmers, micro
and small businesses, and unorganised sector entities.

The RBI’s Small Bank Guidelines

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●● Professionals with a minimum of 10 years of experience in banking, finance, or

microfinance institutions are eligible.
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●● The required minimum capital is Rs 100 crore (minimum paid-up equity capital).
●● A key criterion for licencing such banks will be their local focus and ability to serve
smaller customers.
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●● The bank’s primary mission will be to accept deposits and lend to small farmers,
small businesses, micro and small industries, and unorganised sector entities.
It cannot establish subsidiaries to provide non-banking financial services. After
a five-year stabilisation period and a review, the RBI may broaden the scope of
m

Small Banks’ activities.

●● Normally, the scope of operations would be limited to a few districts (nearby) of
a state. However, it would be permitted to expand its area of operations beyond
)A

contiguous districts in one or more states with reasonable geographical proximity if

necessary.
●● Small banks must adhere to the RBI’s risk management standards and
regulations. They, like any other commercial bank, must meet CRR and SLR
requirements.
(c

●● The maximum loan size and investment limit exposure to individual/group

borrowers/issuers would be limited to 15% of capital funds.

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 226 Principles and Practices of Banking

●● During the first three years, 25% of branches should be in underserved rural
Notes

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areas.
●● Small banks should make 75 percent of their loans to the so-called priority

in
sector, which includes agriculture and small businesses. In addition, banks’ loan
portfolios should include loans and advances of up to Rs.25 lakh to microfinance
businesses.

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●● A strong risk management framework should be implemented, and banks must
adhere to all prudential norms and regulations imposed by the RBI. (These norms
are similar to those that apply to existing commercial banks, such as maintaining

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CRR and SLR, and so on.)

Payments Institution
Payment banks were created to promote financial inclusion by providing “modest

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savings accounts and payments/remittance services to migratory labour workforce,
low-income households, small businesses, other unorganised sector entities, and other
users.” The goal of establishing payments banks is to increase financial inclusion by

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offering:

(1) small savings accounts

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(2) payments/remittance services to migrant workers, low-income families, small
businesses, other unorganised sector entities, and other users.
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Customers will be unable to borrow from them, and their funds will be forced to be
invested in government bonds and bank deposits.

◌◌ Airtel Payments Bank

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◌◌ India Post Payments Bank

◌◌ Fino Payments Bank
◌◌ Jio Payments Bank
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◌◌ Paytm Payments Bank

◌◌ NSDL Payments Bank List of Active Payments Banks in India
The Reserve Bank of India formed a committee led by Dr Nachiket Mor in
ity

September 2013 to investigate ‘Comprehensive financial services for small businesses

and low-income households.’ The committee’s goal was to propose measures to
achieve financial inclusion and increased access to financial services.

In January 2014, the committee submitted its report to the RBI. One of the
m

committee’s key recommendations was to establish specialised banks or “payments

banks” to serve lower income groups and small businesses, so that by January 1, 2016,
every Indian resident would have a global bank account.
)A

These banks can accept restricted deposits, which are currently limited to Rs
200,000 per person but may be increased in the future. These financial institutions are
unable to offer loans or credit cards. This type of bank can handle both current and
savings accounts. ATM and debit cards, as well as online and mobile banking, can be
(c

provided by payment banks.

Why do payments banks exist?

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 Principles and Practices of Banking 227

The primary goal of a payments bank is to provide payment and financial services
Notes

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to small businesses, low-income households, and migrant labour workforce in a secure,
technology-driven environment. The RBI’s goal with payments banks is to increase
financial service penetration in the country’s outlying areas.

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Existing prepaid payment instruments (PPI model) such as Airtel Money pay no
interest on deposits.

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The RBI’s Payments Bank Guidelines
●● Applicants’ eligibility criteria – Prepaid payment instrument issuers, Professionals,

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NBFCs, Telecom companies, Supermarket Chains, Corporates, and so on.
●● Payments Banks would be required to use the word “Payments” in their name to
distinguish themselves from other banks.

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●● The required minimum capital is Rs 100 crore.

What is the scope of the project? –

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◌◌ Payments banks can provide deposits (only current/saving accounts), ATM/
Debit cards, payment and remittance services, and act as a distributor of third-
party products (can cross sell insurance, mutual funds etc.,)
◌◌ r
They would be limited to a maximum balance / deposit of Rs 100,000 per
customer at first. (Depending on performance, the RBI may increase this
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limit.)
◌◌ They are unable to issue credit cards.
◌◌ Payment banks are not permitted to engage in lending activities. They should
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not make any loans.

Is your money safe in a Payments Bank? –

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A Payments bank must invest 75% of its demand deposit balances in Government
Securities (G-Sec) and Treasury Bills. They must adhere to the RBI’s Cash Reserve
Ratio (CRR) and Statutory Liquidity Ratio requirements. A maximum of 25% of its
deposits must be in current and fixed deposits with other scheduled commercial banks.
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Difference Between Small Finance Banks and Payments Bank

Difference Small Finance Bank Payments Bank

Promoter’s Share 40% in the beginning Then, 40% for the first five years from
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over the next 12 years, it can be the date of business start-up.

gradually reduced to 26%.
Capital Required Min Paid Up capital should be Min Paid Up capital should be
)A

100 Cr 100 Cr
Customer Reach Customers are reached through Customers are reached through
the company’s branches. Mobile banks
Demand Deposit Can accept demand deposits as Can accept demand deposit
(c

savings deposits are accepted, like savings deposit only upto

with no set limit. Rs. 2 lakh

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 228 Principles and Practices of Banking

Time Deposit Can accept Time Deposit such Can’t accept Time Deposit such
Notes

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as Fixed Deposit and Recurring as Fixed Deposit and Recurring
Deposit Deposit

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Loan Can offer small loans Cannot offer loan
Credit Card Can issue credit cards Can’t issue credit cards
Branches 25% of branches must be in rural Must have 25% branches in

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areas for the first three years. rural areas

Major differences between Small Finance Banks and Payments Banks

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●● Payments Banks can be promoted by prepaid card issuers, telecom companies,
NBFCs, business correspondents, retail chains, corporates, real estate sector co-
ops, and PSUs.

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●● Individuals with at least ten years of finance experience, NBFCs, community
banks, and other small finance banks promote them.
●● In Payment Banks, the promoters’ share must be 40% for the first five years after

si
the firm’s establishment; however, in Small Finance Banks, the original 40% share
can be gradually reduced to 26% over a 12-year period.
●●
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Payment Banks can only accept demand deposits and hold up to Rs. 2 lakh
per individual, whereas Small Finance Banks can accept all types of deposits,
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including FDs, RDs, Savings, and Current Accounts.
●● Payment Banks can distribute mutual funds, insurance policies, and other low-risk
financial products. Small finance banks must ensure that loans and advances of
less than Rs. 25 lakh constitute at least half of their loan portfolio.
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3.8.3 Business Correspondence

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Business Correspondents are retail agents who represent banks and are in charge
of providing banking services in locations other than a bank branch or ATM. BCs help
banks provide a limited range of banking services at a low cost. As a result, they are
critical in promoting financial inclusion.
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Eligibility for the position of Business Correspondent

The following entities are eligible for appointment as Business Correspondents
(BCS) for banks, according to RBI guidelines:
m

●● NGOs/MFls established under Societies/Trust Acts

●● Societies registered under Mutually Aided Cooperative Societies Acts or State
Cooperative Societies Acts Section 25 companies that are stand-alone entities
)A

or in which NBFCs, banks, telecommunications companies, and other corporate

entities or their holding companies did not have equity stakes in excess of 10%
●● Postal services
●● Ex-servicemen and retired bank employees
(c

●● Retired government workers

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 Principles and Practices of Banking 229

●● Individual proprietors of kirana / medical / fair price shops Operators of individual

Notes

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Public Call Offices (PCOs)
●● Agents for the Government of India’s Small Savings Schemes/Insurance

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Companies Individuals who own gasoline pumps
●● Teachers who have retired
Authorized members of well-managed Self-Help Groups (SHGs) linked to

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banks Non-depositing NBFCs (non-banking finance companies) in the nature of loan
companies with at least 80% of their loan outstanding in financially excluded districts
identified by the Committee on Financial Inclusion.

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The RBI now allows banks to hire any individual, including those running Common
Service Centres (CSCs), as a BC, subject to the banks’ comfort level and their carrying
out appropriate due diligence, as well as instituting additional safeguards as may be

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deemed appropriate to minimise agency risks.

BCs Appointment

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●● They must be a permanent resident of the area where they intend to operate.
They should be well-established, have a good reputation, and have the trust of the
locals.
●● r
BCs’ capacity to invest in POS machines and other equipment. In the case of
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individuals chosen as BCS, the criterion is as follows: A minimum education
qualification of Xth pass is required. Field investigation / RCU to be conducted for
verification of residence and dealings, etc.
●● Check your creditworthiness if you have an account with another bank. Should
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open a bank account (base branch) with an appropriate amount of security

deposit/bank guarantee based on business volume.

BC’s Activities Scope

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BC’s scope of activities includes the following:

●● Raising awareness about savings and other products, as well as providing

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education and advice on money management and debt counselling.

●● Identifying potential customers
●● Collection and preliminary processing of various forms for deposits, including
primary information / data verification
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●● Filling out application forms and account opening forms, including the nomination
clause, and submitting them to the bank.
●● The BC will also complete KYC.
)A

●● Opening of no-frills deposit accounts and other products as technology allows from
time to time.
●● Collection and payment of low-value deposits and withdrawals; minimum: nil;
maximum: Rs. 2000/- per transaction.
(c

●● Receipt and delivery of small value remittances / other payment instruments in

accordance with IDBI Bank’s Fl Plan.

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 230 Principles and Practices of Banking

●● In all such transactions, the BC/his agent will be authorised to accept/deliver

Notes

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cash either at his place of work or at any convenient location, subject to the per-
customer limits (Rs 2000/- in each case).

in
●● For a period of three months, mini account statements and other account
information will be provided.
●● Any other service performed on behalf of the Bank that has been duly authorised

nl
by the appropriate authority.
●● The activities carried out by the Business Correspondents would be in the normal
course of the Bank’s banking business, but would be carried out through and by

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entities located outside of the Bank’s premises.
●● In all such transactions, the BC/his/her agent will be authorised to accept /
deliver cash either at his place of work or at any convenient location, subject to

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the per day / per customer ceilings that have been established. The Business
Correspondents will be assigned to a branch near them (base Branch).
●● Cross-selling of other financial products such as insurance, mutual funds, pension

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plans, and any other third-party product as and when assigned to do so.
●● In the event that BCs have duly appointed sub-agents, BCs are responsible for the
reputational risks involved.
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3.9 Base Rate
The base rate is the minimum interest rate set by the Reserve Bank of India below
which Indian banks are not permitted to lend to their customers. Unless otherwise
mandated by the government, the RBI rule states that no bank may offer loans at
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interest rates lower than the base rate. Base rate, which was introduced in June 2010,
is simply regarded as the standard lending rate offered by commercial banks. It has
been decided to increase transparency and ensure that banks pass along the benefits
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of lower interest rates to borrowers. Loans are priced by multiplying the base rate by a
suitable spread, subject to a credit risk premium.

The base rate was created to replace the flawed benchmark prime lending rate
ity

(BPLR), which was implemented in 2003 to price bank loans based on the actual cost
of funds. The BPLR, on the other hand, was subverted, resulting in an opaque system.
The majority of wholesale credit (loans to corporate customers) was contracted at sub-
BPL rates, accounting for nearly 70% of all bank credit. Banks subsidised corporate
loans under this system by charging high interest rates to retail and small and medium-
m

sized business customers.

The purpose of having a prime lending rate, or the rate that banks charge their best
customers, was defeated by this system. It also caused another issue: bank interest
)A

rates ceased to respond to monetary policy changes introduced by the RBI on a regular
basis.

As a result, the central bank decided in October 2009 to transition all banks to a
new interest rate system that would not only be transparent, but would also transmit
(c

monetary policy signals to the economy. Six months later, in April 2010, the RBI
announced its decision to implement the base rate on July 1, 2010, following a series of

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 Principles and Practices of Banking 231

circulars, discussion groups, and a rigorous consultative process. Banks will no longer
Notes

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be permitted to lend at rates lower than this.

Banks were free to use any method to calculate their base rates under the new

in
rule (the RBI did provide a ‘illustrative’ formula), as long as the RBI found it consistent.
Banks were also directed to publish their base rates on their websites in order to
achieve the goal of making lending rates more transparent. On July 1, all banks in India

nl
announced their base rates. Most public sector banks maintained their base rates at
8%, while most private banks, a few government-owned banks (such as SBI), and
foreign banks maintained their base rates at 7.5%.

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3.9.1 Introduction and Calculations
In recent years, India’s financial sector has undergone numerous reforms. As a
result, banks are given the authority to set their own interest rates as long as they follow

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the RBI’s guidelines. While banks can set and change interest rates, they must also
consider the RBI, which has implemented several interest rate reforms, including the
introduction of concepts such as the Prime Lending Rate Regime and the Benchmark

si
Prime Lending Rate (BPLR), to ensure that interest rates offered by different banks are
similar and competitive. The base rate is one of the most recent reforms implemented
by the RBI.
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The Reserve Bank rationalised the reporting format for scheduled commercial
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banks (SCBs) and introduced a new reporting format with the implementation of the
Base Rate system. As a result, data on SCB lending rates have changed for the quarter
ended September 2010 onwards. First, banks are now advised to report interest rate
ranges for all business contracted, as opposed to the previous system of reporting
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interest rate ranges for only 5% of business contracted at extreme rates on either side.
Second, data on cash credit interest rates have been added.

Base Rate Calculation

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The Reserve Bank of India, the country’s central regulatory body, determines
the base rate. The RBI establishes the base rate in order to provide uniform rates to
all Indian banks, whether they are nationalised or private. The base rate includes all
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aspects of lending rates that are common among different types of borrowers.

A variety of factors are considered when calculating the base rate. These
include, among other things, the cost of deposits, the bank’s administrative costs, the
bank’s profitability in the previous fiscal year, and unallocated overhead costs. While
m

calculating the lender’s base rate, the bank also takes into account some other factors
with predetermined weights. The maximum weight is placed on the cost of deposits
when calculating the new benchmark. However, banks are free to consider the cost of
)A

deposits of various maturities when calculating their base rate.

Factors Influencing the Base Rate

Now that we understand what the base rate is in India and how it is calculated, let
us look at the various factors that influence the base rate. As previously stated, each
(c

bank is free to set its own base rate as long as it adheres to the RBI’s guidelines and
norms. According to RBI guidelines, the base rate must include all elements of lending

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 232 Principles and Practices of Banking

rates that are common to different types of borrowers. While different banks may have
Notes

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different base rates, there are four important components that typically determine the
base rate set by a specific bank.

in
These are some examples:

◌◌ The cost of funds, i.e. the interest rate paid by the bank on deposits
◌◌ Operating expenses

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◌◌ The minimum rate of return.
◌◌ The Cash Reserve Ratio’s Cost

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The base rate offered by two different banks may differ due to any one or more of
the aforementioned factors, with interest rate differentials being the most common.

As the name implies, the base rate is the basic or minimum lending rate set by

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the Reserve Bank of India. No commercial bank is permitted to offer borrowers loans
at a rate lower than the base rate. The RBI implemented this bottom-line-rate system
to improve the clarity and transparency of the lending process in India. The actual loan
pricing is determined by a credit risk premium in addition to the base rate.

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BR is currently used as the benchmark for financial product interest rates in every
Indian bank. The Reserve Bank of India established this standard interest rate system

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and mandated it for all banks in India, without exception. Banks are not permitted to
make loans at interest rates lower than their pre-set base rate unless the government
ve
requests a change.

Commercial banks are permitted to set their own base rates for a given tenor while
adhering to the RBI guidelines. This means that a bank is free to use any benchmark
ni

rate as its minimum lending interest rate. This rate, however, should be determined
on the basis of the MCLR and should be revised monthly in accordance with the most
recent RBI guidelines.
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When did the base rate become effective?

The RBI Base Rate system, which established the standard lending rate for all
commercial banks in India, went into effect on July 1, 2010. It applied to all new loans
ity

taken out by customers on or after July 1, 2010, as well as old loans renewed after that
date.

Banks were permitted to continue using the BPLR system for loans approved prior
to July 1, 2010. They did, however, have the option of switching to the base rate system
m

before the loans expired.

Why did the RBI implement the Base Rate System?

The RBI implemented this benchmark rate system as part of the various measures
)A

it has implemented to reform the interest rates set by banks. Though commercial banks
in India have the freedom to set their own interest rates, the Reserve Bank of India
(RBI) chose a number of reforms to regulate their interest rate setting system.

The Benchmark Prime Lending Rate (BPLR) system was initially introduced by the
(c

RBI to create consistency between the interest rates set by various banks. Under this
system, banks were permitted to fix their standard lending rates with the approval of
their boards. However, because the calculations were not very clear, this system failed
Amity Directorate of Distance & Online Education
 Principles and Practices of Banking 233

to bring transparency to loan rates. In this system, banks had the flexibility to lend at
Notes

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rates lower than the BPLR, which explains why lending rates were not uniform for all
borrowers. Banks tended to offer low-risk customers loans at rates much lower than
their BPLR. As a result, while corporate giants could get loans at lower interest rates

in
than the BPLR, ordinary borrowers had to pay the standard rates. Furthermore, there
were differences in the rates of different types of loans, which is why home loans were
offered to reliable customers at a sub-BPLR rate.

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Following the failure of the BPLR, the RBI implemented the Base Rate system,
which replaced the previous BPLR system, in order to make the lending system more
transparent, clear, and unbiased in terms of interest rates. Under this system, banks

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must determine a minimum rate below which they will not lend to any borrower, with
the exception of DRI allowances, loans to bank depositors against their own deposits,
and loans to bank employees. Following its implementation, banks were obligated to be

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neutral and adhere to a single fixed rate when making loans to borrowers.

As a result, the RBI introduced Base Rate and eliminated BPLR to benefit
borrowers by eliminating commercial banks’ discretion in India.

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The distinction between the base rate and the benchmark prime lending rate

There is a fundamental difference between a bank’s Base Rate and its Benchmark

r
Prime Lending Rate. While the Benchmark Prime Lending Rate (BPLR) is the interest
rate at which a specific bank is interested in lending money to its most reliable
ve
customers, the Base Rate (BR) is the minimum rate mandated by the Reserve Bank
of India to authorised banks for lending money. According to RBI guidelines, all Indian
banks are required to use their base rate rather than their prime lending rate when
making loans to borrowers.
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The primary distinction between BR and BPLR is that BR is a standard rate and
thus more objective or neutral than BPLR. Under BPLR, banks had the flexibility to set
the interest rate for their individual customers; however, BR imposes strict restrictions
U

on this and does not allow banks to make loans at or below the fixed minimum interest
rate.

Under the MCLR norm, the base rate has been modified.
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The base rate has been modified in accordance with the RBI’s most recent MCLR
regulation. With effect from April 1, 2016, Indian banks have transitioned to a lending
system based on the marginal cost of funds. Banks must use the MCLR method to
calculate their base rate under this standard. The cost of the funds must be calculated
m

using this methodology based on the marginal cost. The MCLR is determined by the
following factors:

◌◌ Marginal cost of funds

)A

◌◌ Negative CRR carry on amount

◌◌ Cost of operation
◌◌ Tenor premium
Note: The marginal cost is calculated by multiplying the bank’s repo rate by a
(c

number of additional expenses incurred in the acquisition of funds.

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 234 Principles and Practices of Banking

The MCLR reform requires banks to revise their MCLR every month, making this
Notes

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method more dynamic in nature.

What loans are exempt from the base rate?

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Although the RBI has mandated a base rate as the minimum interest rate to be
charged to borrowers, this standard rate is not applicable to all loans. Banks can set the
interest rate at which these loans are made available to customers. These are the types

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of loans that are not subject to BR:

◌◌ DRI allowances, or differential rate of interest allowances.

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◌◌ Loans to employees of the relevant banks.
◌◌ Loans to depositors of the bank in exchange for their own deposits.
◌◌ Interest rate subsidy approved by the government for rupee export credit and
agricultural loans.

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◌◌ Exemplifications of restructured loans
How is BR more profitable than BPLR?

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Base Rate is a novel approach to lending money that makes the borrowing process
more transparent and unbiased for customers. Prior to the implementation of the Base
Rate, banks were permitted to charge interest on offered loans based on their own
r
preferences under the Benchmark Prime Lending Rate. However, now that the RBI has
ve
mandated the Base Rate for all commercial banks, they are obligated to follow the new
rule and can no longer be selective in lending money to their dependable customers.

The BPLR-based lending process was complicated, and customers had no exact
standard for determining a bank’s correct interest policy. Despite the fact that the
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RBI frequently reduced the minimum lending amount for banks, banks used to follow
their own lending rate (BPLR) to maximise profits from borrowers. However, since the
BPLR was replaced with the Base Rate system, customers can now obtain loans at
U

reasonable interest rates without paying more than the banks’ preferred customers.

In short, the BR, as the interest rate benchmark, has made the loan borrowing
process more equitable and has ended the banks’ monopoly. Furthermore, because
banks are required to clearly declare their respective base rates on their websites,
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borrowers can compare the rates of all banks and then choose the most cost-effective
one.

Is it possible for a borrower to convert an existing loan from BPLR to BR?

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Yes, you can change your existing loan rate from BPLR to BR in accordance with
RBI guidelines. Though the BR applies to all new loans sanctioned after July 1, 2010,
if you have loans that were sanctioned prior to that date, you can easily switch from
)A

BPLR to BR by contacting your nearest loan centre or customer support executives.

Because BR is more neutral and customer-friendly than BPLR, you are more likely
to pay less interest under BR. Thus, if you have already taken a loan based on BPLR,
you should change the rate of interest to BR as soon as possible, as this will help you
save a significant amount of money on your monthly EMIs.
(c

Is it possible for banks to change their base interest rates?

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 Principles and Practices of Banking 235

Yes, banks have the ability to change their base rate once a month. Previously,
Notes

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banks were permitted to change their BR once every quarter; however, the new MCLR
reform requires banks to change their basic lending rate once every month. According
to the new standard, banks must review their base rate every month and make any

in
necessary changes. Following the review, each bank is required to release the new
base rate to the public. The entire process is extremely transparent, and it directly
benefits customers.

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How Has BR Made the Indian Lending Process More Transparent?

By replacing the BPLR-based lending process, BR has brought transparency and

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stability to the Indian lending system. Prior to the implementation of the Base Rate,
banks used to lend money based on their own BPLR, which resulted in a high profit for
them and fewer benefits for the borrowers. However, following the implementation of
the BR system, commercial banks are no longer able to lend money to any borrower

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at a rate lower than the benchmark rate. Customers can now pay an interest amount
based on the website’s base rate without discrimination and obtain loans to meet their
financial needs at an affordable cost. In this way, BR has increased system clarity and

si
transparency, which has largely benefited borrowers.

We can say that BR has aided the RBI in gaining better control of India’s financial
lending system. Because banks can no longer charge customers unfair interest rates,
r
bank dominance in the Indian financial market has finally come to an end.
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3.9.2 Prime Lending Rate
In the fiscal year 2003-04, the Reserve Bank of India (RBI) established the
Benchmark Prime Lending Rate. The prime lending rate (PLR) is the interest rate at
ni

which commercial banks lend to their most reliable and creditworthy customers.

The prime lending rate is determined by the Repo rate. Currently, all commercial
banks have the authority, with the approval of their respective boards, to set their own
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benchmark prime lending rate (BPLR). The prime lending rate is critical for borrowers
because it has a direct impact on the lending rates for a home loan.

The prime lending rate is the primary determinant of most lending institution
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interest rates; it is a component of the rate charged to the customer. Interest rates are
the compensation that banks receive for the risk that they take, and they are based
on the borrower’s credit history. Interest rates protect banks from the costs of lending,
including the cost of default risk.
m

The “Default Risk” is the primary factor that determines the interest rate a bank will
charge a prospective borrower. Creditworthy customers are the most trusted because
they are unlikely to default. As a result, banks charge them lower interest rates than
)A

other customers who may be more likely to default.

Banks in India are using PLR for home loans.

The prime lending rates are set by the respective banks and are consistent across
all of the banks’ branches. The spread and prime lending rates are used to calculate the
(c

interest rate.

SPREAD + PRIME LENDING RATE = INTEREST RATES

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 236 Principles and Practices of Banking

The spread component can be positive or negative and remains constant

Notes

e
throughout the loan’s term. Any change in the PLR has no effect on the Floating Rate
of Interest. Except for home loans, most loans in India have a fixed interest rate. As
a result, changes in the PLR have no effect on the majority of loans; however, home

in
loans with floating interest rates are affected by the PLR.

Base Rate and Prime Lending Rate

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Although PLR is the lowest applicable rate, especially for creditworthy customers,
banks have begun lending to customers at rates lower than the benchmark prime

O
lending rate over time. As a result, the phrase “Benchmark prime lending rate” has been
replaced by “Base Rate” since July 2010.

Although banks have the authority to set their own base rates, commercial banks
are not permitted to lend below the Base Rate, and exceptions are only granted by the

ty
Reserve Bank of India.

3.10 Treasury Management

si
The role of treasury operations has become much more critical in the current
dynamics, and it has never been this important before. Against the backdrop of the

r
current business environment’s challenges and uncertainty, the picture that emerges is
one of prudent stewardship of company funds and capital preservation. The treasury
ve
role, which primarily focuses on the planning and management of a company’s cash
needs, includes the internal processes and external banking relationships that facilitate
that cash management. The management of financial risks that a company faces,
ranging from counterparty risk to market risk, is part of the responsibility for these
ni

financial processes.

3.10.1 Introduction
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The base rate is set in order to increase transparency in the credit market and
ensure that banks pass on lower funding costs to their customers. Loan pricing will be
accomplished by combining a base rate and a suitable spread based on the credit risk
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premium.

Although small businesses do not typically have a formal treasury department,

VC-backed firms, in particular, require effective cash management in order to grow at a
rapid pace. These functions continue to exist, but are frequently handled by accounting
m

and payroll teams. How important is treasury management for these VC-backed, high-
growth startups?

Treasury Function and Structure

)A

The Treasury function must concentrate its efforts on supporting the specific
company’s business model and ensuring that Treasury strengthens and protects that
company’s ability to move forward. Every company has a unique set of requirements
that stem from its business model.
(c

A very small team of probably one or two members plays a critical role in the
company’s rapid expansion. The group’s responsibilities include the following:

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 Principles and Practices of Banking 237

◌◌ Forecasting cash requirements

Notes

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◌◌ Reducing payment friction by managing the banking portal
◌◌ Ensuring a reasonable return on deposits.

in
◌◌ The treasury function’s primary goal is risk management and capital
preservation.
The ability to assess best practises through the treasury lens, understanding what

nl
can be done to strengthen, preserve, and protect a company’s capital, is an advantage
of having a more formal treasury function.

As a high-growth startup, you’ll most likely have more money in the bank,

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and investing that money is critical. The greater your access to capital, the more
opportunities you will have to grow the balance sheet and the company.

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Relationships with Banks and Cash Management
As the economy deteriorates, cash management becomes increasingly important.
This is especially important in small businesses. You must manage cash flow on a

si
daily basis, moving money as needed. It is not only a matter of today’s cash position,
but also of the cash forecast. It may be time to begin utilising tools such as real-time
payment systems for accounting automation and payroll.

Yield Pursuit r
ve
If you want to maximise the yield on your deposits, look beyond current accounts
and bank FDs. There are fully liquid products available that invest in government
securities and money market funds. Your funds will be available in a day or two at most.
Concentrate on maximising the return on your investment.
ni

When it comes to running a business, liquidity is king, and you must have access
to capital. Preserving capital is more important than increasing yield, as stated by the
adage “Return of capital is more important than Return on capital.” The bottom line is
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that Treasury is there to help, not to manage assets.

Earning an extra few hundred thousand rupees may not be worth the extra work
and potential risk for a large company, whereas for a smaller company, that amount
ity

may cover the salary of a critical resource or their marketing budget for the entire
month.

A formal treasury team in an organisation is a luxury enjoyed by larger businesses.

Smaller businesses must still perform many of the same functions as treasury
m

departments, utilising both internal and external resources who may have competing
responsibilities. Adopting a “treasury lens” can assist a company in thinking differently
about the processes, risks, and opportunities associated with ensuring that a
)A

company’s cash needs are met and that investments fit the overall objectives of the
company.

Treasury management is at the heart of India’s brisk corporate growth.

As a result of the nationwide lockdown and strict precautionary measures

(c

that halted operations and economic activity, a liquidity cash crisis erupted, forcing
corporations and organisations to rush for cash and liquidity in order to keep their

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 238 Principles and Practices of Banking

operations afloat. Soon after the initial setback, it became clear that companies
Notes

e
with good cash flow management were better able to weather the storm than their
competitors. This significant realisation is one of the primary reasons that several
industry experts and corporate leaders have acknowledged that treasury management

in
is critical to the growth of corporates and businesses in India.

Technical jargon, long legal terms, and jumbled explanations may sound fancy and

nl
necessary at times, but the basic structure that most people understand is profit and
loss. Because the ultimate goal of corporations is to maximise shareholder profits, it
is the treasury’s responsibility to maximise cash liquidity through cashflow excellence
and short- or medium-term financing solutions. The treasury management team is

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essentially the cash custodian, controlling it through liquid assets or physical money.

In layman’s terms, the treasury management team must ensure that businesses
always have cash on hand. Needless to say, extra cash can keep a business running

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and even keep it from going bankrupt during a crisis. However, now that the pandemic
waves have subsided, corporate leaders have the opportunity to repair cash flow
flaws and construct a long-term cash management system. Once again, treasury

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management can be of great assistance in developing a strong financial ecosystem.

How can treasury management strengthen its current structure?

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Among the horrors of the pandemic, one silver lining emerged in the face of the
need for empowered cash excellence, which falls under treasury management. This
ve
gave rise to the modern-day Treasury Management System (TMS) software component
concept. It provides treasurers and the company’s financial leadership with data and
information that allows them to visually strategize how to optimise cash, manage bank
accounts, govern liquidity, and monitor investments, debts, and loans.
ni

The answer to smooth development and rapid advancements, like in any other
business segment, is hidden under the broad umbrella of digital transformation, data-
driven analytics, Application Programming Interface (APIs), blockchain, and cutting-
U

edge fintech technology paired with automation tools like Machine Learning (ML) and
Artificial Intelligence (AI).

Banks are currently opening up their core banking through APIs, which will be
ity

useful for consolidating balances across all accounts. This bank balance updating is a
massive task for treasury teams, especially when their corporate is spread across the
globe. In this case, the treasury team benefits from auto-updating balances, and the
connection to ERP is an added bonus, resulting in near-perfect cash forecasting and
m

planning. Maker-checker and authorisation are also thriving with modern TMS, assisting
the execution team to follow up with those who need to act in the workflow.

Treasury management is an underappreciated star.

)A

Today’s volatile but equally vulnerable financial environments necessitate

effective treasury management to oversee cash visibility, short- and long-term
funding requirements, and cash flow forecasting to ensure corporate financial and
operational security. Without a doubt, treasuries have an impact on every aspect of a
corporation’s or organization’s economic performance. In fact, they are responsible for
(c

generating profitable returns. It is past time to recognise treasurers, as strong treasury

management is directly proportional to a stronger corporate foundation.

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 Principles and Practices of Banking 239

Summary
Notes

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●● The application of corporate governance standards in any jurisdiction is naturally
expected to be pursued in accordance with applicable national laws, regulations,

in
and codes (for example, taking into account the existence of oversight boards in
some jurisdictions).
●● Shareholder rights are a critical corporate governance issue for publicly traded

nl
companies. These rights are not the primary focus of this guidance and are
addressed in the OECD’s corporate governance principles.
●● The Committee, on the other hand, recognises the significance of shareholder

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rights and responsible shareholder engagement. The Committee also recognises
the significance of exercising shareholder rights, especially when certain
shareholders have the right to appoint a representative to the board. In such
cases, the suitability of the appointed board member is as important as their

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understanding of the responsibility to look after the interests of the bank as a
whole, rather than just the shareholders.
●● Effective implementation of sound corporate governance necessitates the

si
establishment of appropriate legal, regulatory, and institutional foundations. A
variety of factors, such as the legal system, stock exchange rules, and accounting
standards, can have an impact on market integrity and systemic stability.
●●
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However, such factors are frequently outside the purview of banking supervision.
ve
Supervisors are encouraged, however, to be aware of legal and institutional
impediments to sound corporate governance and to take steps to foster effective
corporate governance foundations where they have legal authority to do so.
Where this is not the case, supervisors may want to consider supporting legislative
ni

or other reforms that would give them a more direct role in promoting or requiring
good corporate governance.
●● The principles of good corporate governance should also apply to state-owned or
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state-supported banks, even if such assistance is only temporary.

Glossary
ity

●● Base Rate: The base rate is the minimum interest rate set by the Reserve Bank of
India below which Indian banks are not permitted to lend to their customers.
●● Business Correspondence: Business Correspondents are retail agents who
represent banks and are in charge of providing banking services in locations other
m

than a bank branch or ATM.

●● Small-Scale Finance Institutions: Small finance banks are financial institutions that
provide financial services to underserved and unbanked areas of the country.
)A

●● Loans on instalments: These are the most common type of consumer durable
loans, and they are repaid in weekly, fortnightly, monthly, or bi-monthly instalments
on a set schedule.
●● Variable-rate consumer durable loan: The interest rate charged on the outstanding
(c

balance in a variable rate consumer loan varies with changes in market interest
rates.

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 240 Principles and Practices of Banking

●● Interest rate reductions and a flat rate of interest: As the name implies, in the
Notes

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former, the borrower only pays interest on the outstanding loan balance, i.e.,
the balance that remains outstanding after the principal repayment has been
deducted.

in
●● Manufacturing Enterprises: Entities engaged in the manufacturing or production of
goods pertaining to any industry specified in the first schedule to the Industries

nl
(Development and Regulation) Act 1951, or employing plant and machinery in the
process of value addition to the final product having a distinct name, character, or
use.

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●● Service Enterprises: These are businesses that provide or render services and
are defined by their investment in equipment. Small, medium, and large scale
industrial units are generally classified based on their size, capital invested, and
number of human resources employed.

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●● Financial Inclusions: Financial inclusion can be defined as the process of ensuring
vulnerable groups, such as weaker sections and low-income groups, have access
to financial services and timely and adequate credit when needed at an affordable

si
cost.
●● Lok Adalats (Local Adalats): They can handle small NPAs up to Rs. 20 lakhs. They
guarantee a quick recovery and also have a cloak of authority.
●●
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Doubtful NPA: NPAs that have remained in the substandard category for a period
ve
of 12 months or less.
●● Loss Assets: This occurs when an NPA has been identified as a loss by the bank,
an internal or external auditor, or during an inspection by the Reserve Bank of
India (RBI), but the loan has not been completely forgiven.
ni

Check Your Understanding

1. The RBI Base Rate system, which established the standard lending rate for all
U

commercial banks in India, went into effect on July 1, ...........

(a) 2010
(b) 2009
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(c) 2011
(d) 2012
2. The Reserve Bank of India, the country’s central regulatory body, determines the
m

........... rate.
(a) base
)A

(b) high
(c) low
(d) current
3. The primary goal of a ............ bank is to provide payment and financial services
(c

to small businesses, low-income households, and migrant labour workforce in a

secure, technology-driven environment.

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 Principles and Practices of Banking 241

(a) payments
Notes

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(b) savings
(c) international

in
(d) RBI
4. Secured consumer loans are loans that have ..............backing them up (assets that

nl
are used to cover the loan in the event that the borrower defaults).
(a) collateral
(b) dissimilar

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(c) direct
(d) pledge

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5. Personal loans are ...........loans in which the bank lends you money based on your
creditworthiness and there is no need for security for the money borrowed.
(a) unsecured

si
(b) secured
(c) bank guranteed
(d) consumer guranteed r
ve
6. Microfinance in India began with the Self-Help Group-Bank Linkage model, which
was developed in ..........by the National Bank for Agriculture and Rural Development
(NABARD) to connect the unorganised sector to the formal banking sector.
(a) 1992
ni

(b) 1990
(c) 1991
U

(d) 1995
7. Small Scale Industries (SSI) are those in which manufacturing, production, and
service delivery are done on a ............scale.
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(a) small or micro

(b) big or macro
(c) wide
m

(d) international
8. The Pradhan Mantri Jan Dhan Yojana was launched on August 28, .............., and
since then, it has reduced the number of villages in a 5-kilometer radius that do not
)A

have access to bank accounts to just 256.

(a) 2014
(b) 2016
(c) 2017
(c

(d) 2018

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 242 Principles and Practices of Banking

9. The .................... Act authorises Indian banks and financial institutions to sell or
Notes

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auction the assets/properties of credit defaulters without the intervention of the
courts.

in
(a) SARFAESI
(b) bank
(c) bank protection

nl
(d) defaulter
10. Fixed obligation to income ratio (FOIR) refers to how one manages his or her .............

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and how frequently they are repaid.
(a) debts
(b) savings

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(c) money
(d) finances

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Exercise
1. What are lending principles followed by banks?
2. r
Define working capital and term loans.
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3. What are Appraisal Techniques for loan sanction?
4. Define credit monitoring.
5. What are the factors that contribute to NPAs?
ni

6. Define DRT/DRAT.
7. What is SARF AESI Act 2002?
8. What is Competition Act 2005?
U

9. What is Credit Appraisal Mechanism?

10. What is meant by credit score?
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11. What is PMJDY Agriculture scheme of Indian government?

12. What are SHGs?
13. What are Small Scale Industries (SSI)?
m

14. What is Microfinancing?

15. Define personal loans.
)A

Learning Activities
1. Discuss Tandon Committee recomendations to develop guidelines for commercial
banks.
2. Discuss Chore Committee review regarding workings of the cash credit system in
recent years, with particular reference to the gap between sanctioned limits and the
(c

extent to which they were used.

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 Principles and Practices of Banking 243

3. Discuss Nayak Committee report regarding review of Governance of Boards of

Notes

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Banks in India and to review the governance of Indian bank boards.

Check Your Understanding - Answers

in
1. 2010
2. Base

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3. Payments
4. Collateral

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5. Unsecured
6. 1992
7. small or micro

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8. 2014
9. SARFAESI

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10. Debts

Further Readings and Bibliography

1.
r
The Basel Committee on Banking Supervision: A History of the Early Years
1974–1997, Charles Goodhart
ve
2. Indian Banking System, Dr. V.C. Sinha
3. Principles of Banking for to days bankers, Ashok Kumar Das
4. Banking Reforms & Productivity in India, Tapiawala Medha P
ni
U
ity
m
)A
(c

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 244 Principles and Practices of Banking

Module - IV: Other Banking Products and Technology

Notes

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Learning Objectives:

in
●● Banking technology - CBS, Electronic Products, Distribution Channels, Teller
Machines, Cash Dispenser

nl
●● Banking supports - ATM, Home Banking, Electronic Payment System
●● Global Development and Banking Technology
●● Online banking - PINs, Smart Cards, Signature Storage and Display, Cheque

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Truncation, Microfiche
●● Electronic fund transfers - SWIFTS, RTGS
●● IT in banking - RBI NET, DATANET, NICNET, I-NET, Email

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●● Cyber security issues - Protecting the Confidentiality and Data, Phishing Attack
●● Cloud Computing and Mobile Banking

si
Introduction
Many bank IT initiatives began in the late 1990s or early 2000s, with a focus on
r
the adoption of core banking solutions (CBS), branch automation, and centralization of
ve
operations in the CBS. Most banks completed their transformation to technology-driven
organisations over the last decade.

Moving from a manual, scale-constrained environment to a global presence with

automated systems and processes, it is difficult to imagine the sector as it was prior to
ni

the reforms, when a simple cash deposit or withdrawal would take a day. ATMs, mobile
banking, and online bill payments to vendors and utility service providers have virtually
eliminated the need for customers to visit a branch. Branches are also evolving from
U

transaction processing points to relationship management hubs.

Technology is shaping the future of both corporate and retail banking. With the
widespread adoption of online and mobile banking, financial institutions now have more
ity

data at their disposal to assist them in making smarter decisions, better understanding
customer needs, and providing stronger offerings to customers.

Customers now expect more services to be delivered digitally and through a

self-service model. Many customers prefer to skip the line at the branch for everyday
m

transactions and account maintenance, making banking more digital than ever.

Meanwhile, corporate and retail banks are using analytics, big data, and AI to gain
insights and competitive advantages. These technologies assist banks in identifying
)A

opportunities to increase their bottom line, reduce risks, and improve the customer
experience—both online and in-branch. Connected devices in branch offices assist
banks in gaining insights into customer behaviour and providing more tailored offerings
to those they serve—ultimately facilitating a frictionless experience that is focused on
the customer’s needs, regardless of how they interact with the bank.
(c

A variety of technologies, ranging from edge compute solutions in branches to

high-performance data centre environments, are being deployed to make it all possible.

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 Principles and Practices of Banking 245

Digital technology is critical to keeping branch banking relevant, resilient to cyber

Notes

e
threats, competitive, and profitable. Self-service options, IoT sensors, and AI are being
used to provide new services to customers, identify business needs, and uncover new
growth opportunities.

in
In branch locations, technologies such as dynamic digital signage and self-service
kiosks use cloud-based analytics and artificial intelligence (AI) to streamline customer

nl
visits and provide more personalised experiences.

New Internet of Things (IoT) technologies are bringing analytics and artificial
intelligence (AI) into the branch, allowing physical locations to function more like online

O
channels. Banks, for example, can use IP cameras and AI-powered vision technology to
track how long customers wait for a teller at various times of the day. These insights can
assist branch managers in making more informed staffing decisions.

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4.1 Banking Technology
The term “Banking Technology” refers to the use of sophisticated information and

si
communication technologies, as well as computer science, to enable banks to provide
better services to their customers in a secure, reliable, and cost-effective manner, while
maintaining a competitive advantage over other banks.

4.1.1 CBS
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CBS is an abbreviation for Core Banking Solution, which is the networking of
various bank branches via a strong IT infrastructure. It enables customers to manage
their bank accounts and access banking services through a centralised network. In
ni

other words, with CBS, their accessibility is not limited to a single bank branch, but to
the entire bank.

CBS has been widely used by banks throughout India due to its numerous benefits.
U

For starters, it aids in the acceleration of the majority of transactions that are carried out
across bank branches via the network with the assistance of a centralised server. CBS
also provides powerful software programmes to assist banks with basic operations such
as deposit and loan calculations, interest calculations, and so on.
ity

CBS’s Importance for Banks

Banks require CBS to:

●● Meet their customers’ growing demands

m

●● Simplify and accelerate basic banking processes so that banking personnel can
focus on other areas such as upselling and cross-selling, marketing, and so on
)A

●● Reduce the time required for banking transactions

●● Make banking services more accessible and convenient for customers

4.1.2 Electronic Products

(c

The automation of traditional banking services is referred to as digital banking.

Customers of a bank can use digital banking to access banking products and services
via an electronic/online platform. Digital banking entails digitising all banking operations
Amity Directorate of Distance & Online Education
 246 Principles and Practices of Banking

and replacing the bank’s physical presence with an everlasting online presence,
Notes

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obviating the need for a consumer to visit a branch.

Payment Methods in Digital Banking

in
Cards for banking: Cards are used not only to withdraw cash, but also to enable
other forms of digital payment. Cards can be used for online purchases as well as at
point-of-sale (PoS) machines. Banks can also issue prepaid cards, which are not linked

nl
to a bank account and function solely on the money loaded onto them.

USSD (Unstructured Supplementary Service Data): Mobile transactions can be

O
completed without the use of an application or an internet connection by dialling *99#.
The number is applicable across the country and promotes greater financial inclusion
on the ground. The service allows the caller to navigate an interactive voice menu and
select an option on the mobile screen. The only catch is that the caller’s mobile number

ty
must be associated with the specific bank account.

Aadhaar Enabled Payment System (AEPS): After successfully verifying the

Aadhaar number, AEPS allows the client to initiate banking instructions.

si
Unified Payments Interface (UPI): At the moment, UPI is the most popular form
of digital banking. UPI employs a virtual payment address (VPA) to allow users to
transfer funds without entering their bank account number or IFSC code. Another
r
notable feature of UPI is that the applications allow you to consolidate all of your bank
ve
accounts into a single location. Funds can be transferred and received at any time of
day or night. In India, UPI-based apps include BHIM, PhonePe, and Google Pay. In
addition to transferring funds to other virtual addresses and bank accounts, the BHIM
application allows users to transfer funds to another Aadhaar number. More importantly,
ni

UPI payments are free of charge.

Mobile wallets have eliminated the need to remember four-digit card pins, enter
CVV information, or carry loose cash. Mobile wallets save bank account and card
U

credentials, allowing users to easily add funds to the wallet and make payments to
other merchants who use similar apps. Paytm, Freecharge, Mobiwik, and other popular
mobile wallets Mobile wallets, on the other hand, usually have a limit on how much
money can be deposited in the wallet. A small fee may also be levied when the funds
ity

from the mobile wallet are deposited back into the bank account.

PoS terminals: PoS terminals are typically portable devices that read a card to
authorise and complete a payment. This is the payment method used by supermarkets
and gas stations. However, as digital banking has grown in popularity, PoS terminals
m

have evolved into more than just physical PoS devices. Virtual and mobile PoS
terminals have emerged, which use the NFC feature of mobile phones and web-based
applications to initiate payment.
)A

Internet and Mobile Banking: Also known as e-banking, internet banking refers to
obtaining certain banking services such as fund transfers and account opening and
closing via the internet. Because internet banking is limited to core functions, it is a
subset of digital banking. Similarly, mobile banking is the provision of banking services
(c

via mobile-based applications.

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 Principles and Practices of Banking 247

4.1.3 Distribution Channels

Notes

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Banking services are delivered through six main channels. The channels are as
follows:

in
1. Banking in a Branch
2. Cellular Banking

nl
3. ATM Banking Channel
4. Mobile banking, also known as phone banking or telebanking

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5. Personal Computer Banking
6. Self-Service Banking Internet banking, online banking, and e-banking are all
terms for the same thing.

ty
1. Branch Banking: A bank’s branch is a location, office, or unit where all banking
operations are performed under one roof. People visit the branch for their banking
needs. This is the Bank’s most popular and thus most important channel.

si
It is a location where customers can come in and use a variety of services and
banking products all in one location. Customers can seek advice from bank staff
in the event of a problem, removing any doubts and clarifying any questions they
may have about banking operations. In fact, a branch is a location that serves as
r
a channel of sales and services, and bank employees can play an important role
ve
in customer satisfaction by smiling. The branch is a channel that can improve the
overall image of the bank by developing personal relationships with customers and
improving the bank’s customer relationship management.
2. Mobile Banking: In this day and age, every bank wants to reach as many people as
ni

possible in order to increase their customer base. Some banks have begun to offer
mobile banking services as part of this process. A mobile van is outfitted with the
necessary equipment, and a few staff members are assigned to these vans.
U

These vans travel around the neighbourhood, providing door-to-door service

to customers. However, such a system provides only a limited range of banking
services. The primary services include only cash receipt and payment. Some
ity

ancillary services, such as balance inquiry and cheque collection, are also available.
3. ATM Banking Channel: The ATM is an acronym for Automated Teller Machine. Prior
to the introduction of ATMs in the 1980s, people were only familiar with one teller. A
person working behind the cash register, making cash payments or receiving cash
m

from customers. For cash transactions, one had to physically go to the teller, and only
during the bank’s working hours. The ATM’s invention altered the entire scenario.
4. Mobile Banking or Phone Banking, Tele-Banking: It is surprising how many people
)A

use mobile or phone banking without realising that they are receiving restricted
services. It is another electronic banking channel, similar to ATMs, that provides
customers with round-the-clock 24 hour banking. When you deposit money in cash
or by check, an SMS will appear on your phone informing you that the money has
been credited to your account.
(c

Similarly, whenever a withdrawal is made from your account, a similar message will
be sent to your mobile device. This phone banking is one of the ways that banks
keep their customers informed about the transactions in their accounts.
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 248 Principles and Practices of Banking

Customers, on the other hand, can approach their banks and request to use
Notes

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phone banking or tele-banking. The bank must provide its customers with an IVR
computerised system. This IVR technology, which automates interactions with phone
callers, is known as Interactive Voice Response.

in
IVR is increasingly being used by banks to reduce the cost of services, inquiries,
and support calls. The system allows for input and responses to be gathered

nl
through spoken words using voice recognition. IVR solutions allow users to retrieve
information from banks as well as send information, requests, and queries. With the
invention of IVR, the practise of phone banking has grown steadily because it allows
access to bank services from anywhere, such as the home, office, workplace, or

O
anywhere else.
5. PC Banking, Self Service Banking: Internet banking as it is now known has gone
through many stages of development. It was known by various names during each

ty
phase. In its early stages, in the early 1980s, it was known as Home Banking, which
refers to banking transactions that can be completed while sitting at home. During
the modern era, it was also referred to as Self Service banking.

si
Customers were initially able to perform some routine banking functions at home.
Telephone or cable connections were required to use home banking services, and
transactions were carried out using a terminal, keyboard, and monitor (TV or PC).
r
Customers were able to use this service to inquire about their account balances,
ve
transfer funds between accounts, pay bills, and buy/sell investments or securities.
All of this was done by the customers on their own system while sitting at home, the
office, or the workplace.
6. Internet Banking, Online Banking, and E-Banking: Most banks in India now have
ni

their own websites for the purpose of providing banking services over the internet.
The Reserve Bank of India has also issued internet banking guidelines that all banks
must follow. Although multinational and private sector banks have been successful
U

in establishing internet banking, some public sector banks have lagged behind due
to inherent difficulties.
The majority of public sector banks have a large network of branches, many of
which are located in remote areas with limited connectivity. These banks have a
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large customer base, which includes illiterate customers. Some people are still using
outdated and traditional application methods and are resistant to change.
It may not be possible to provide infrastructure for the launch of internet banking to
a large network of branches all at once. However, it is very likely that these banks
m

have made significant progress and are now nearing the point where they will all be
web-enabled.
)A

4.1.4 Teller Machines

Personal Teller Machines are ATMs that allow you to speak with a live teller during
specific hours. The live teller can walk you through every step of your transaction and
answer questions about your accounts, just like you would at a branch teller line. The
(c

Personal Teller Machine offers almost every transaction option available at the teller
line, whereas the ATM only allows you to withdraw or deposit money. Personal Teller

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 Principles and Practices of Banking 249

Machines allow for more flexibility in cash withdrawal, whereas ATMs only accept single
Notes

e
denominations.

Features:

in
●● Personal Teller Machines are self-service kiosks that allow a customer to request
and print an official check, which is not possible with an ATM.

nl
●● Accept checks and cash. There is no deposit slip required! You only need to show
a valid ID, and the live teller will take care of the rest.
●● Checks in cash Each Personal Teller Machine is capable of dispensing large bills,

O
small bills, and even coins.
●● Transferring Funds Savings account or checking account? Live tellers can transfer
funds to any location you specify.

ty
●● Account enquires. Live tellers are available to discuss any and all account-related
questions, in addition to balance inquiries.
●● Obtain money. To withdraw cash, use a Personal Teller Machine, which functions

si
similarly to an ATM.

4.1.5 Cash Dispenser

r
Teller cash dispensers (TCDs) are unidirectional devices in which cash is
ve
manually loaded into a TCD under dual control and then dispensed to customers as
needed. When a location is cash-strapped, this is an excellent solution. This means
they spend more money than they take in. It’s simple to use, highly secure, and has
a large capacity. TCDs are commonly installed in bank or credit union drive-thrus. It’s
ni

ideal for retail cash rooms in the right setting, which are commonly found in gaming or
casino environments. It’s also common in municipal offices, where cash is frequently
disbursed.
U

By automating many key tasks at the branch level, cash dispensers are
revolutionising the way banks and credit unions do business. Cash dispensers are
smart vaults that dispense cash to tellers as customers withdraw money. Cash is
dispensed by recyclers as well as accepted as a deposit by customers. All transactions
ity

are automatically reflected in the bank’s balances, reducing the amount of cash
required to keep operations running smoothly.

Cash dispensers increase tellers’ and front-line workers’ productivity while

eliminating human error and reducing cash requirements for each branch. Banks, credit
m

unions, and other financial institutions typically use dispensers and recyclers.

Some of the common characteristics are:

)A

◌◌ Capable of serving two tellers at the same time

◌◌ Available with front or rear access
◌◌ Available in 5 and 6 denomination configurations
◌◌ 18,000 note capacity (3,000 notes per casette)
(c

◌◌ Dual control access locks

◌◌ Reduces average vault purchase time from twenty minutes to two minutes

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 250 Principles and Practices of Banking

◌◌ Provides a variety of coin dispensing options

Notes

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4.1.6 ATM

in
An automated teller machine (ATM) is a type of electronic banking terminal that
allows customers to conduct basic transactions without the assistance of a branch
representative or teller. Most ATMs allow anyone with a credit or debit card to withdraw

nl
cash.

ATMs are convenient because they allow customers to perform quick self-service
transactions such as deposits, cash withdrawals, bill payments, and account transfers.

O
Fees for cash withdrawals are frequently charged by the bank where the account is
held, the operator of the ATM, or both. Some or all of these fees can be avoided by
using an ATM operated directly by the bank with which the account is held.

ty
ATMs are also known as automated bank machines (ABM) or cash machines
in different parts of the world. ATMs are classified into two types. Customers can
only withdraw cash and receive account balance updates with basic units. The more
sophisticated machines accept deposits, process line-of-credit payments and transfers,

si
and access account information.

To gain access to the advanced features of the complex units, a user must

r
frequently be a customer of the bank that operates the machine. Analysts predict that
ATMs will become even more popular, with an increase in ATM withdrawals. ATMs of
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the future will most likely be full-service terminals that replace or supplement traditional
bank tellers.

Elements of ATM Design

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Despite the fact that each ATM has a unique design, they all have the same basic
components:
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●● Card reader: This component reads the chip on the card’s front or the magnetic
stripe on the card’s back.
●● Keypad: The customer uses the keypad to enter information such as their personal
identification number (PIN), the type of transaction required, and the amount of the
ity

transaction.
●● Cash dispenser: Bills are dispensed through a slot in the machine, which is linked
to a safe at the machine’s bottom.
●● Consumers can request receipts to be printed here if necessary. The type of
m

transaction, the amount, and the account balance are all recorded on the receipt.
●● Screen: The ATM displays prompts that guide the user through the transaction
)A

process. Account information and balances, for example, are also displayed on the
screen.
●● Slots for depositing paper checks or cash are now common in full-service
machines.
(c

4.1.7 Home Banking

Home banking is a type of banking that allows you to conduct many financial

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 Principles and Practices of Banking 251

transactions from the convenience of your own home. However, the term “home
Notes

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banking” can be misleading because it is not limited to your home. If you have access
to the internet or a phone, home banking allows you to access your bank account
information from anywhere, at any time. Banking by mail is a type of home banking as

in
well.

Every day, technology touches nearly every aspect of our lives, and banking is

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no exception. That is why understanding the many different aspects of home banking
and how it works can assist you in making the best financial decision for your needs.
While home banking may alter the way you bank, it does not alter the fundamentals of
banking. This means that you must still have a bank account with a financial institution

O
in order to use home-banking features. Home banking, on the other hand, is a more
convenient alternative to branch banking.

Because of the “anytime, anywhere” nature of home banking, you can perform

ty
transactions and access banking services more quickly to meet your financial needs.

●● Checking your account balance at any time

si
●● Viewing your deposits and pending charges
●● Setting up notifications and account alerts if your balance falls below a certain
level
●● Transferring money between accounts r
ve
●● Paying bills online or via a mobile app

Home Banking Varieties

Although the name implies a connection to home banking, there are a variety of
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ways to administer home baking.

Online Banking: Online banking allows you to manage your finances from the
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comfort of your own home. You can also complete transactions remotely from anywhere
at any time if you have an eligible account and secure internet access.

Mobile Banking: Using your mobile phone to access your bank account information
is known as mobile banking. You can get the information from your bank’s website,
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through text messaging, or by downloading its app.

Banking by Mail is a service that allows you to mail deposits, payments, and
information directly to your bank or credit union. You can also request a receipt for your
transaction via mail.
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Telephone Banking: In general, this refers to contacting your financial institution

over the phone. Similarly, telephone banking can be used to conduct automated
)A

transactions such as checking your account balance, transferring funds, and

determining whether transactions or checks have cleared.

4.1.8 Electronic Payment System

An e-payment system is a method of conducting transactions or paying for goods
(c

and services via electronic means. Because of the growing popularity of internet-based
banking and shopping, e-payment systems have evolved significantly over the last few

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 252 Principles and Practices of Banking

decades. E-payments quickly became dominant in Europe, displacing traditional cash

Notes

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settlements.

Various e-payment systems are available.

in
Electronic wallets and Visa or Mastercard credit or debit cards are without a
doubt the most popular e-payment systems in Europe. Local debit or credit cards,
bank transfers, mobile apps, smart cards, AI-based payments, or bitcoin wallets are

nl
other options. Keeping an eye on the development of e-payment systems is critical for
merchants. It can open up a plethora of new opportunities for you to reach out to new
customers and grow your business.

O
Let’s take a look at the e-payment systems that customers prefer.

●● Wallets on electronic devices: E-wallets, also known as digital wallets, have

emerged as one of Europe’s dominant e-payment systems. They fully meet the

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high expectations of European consumers by providing a quick, secure, and
flawless checkout process. In a nutshell, an e-wallet is electronic storage where
customers store the data from their credit or debit cards, which they can then use

si
without having to carry a physical card with them.
●● Mobile wallets vs. mobile apps: Which is better? Some people use the terms
digital wallet and mobile wallet interchangeably. However, it’s important to
r
understand that a mobile wallet is a subset of the e-wallet payment system.
ve
The distinction between them is due to the device through which the wallet is
accessed. Mobile wallets can be accessed via a mobile application, whereas
digital wallets can be accessed via any device. PayPal, Apple Pay, and Google
Pay are the most popular.
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●● Credit and debit cards: When it comes to credit and debit cards, Europeans prefer
Visa and Mastercard. Cards are the most popular payment method in the Czech
Republic, Estonia, France, and Switzerland. Although American Express and
U

Discover are well-known and widely accepted outside of Europe, they do not rank
among the top five in Europe. Aside from the well-known credit and debit card
networks, one may come across smart cards (with a chip inside) or stored value
cards (prepaid cards or gift cards).
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●● Bank transfers are completely electronic funds transfers between bank accounts
that are safe and secure. Most importantly, they are not subject to chargebacks.
Direct debit is a type of payment instruction for your bank. Your bank transfers
funds from your account to the specified account based on this instruction. Direct
m

debits are a quick and easy way to pay recurring bills or payments.
●● In layman’s terms, e-cash or electronic cash is derived from cryptocurrency.
Currency information is downloaded and saved on the computer hard drive, where
)A

it will remain until payment is made. David Chaum, a pioneer in cryptography and
the inventor of digital cash, coined the term.
●● E-check: As the name suggests, e-checks are electronic versions of paper checks.
Their function remains the same – they are used to transfer funds between
accounts.
(c

●● QR codes (Quick Response): QR is an abbreviation for “Quick Response.” These

are the most common 2D barcodes, and they are easily readable by all types of
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 Principles and Practices of Banking 253

smartphones. The code lines contain all of the necessary information about the
Notes

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transaction and the merchant — everything you need to successfully complete the
transaction.

in
●● Wearable/payable devices: Because customers value convenience, alternative
payment devices are becoming increasingly popular. Smartwatches or wristbands
that allow you to pay at the grocery store are nothing new these days. These

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devices are linked to the customer’s bank account and function as a contactless
payment device.

The Advantages of Using an E-Payment System

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E-payment systems significantly enhance our banking experience. Even the most
“cash-loyal” shoppers were converted to electronic money users by the Covid-19
pandemic. As a result, merchants must implement a variety of e-payment solutions in

ty
order to meet the growing expectations of their customers. With the growing popularity
of NFC technology and biometric security layers, e-payments are becoming even more
secure and convenient. Customers and merchants have become more accepting of
“non-cash” payments, as their benefits are difficult to overlook.

si
Among the most important are:

◌◌ The absence of geographical boundaries and limits. Custom-made checkouts

r
enable merchants to reach more customers from all over the world, increasing
ve
sales profits.
◌◌ Quicker payment processing. It’s because transactions are completed in
seconds (with a single click) without wasting the time of customers.
◌◌ Convenience. Customers can pay for items on an e-commerce website 24
ni

hours a day, seven days a week. They only need a device that can connect to
the internet. It’s really that simple!
◌◌ Lower transaction costs and lower technology costs.
U

◌◌ Simple payment integration. Adding payments to a website isn’t difficult.

To make e-payments more widely available, developers tend to simplify
integration processes.
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◌◌ Advanced fraud prevention tools and sophisticated security layers. The

elements listed above, as provided by payment gateways and payment
providers, make electronic transactions safe and easy for merchants and
customers.
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4.1.9 Global Development and Banking Technology

Digitalization is altering how people interact and conduct business on a daily basis,
)A

and advances in banking technology are continuing to shape the future of financial
services worldwide. The growing demand for a digital banking experience among
millennials and Gen Zers is changing the way the banking industry operates as a whole.

Technology has a hand in seemingly every aspect of the banking industry, from
retail and mobile banking to neobank startups; and the influence of technology will
(c

continue to propel banking into a digitised future.

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 254 Principles and Practices of Banking

Retail banking, also known as consumer banking, refers to the services that banks
Notes

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can provide to their customers, such as savings and checking accounts, credit and
debit cards, and loans. The growing desire of consumers to access financial services
through digital channels has resulted in a flood of new banking technologies that are

in
reimagining the entire retail banking market.

Retail banking’s Future

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Technology aimed at improving retail banks’ operational efficiency is having a
positive impact on the market. According to Insider Intelligence, 39 percent of retail
banking executives believe technology has the greatest impact on cost reduction, while

O
only 24 percent believe it has the greatest impact on customer experience. To remain
competitive, retail banks are also launching platforms in the Banking-as-a-Service
(BaaS) space.

ty
For example, UK neobank Starling used to only offer B2C retail banking services;
however, after launching a BaaS platform, Starling diversified its product and revenue
streams, allowing it to remain relevant in the neobank space.

si
Meanwhile, mobile banking has cemented its position as a must-have feature
for financial institutions looking to stay competitive, particularly among digitally savvy
millennials and Gen Zers. In fact, according to Insider Intelligence’s fourth annual
r
Mobile Banking Competitive Edge Study, mobile is one of the top three factors
ve
influencing their choice of FI for more than 45 percent of respondents.

Mobile banking’s Future

Mobile banking has become the preferred method for users to make deposits,
ni

account transfers, and track their spending and earnings, as well as a key differentiator
for banking leaders. Almost 80% of our survey respondents who have used mobile
banking say it is their primary method of accessing their bank account.
U

Since the start of the coronavirus pandemic, mobile capabilities have become a
more important factor in bank selection among respondents than it was the previous
year. Financial institutions should understand which mobile banking features consumers
value the most and where they stand in comparison to their competitors so that they
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can focus their efforts in specific areas.

Consumers’ primary concern when it comes to mobile banking is security. The

fear of a data breach raises demand for services that keep users’ data secure–allowing
consumers to place holds on credit or debit cards, schedule travel alerts, and file and
m

review card transaction disputes are just a few examples of successful security banking
features.

Online banking, which includes mobile banking, refers to the overall experience of
)A

banking via digital channels such as mobile apps, desktop, live chatbots, and others.

Online banking’s Future

Mobile banking has surpassed online banking in popularity, and the overall number
(c

of online customers has decreased globally. Mobile banking is growing at five times
the rate of online banking, and half of all online customers also use mobile banking,
according to Insider Intelligence.
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 Principles and Practices of Banking 255

Despite this growing popularity, some banks are still unable to meet the demand
Notes

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for mobile tasks such as bill payment and reward redemption, forcing them to redirect
users to online banking. Even so, as millenials and Gen Zers continue to gravitate
toward the mobile market, this push will not be enough to popularise online banking.

in
Neobanks, or digital-only banks, are redefining the future of banking around the
world. Despite a sluggish start in the United States due to high regulatory barriers,

nl
recent developments and regulatory loosening indicate that US neobanks are poised to
take off.

The Future of All-Digital Banks

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Sophisticated mobile banking tools are a key factor driving the meteoric rise
of US neobanks, and their importance has grown in the aftermath of COVID-19. To
successfully scale their businesses, incumbent financial institutions, neobanks, and

ty
tech companies can all benefit from understanding how leading neobanks are raising
the bar for customer expectations and trust.

Trends in Banking Technology

si
Consumers, particularly Gen Zers, who see technology as something that improves
their lives, are driving the future of banking technology. The use of an application
r
programming interface (API) to make proprietary data available to anyone who has the
consumer’s permission to access it is a common trend in banking technology.
ve
APIs could be used to make it possible for a bank’s mobile app to retrieve
customer account information. Fintechs have also used API technology to make their
businesses run, and their success is inspiring competitors to create their own APIs.
ni

Furthermore, according to a 2020 Insider Intelligence survey of banking executives,

66% believe that new technologies such as blockchain, artificial intelligence (AI), and
the Internet of Things (IoT) will have the greatest impact on banking by 2025. Banks,
U

according to Insider Intelligence, are looking into blockchain technology in the hopes of
streamlining processes and lowering costs.

Consumers can already see AI being used by most banks in the front office via
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chatbots. Banks are using artificial intelligence to improve customer identification and
authentication while also simulating live employees with chatbots and voice assistants.

4.2 Online Banking

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A user can conduct financial transactions over the Internet by using online banking.
Online banking can also be referred to as Internet banking or web banking. It provides
customers with almost every service previously available only through a local branch,
)A

such as deposits, transfers, and online bill payments. Almost every banking institution
offers some form of online banking, which is available both on desktop computers and
through mobile apps.

4.2.1 PINs
(c

A PIN is a numerical code that is used in many electronic financial transactions.

Personal identification numbers are typically assigned to payment cards and may be

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 256 Principles and Practices of Banking

required to complete a transaction. A personal identification number (PIN) is used to

Notes

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add extra security to the electronic transaction process.

Personal identification numbers (PINs) add an extra layer of security to an account

in
and are most commonly associated with debit cards linked to a person’s bank account.
When a person receives a debit card, they must select a unique personal identification
number (PIN) that they must enter every time they want to withdraw money from an

nl
ATM and, in many cases, when they make payments at various merchant stores.

PINs, which are similar to passwords, are used in a variety of other applications,
including home security and mobile phones. A personal identification number (PIN)

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is essentially any numerical method used to verify an individual’s identity. Personal
identification numbers (PINs) are usually four to six digits long and are generated by the
issuing bank using a coding system that makes each PIN unique, or they are chosen
by the account holder themselves. A PIN is typically mailed to a cardholder in addition

ty
to the associated card or punched in at a local branch when opening an account in
person.

When selecting a PIN, it is best to select one that is difficult to guess but also easy

si
for the account holder to remember. Short, simple PINs, such as “123,” or numbers that
would be easy to guess in cases of fraud; common information, such as an account
holder’s birthday, marriage anniversary, or Social Security Number, are discouraged.
r
Account holders must be cautious when sharing or disclosing their personal
ve
identification number in order to prevent unauthorised access to their bank accounts.

4.2.2 Smart Cards

A smart card is a card that stores information on a microprocessor or memory chip
ni

instead of the magnetic stripe found on ATM and credit cards. Smart cards contain
embedded microprocessor chips, which add an additional layer of security for users.
They resemble standard credit cards or driver’s licences, but instead of being made of
U

a single piece of plastic, they are made up of tiny boxes that house the microprocessor
itself.

Smart cards cannot be read in the same way that regular credit and debit cards
ity

can because they do not have magnetic strips. They are read either by physical slots
designed for chip reading or by short-range Wi-Fi using near field communication, or
NFC.

Smart cards are used for more than just transferring financial information; they
m

can also be used for a variety of identification purposes. Some businesses provide
smart identification cards to their employees as an added layer of security for both the
organisation and the individuals who work there.
)A

Smart cards are essential for security in all of their applications. Smart cards
provide users and institutions with additional security for transactions and account
information in an age of increasing technology hacks and security challenges. Smart
card transactions are encrypted to protect the transfer of information from one party
to the next. Each encrypted transaction is unhackable and transfers no additional
(c

information beyond what is required to complete the single transaction.

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 Principles and Practices of Banking 257

4.2.3 Signature Storage and Display

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Every industry is undergoing digital transformation. One of them is the banking
sector. The banking industry is critical and highly sensitive. The use of a digital

in
signature is one of the technological innovations that is rapidly transforming the
industry. The main motivation for developing electronic signatures for banking was to
make it easier for financial institutions to operate.

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A digital signature is a technology that has the potential to accelerate financial
institutions’ growth and speed. As we all know, a signature is required in every banking
institution. Opening an account, depositing money, withdrawing money, and any other

O
banking activity.

Consider how much time people waste while waiting for their loan documents to be
signed in order for them to be approved. Consider how inconvenient it is to wait in line

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for hours for your bank documents to be signed. Such a time-consuming, inefficient,
and tedious process is motivating banks to adopt digital signatures.

The primary reasons for banks to adopt eSignature solutions are:

si
1. A digital signature is a secure form of identification: Many financial institutions have
begun to accept digital signatures for advanced securities measures in recent years.
A digital sign is secure and cannot be manipulated in the same way that a handwritten
r
sign can. As a result, electronic signature for banking is a very effective method of
ve
obtaining signatures.
Additionally, secure digital signature transactions have aided the growth of online
businesses. This is because banks can now approve transactions for online business
owners in a faster, more efficient, and secure manner. Prior to the introduction of
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digital signatures, you had to go to the bank to conduct any banking transaction.
However, with a digital signature, you can securely and quickly access your bank. In
fact, the banking digital signature is expected to grow at a 26.5 percent annual rate
U

over the next five years. Banks can increase their security by implementing public
key infrastructure digital signature technology. Individual identification standards are
higher and more accurate with this technology.
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2. Improved transparency and efficiency: Transparency and efficiency are ideal in any
banking or financial institution. However, by implementing eSignature solutions for
banks, transparency and efficiency issues can be addressed.
For example, the lending process can be time-consuming and frustrating for both
m

the bank and the customer. If you are applying for a loan, you must have multiple
businesses and people sign your application. When using the traditional signature,
your recipient will have a difficult time determining how far you have progressed in
your signing process. This is most common when the agreements to be signed are
)A

sent via fax or paper. However, when you use a digital signature, there is transparency
because the person who is supposed to sign your agreement can track how far you
have progressed in the process.
A bank can send digitally signed agreements to multiple signers at once when
(c

using a digital signature. This is due to the fact that the person has access to your
agreements thanks to your digital signature. Furthermore, if a recipient fails to sign,
the bank can send remainders to ensure an efficient transaction. Customers will be

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 258 Principles and Practices of Banking

able to obtain quality and efficient banking services as a result of digital signatures.
Notes

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As a result, the customers are satisfied.
3. Time-saving: A digital signature is a valuable asset that banks can use to strengthen

in
their portfolios. But how exactly? Through the use of esignature for banking, they are
digitalizing their services. For example, if a bank uses a faster digital signature, it can
serve more customers for a limited time. This means that, in the end, the bank will

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profit more than if it used the traditional paper signatures system.
4. Cost-cutting: A digital signature is a valuable technology that can help banks save
thousands of dollars each year. This is due to the bank’s refusal to spend money

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on purchasing signature-writing materials. Printing costs, paper costs, and other
expenses fall into this category. The funds used to cover such expenses can be put
to better use, such as lending to people and collecting interest.
5. Document centralization: Banks and financial institutions deal with a wide range of

ty
documents on a daily basis. Similarly, banks have numerous branches that report to
the main branch. For banks to have efficient and organised document centralization,
the use of digital signatures is required. This is due to the fact that the traditional

si
process is expensive, time-consuming, and tedious. As it allows for the easy capture
of customer signatures, digital signatures aid in the centralization of documents in
banks.
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When a signature is inserted into a document template, it is automatically saved
ve
in the bank’s document management system. This means that any branch of a
particular bank can access the signature and serve a specific customer.
6. Enhance brand image: The use of digital signatures in the banking sector improves
customer perception. This is because it gives the customer the impression that the
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bank cares about them by implementing new technology that will improve how banks
deliver services to them. Customers will also be impressed by the bank’s use of
technology to combat fraud because a digital signature is secure.
U

A bank can also benefit from the use of a colourful and large-screen tablet for digital
signature. This is possible by displaying new financial services offered by the bank
through message advertisements.
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7. Fights against fraud: The use of traditional paper banking documentation signatures
leaves room for fraud. This is due to instances such as signature forgery. Documents
can also be stolen, misplaced, or lost. However, with digital signature technology,
securely storing and verifying signatures is a simple task. As a result of the use of
electronic signatures, signature fraud in banks will be reduced.
m

4.2.4 Cheque Truncation

)A

Cheque Truncation System (CTS) is a method of clearing cheques electronically

rather than having the presenting bank process the physical cheque while it is on its
way to the paying bank branch. The Reserve Bank of India (RBI) has taken this step to
expedite cheque clearance.

Despite the availability of major products such as RTGS (real-time gross

(c

settlement) and NEFT (national electronic funds transfer), which enable inter-bank and
customer payments to be made online and in near-real time, cheques remain the most

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 Principles and Practices of Banking 259

popular mode of payment in the country, which is why the RBI has decided to focus on
Notes

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improving the efficiency of the cheque clearing cycle.

According to the RBI, banks must ensure that all of their branches participate in

in
image-based CTS by September 30, 2021. The CTS process is currently operational at
major clearinghouses across the country, but not at all bank branches.

The CTS will eventually cover all bank branches in the country. It will make the

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paper-based clearing system more convenient for customers and more efficient. In
addition to operational efficiency, CTS provides a variety of other benefits to banks and
customers, such as human resource rationalisation, business process re-engineering,

O
cost-effectiveness, adoption of cutting-edge technology, and so on.

“Because there is no physical movement of cheques under CTS, the cost of

cheque collection is reduced.” Furthermore, logistical issues are eliminated, and

ty
instrument loss in transit is no longer an issue. This reduces operational risk and the
risks associated with paper clearing while also increasing operational efficiency “”
formalised paraphrase CTS has also resulted in the consolidation of multiple clearing
locations managed by various banks with varying service levels into a national standard

si
clearing system with uniform processes and practises. This has eliminated the need for
multiple clearing house locations and reduced the investment in MICR machines and
the associated AMC costs. As a result, operational overhead has been reduced on the
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cost front, and clearing differences and reconciliation issues have been eliminated on
ve
the inter-operational front. Customers will benefit from faster, better, and more seamless
services at lower costs.”

Furthermore, CTS cheques have additional security features such as watermarks

and the bank’s logo printed with special ink that is visible only under UV scanners.
ni

These security features ensure uniformity across bank-issued cheques and aid in the
better scrutiny of deposited cheques, reducing fraud. The RBI’s CTS process across the
country will be a significant step toward Digital India. Whereas RTGS, NEFT, and even
U

IMPS were game changers for the banking sector, primarily in urban areas, cheques
remain one of the most popular modes of payment because they serve both rural and
urban India.
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4.2.5 Microfiche
Microfiche is a thin photographic film, typically four by five inches in size, that
can store information in a miniaturised form. This method is used to preserve fragile
materials such as archival documents, journals, books, newspapers, and magazines, as
m

well as to save space in libraries and other archives.

Microfiche is simple to use and does not necessitate any specialised knowledge or
software. The documents are photographed and stored on the microfiche card, which
)A

has a limited storage capacity. The images are too small for the naked eye to read. A
special device is used to greatly magnify the contents of the microfiche in order to read
it. Microfiche, like microfilm, is available in both positive and negative images, though
negative images are more common.
(c

There are numerous advantages to using microfiche, such as ease of storage. As

a single sheet can store numerous images, many documents can be stored in a small
space. It also makes it simple and convenient to access grouped documents. Updating
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 260 Principles and Practices of Banking

is also simple because a new sheet can be added to the file at any time, which aids
Notes

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in keeping the documents organised. This is one of the primary reasons for storing
photos, newspapers, journals, and other documents on it. Microfiche is a flat film sheet
that does not require spinning film onto reels as microfilm does. Microfiche also takes

in
up less space and requires less storage than microfilm.

One of the major drawbacks of using microfiche is the lack of portability. It

nl
necessitates the use of specialised equipment for reading and duplicating the cards,
which is costly. Microfiche is also more expensive to manufacture than microfilm.

With the advent of digital storage options, microfiche is no longer as widely used as

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it once was.

4.2.6 Note and Coin Counting Devices

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Note Counters
Simple piece counters, mixed note counters, and advanced note counters with
fitness detection are all part of this product line. CTcoin’s note counters are well-known

si
for their extreme durability, dependability, and the best “value for money.”

Features
●● Full line CIS sensor r
ve
●● UV, MG, MT and IR detections
●● Multi-Currency
●● Mix counting mode and Value counting mode
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●● USD mix counting

●● Accumulate function
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●● Automatic and manual start functions

●● Batch function
●● These models have chain notes, half note and double note detections
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●● LCD display, 7 digits-counting, 3 digits-batch, 3 digits-message

●● Self diagnostics of the system
●● USB interface for software upgradation
m

Coin Counters
Coin counters are used and operated by staff in a bank, a retailer, or a vending
)A

operator. Due to increased demands in the workplace, machine and operating silence is
a critical concept. This category includes a variety of coin counting machines that are all
built to high quality standards and design ethics.

These models have a larger capacity and an integrated inspection tray with a
cleaning system to ensure that coins are handled as safely as possible. In addition, the
(c

5th generation alloy sensor technology has the highest counting accuracy, rejecting
foreign coins, counterfeit coins, tokens, and so on.

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 Principles and Practices of Banking 261

Features:
Notes

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●● Improved features in the next generation
●● Coin feeder for large quantities of coins.

in
●● Large inspection tray with cleaning system.
●● Improved reject of foreign coins, tokens etc.

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●● Counting of up to 20 different coin denominations.
●● Rejection of foreign coins, counterfeit coins, tokens etc.

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●● 2 different coin denominations can be shown in the two-line display.
●● Tilt sensor for easy cleaning of coin rail.
●● Programmable bag stops (by number or weight).

ty
●● Battery back-up.
●● Coin tubing and bagging programme.

si
●● Programmable fee system.

4.3 Electronic Funds Transfer

r
An electronic funds transfer (EFT) is the electronic transfer of money over an online
ve
network. Electronic funds transfers can be performed between the same bank or a
different one, and they can be accomplished using a variety of payment systems. An
EFT can be initiated by a person or an institution such as a business, and it often does
not require much more than a bank account in good standing.
ni

An electronic funds transfer is a common method for moving funds from one
account to another over a computer network. Electronic funds transfers replace paper
transfers and human intermediaries while providing the customer with the convenience
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of doing her own banking.

4.3.1 Swifts
ity

The Society for Worldwide Interbank Financial Telecommunications (SWIFT)

system is at the heart of most international money and security transfers. SWIFT is
a massive messaging network that banks and other financial institutions use to send
and receive information such as money transfer instructions quickly, accurately, and
securely.
m

SWIFT is a messaging network used by financial institutions to securely transmit

information and instructions using a standardised code system. Although SWIFT has
become an important part of the global financial infrastructure, it is not a financial
)A

institution in and of itself: it does not hold or transfer assets. Rather, its usefulness
stems from its ability to facilitate secure, efficient communication among member
institutions.

SWIFT assigns each financial institution a unique code of eight or eleven

(c

characters. The code is also known as a bank identifier code (BIC), a SWIFT code, a
SWIFT ID, or an ISO 9362 code. Let’s take a look at an eight-character SWIFT code to
see how it’s assigned.
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 262 Principles and Practices of Banking

●● First four characters: the institute code

Notes

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●● Next two characters: the country code
●● Next two characters: the location/city code

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●● Last three characters: optional, but organizations use them to assign codes to
individual branches.

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Who Uses SWIFT?

SWIFT’s founders initially intended for the network to only facilitate communication
about Treasury and correspondent transactions. The robustness of the message format

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design allowed for massive scalability, allowing SWIFT to gradually expand to provide
services to the following organisations:

◌◌ Banks

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◌◌ Brokerage institutes and trading houses
◌◌ Securities dealers
◌◌ Asset management companies

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◌◌ Clearinghouses
◌◌ Depositories
◌◌ Exchanges
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◌◌ Corporate business houses
◌◌ Treasury market participants and service providers
◌◌ Foreign exchange and money brokers
SWIFT has become an essential component of the global financial infrastructure.
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In 2021, more than 11,000 global SWIFT member institutions sent 42 million messages
per day on average through the network, an increase of 11.4 percent over 2020.
Countries all over the world have an incentive to stay in good standing with SWIFT
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because they rely on it for fast, seamless, and secure communication. SWIFT is
supervised by central banks from the Group of Ten (G10) countries, but it is a neutral
organisation that serves all of its members.
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4.3.2 RTGS
The Reserve Bank of India operates and manages the Real Time Gross Settlement
(RTGS) fund transfer service (RBI). Its popularity stems from the fact that it settles
transfer requests on a gross or instruction-by-instruction basis rather than the more
m

common batch-clearing format. As a result, funds can be transferred from one bank
account to another quickly and easily. However, before you begin a transaction, you
should be aware of the RTGS transaction limit, which determines the minimum and
)A

maximum amounts that can be transferred using the service. You must also keep your
transactions within the RTGS daily limit.

As a payment system, RTGS is intended for high-value transactions and has a

minimum and maximum limit.
(c

RTGS Minimum Limit: This is the amount of money you must transfer in order to be
eligible for RTGS. The RTGS minimum amount limit is 2 lakh.

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 Principles and Practices of Banking 263

The RTGS transaction upper limit is referred to as the RTGS maximum limit. Your
Notes

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transaction amount should fall within this range. The upper limit for RTGS transactions
differs from bank to bank.

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Individual banks may also impose a daily limit, which you must abide by.

RTGS transactions can be initiated 24 hours a day, seven days a week through
Retail Internet Banking and Corporate Internet Banking, as detailed below:

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◌◌ From 7:00 am to 6:00 pm – As per customer approval limit
◌◌ From 6:00 pm to 7:00 am – upto INR 1 Crore (including 2nd & 4th Saturday,

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Sunday & Bank Holidays)

4.4 Information Technology

Today’s banking environment is extremely competitive. To be able to survive and

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grow in a changing market environment, banks are turning to the latest technologies,
which are viewed as a “enabling resource” that can aid in the development of learner
and more flexible structures that can respond quickly to the dynamics of a rapidly

si
changing market scenario. It is also regarded as a tool for cost reduction and effective
communication with people and institutions involved in the banking industry.

Information technology enables sophisticated product development, improved

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market infrastructure, the implementation of dependable risk-control techniques,
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and the ability of financial intermediaries to reach geographically distant and diverse
markets. The Internet has had a significant impact on bank delivery channels. The
internet has emerged as a vital channel for the delivery of banking products and
services.
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Customers can view their accounts, obtain account statements, transfer funds, and
purchase draughts by simply pressing a few buttons. The introduction of smart cards, or
cards with a microprocessor chip, has added a new dimension to the scenario. With the
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introduction of ‘Cyber Cash,’ the exchange of money is done entirely through ‘Cyber-
books.’ Electricity and telephone bill collection has become simple. The upgradeability
and flexibility of internet technology has provided banks with unprecedented
opportunities to reach out to their customers. Without a doubt, banking services have
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undergone significant changes, as have customers’ expectations of banks.

IT is transitioning from a back-office function to a primary aid in increasing a

bank’s value over time. IT accomplishes this by maximising banks’ proactive measures
such as strengthening and standardising banks’ infrastructure in terms of security,
m

communication, and networking, achieving inter-branch connectivity, transitioning to a

Real Time Gross Settlement (RTGS) environment, forecasting liquidity by building real-
time databases, and using Magnetic Ink Character Recognition and Imaging technology
)A

for cheque clearing, to name a few. Indian banks are aggressively pursuing retail
banking.

The increasing sophistication of technology and the growing popularity of the

Internet have been the primary drivers of charge. Customers’ expectations are changing
(c

as they transition from traditional banking to e-banking.

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 264 Principles and Practices of Banking

E-Banking:
Notes

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E-banking first appeared in the United Kingdom and the United States in the
1920s. It becomes widely used in 1960, thanks to electronic funds transfer and credit

in
cards. In the early 1980s, the concept of web-based baking emerged in Europe and the
United States.

E-banking is a relatively new phenomenon in India. The traditional growth model

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has been through branch banking. Non-branch banking services were only introduced
in the early 1990s. In comparison to public sector banks, new private sector banks and
foreign banks are hampered by a lack of a strong branch network. In the absence of

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such networks, the market has seen the emergence of many innovative services by
these players via direct distribution strategies of non-branch delivery. All of these banks
are using home banking as a key “pull” factor to entice customers away from well-
established public sector banks.

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Many banks have modernised their services by incorporating computer and
electronic technology. The electronic revolution has enabled banks to provide
customers with greater ease and flexibility in their banking operations. Customers have

si
said goodbye to large account registers and large paper bank accounts as a result of
e-banking. E-banks, also known as easy banks, provide the following services to their
customers:

◌◌
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Debit and credit cards
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◌◌ ATM
◌◌ E-Cheques
◌◌ TFT (Electronic Funds Transfer)
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◌◌ Accounts for DeMAT

◌◌ Banking on the Go
◌◌ Banking over the phone
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◌◌ Banking on the internet

◌◌ E-commerce (Electronic Data Interchange)
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Advantages of E-banking:

To the Client:
◌◌ Anywhere Banking services are available wherever the customer is in the
world. Balance inquiries, service requests, and instructions can be issued
m

from anywhere in the world.

◌◌ Anytime Banking entails managing funds in real time, 24 hours a day, seven
days a week.
)A

◌◌ Convenience is a huge psychological benefit all the time.

◌◌ Reduces the customer’s “Cost of Banking” over a period of time.
◌◌ Withdraw cash from any branch or ATM.
(c

◌◌ Online purchasing of goods and services, including online payment.

To the lender:

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 Principles and Practices of Banking 265

◌◌ Innovative, scheme, addresses competition, and positions the bank as a

Notes

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technology-driven player in the banking sector market.
◌◌ Reduces the number of customer visits to the branch and, as a result, the

in
amount of human intervention.
◌◌ Inter-branch reconciliation is immediate, reducing the possibility of fraud and
misappropriation.

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◌◌ Online banking is an effective medium for promoting the bank’s various
schemes, and it is a marketing tool.
◌◌ Individualized and customised services are made possible by integrated

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customer data.

IT’s Influence on Service Quality:

The most visible impact of technology is reflected in how banks respond

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strategically in order to make effective use of it for efficient service delivery. This effect
on service quality can be summarised as follows:

With automation, service is no longer just a marketing advantage for large banks.

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By integrating IT into their operations, small and relatively new banks with a limited
network of branches become better positioned to compete with established banks.

r
Some financial services have become commoditized as a result of technological
advancements. As a result, banks cannot take a lifetime relationship with their
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customers for granted, and they must work constantly to foster this relationship and
retain customer loyalty.

On the one hand, technology serves as a powerful tool for customer service; on the
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other hand, it results in the depersonalization of banking services. This has a negative
impact on relationship banking. A decade of computerization will almost certainly never
be able to replace a simple or warm handshake.
U

Banks must automate routine customer inquiries through self-service channels

in order to reduce service delivery costs. To accomplish this, they must invest in call
centres, kiosks, ATMs, and Internet access. To be customer-centric, banks today
require IT infrastructure that is integrated with their business strategy.
ity

IT’s Impact on the Banking System:

The banking system is gradually transitioning away from traditional banking and
toward relationship banking. Traditionally, the bank’s relationship with its customers
m

has been one-to-one through the branch network. This was implemented, with clearing
and decision-making responsibilities concentrated at the branch level. The head office
was in charge of the overall clearing network, the size of the branch network, and staff
)A

training in the branch network. The bank monitored the organization’s performance and
established decision-making parameters, but the information available to branch staff
and customers was limited to a single geographic location.

The modern bank cannot rely solely on its branch network. Customers are
increasingly demanding new, more convenient delivery systems, and services such as
(c

Internet banking serve a dual purpose for the customer. They offer traditional banking
services as well as much easier access to information about their account status

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 266 Principles and Practices of Banking

and the bank’s many other services. To accomplish this, banks must create account
Notes

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information layers that can be accessed by both bank staff and customers.

The use of interactive electronic links via the Internet could go a long way toward

in
providing customers with more information about their own financial situation as well as
the services provided by the bank.

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IT’s Impact on Data Privacy and Confidentiality:
Data stored in computers is now displayed when needed via internet banking,
mobile banking, ATMs, and so on. All of this has given rise to concerns about data

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privacy and confidentiality, which are as follows:

●● The computer’s data processing capabilities, particularly its rapid throughput,

integration, and retrieval capabilities, raise concerns in people’s minds about
whether their privacy is being eroded.

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●● Everything appears to be in order as long as individual data items are available
only to those directly involved, but the incidence of data being cross referenced to
create detailed individual dossiers raises privacy concerns.

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●● Customers are concerned about the inadequacy of privacy maintained by banks
with regard to their transactions, and they view computerised systems with
scepticism.
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Aside from any constitutional aspects, many nations consider privacy to be a
human right and believe it is the responsibility of those involved with computer data
processing to ensure that computer use does not revolve to the point where different
data about people can be collected, integrated, and retrieved quickly. Another important
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responsibility is to ensure that the data is only used for the intended purpose.

4.4.1 RBI NET

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No information available

4.4.2 DATANET
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With the growing number of network security threats, it is more important than
ever to provide reliable and secure ways to connect local branches with corporate
headquarters of financial and banking institutions, as well as insurance companies.

To achieve this, DataNet proposes cost-effective banking and financial

m

communications solutions:

◌◌ Accuracy
◌◌ Reliability
)A

◌◌ Security
◌◌ Redundancy
◌◌ Recovery
(c

◌◌ Scalability
◌◌ Greater operational efficiency
◌◌ Delivery of non-stop data
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 Principles and Practices of Banking 267

◌◌ Faster transaction speeds

Notes

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◌◌ Drive online services
◌◌ Improved customer satisfaction and relationships

in
DataNet’s communications solutions meet the networking needs of the financial
sector by supporting real-time business critical applications such as cloud-based
services, ATMs, credit card services, branch bank automation, secure financial

nl
transactions, electronic transfers, online banking, micro-finance, mobile money
services, smartphone mobile transactions, SMS, contactless digital wallets, point of sale
systems, file/software updates, standard office systems, multi-medium systems, and

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multi-medium systems.

4.4.3 NICNET

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The National Informatics Centre (NIC) has institutional links with all Ministries/
Departments of the Central Government, State Governments, Union Territories,
and District Administrations of the country via its Information and Communication
Technology (ICT) Network – NICNET. The National Informatics Network (NICNET) is a

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satellite-based nationwide computer communication network that is a type of Wide Area
Network (WAN).

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NICNET has been instrumental in steering e-Governance applications in
Government Ministries/Departments at the Centre, States, Districts, and Block
ve
level, facilitating improvement in Government services, greater transparency, and
promoting decentralised planning and management, resulting in better efficiency and
accountability to the people of India.
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Direct peering between NICNET and BSNL, PGCIL, and Railtel has been
completed in Delhi and Hyderabad in order to save Internet bandwidth and provide
faster access to each other’s networks and data centres. Peering with Google,
Microsoft, and the Akamai Content Delivery Network has resulted in faster access to
U

Google services and other important international websites.

The restructuring of the videoconferencing network has enabled it to handle large-

scale important video conferencing such as the PRAGATI of the Hon’ble Prime Minister
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and GST Council Meetings of the Hon’ble Finance Minister, among others.

4.4.4 I-NET
Credit and debit card transactions between financial institutions were processed by
m

the Interbank Network for Electronic Transfer (INET) (FIs). Prior to the introduction of
Banknet, it handled the transfer of funds from cards bearing the MasterCard Inc. (MA)
logo.
)A

The Interbank Network for Electronic Transfer (INET) handled funds transfers,
whereas MasterCard’s Interbank National Authorization System (INAS) handled card
authorizations.

The Interbank National Authorization System (INAS) was the first component of
(c

MasterCard’s global telecommunications network, offering electronic authorization

in place of earlier phone authorization technology. Later, the Interbank Network for

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 268 Principles and Practices of Banking

Electronic Transfer (INET) was established, providing electronic settlement services to

Notes

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replace the previous system in which banks sent paperwork to each other.

Interbank Network for Electronic Transfer (INET) and Interbank National

in
Authorization System (INAS) were eventually combined into a single entity known as
Banknet: a global telecommunications network that connects all MasterCard card
issuers, acquirers, and data processing centres into a single financial network.

nl
Banknet enables payments to be made all over the world. It has been in operation
since 1997 and can handle millions of secure transactions per hour through its
thousands of data centres spread around the world.

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The architecture of Banknet is built on a peer-to-peer protocol that routes
transactions to various endpoints. In the event of a shutdown, data centres are outfitted
with technology that provides redundancy and automatic activation of backup services.

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Banknet’s architecture enables bandwidth to be regulated based on demand. This
function is critical for regulating the system’s capacity during peak times, such as the
holiday shopping season. Banknet primarily collaborates with AT&T Inc. on this and

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other technologies.

Banknet also offers transaction research for chargeback requests. This allows
cardholders to receive approved chargebacks in as little as a few hours.
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4.4.5 Email
Email money transfer (EMT) is a retail banking service that enables users to
transfer funds between personal accounts via email and their online banking service.
Email money transfers are commonly referred to as Interac e-Transfers in Canada.
ni

Because the transfer is only notified via email, EMTs are regarded as a secure
method of transferring money. The actual funds are settled using existing fund transfer
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networks that banks have been using for years.

When senders first open their online banking account, whether on a desktop
computer or a mobile application, they initiate an email money transfer (EMT). They will
then specify the amount to be sent as well as the account from which the funds will be
ity

withdrawn. They decide who will receive these funds. When funds are confirmed, they
are immediately debited.

An email is sent to the recipient of the funds with an answer to a specific security
question; additionally, separate instructions regarding the retrieval of the funds via a
m

secure website are sent to the recipient. The recipient must correctly answer a security
question in order to gain access to the funds. Funds could be returned to the sender
after a certain number of unsuccessful attempts.
)A

If the recipient successfully navigates the security barrier, the funds will be
deposited immediately and, in most cases, at no additional cost if the recipient is a
member of a participating online banking institution. If the recipient is not a customer
of a participating online banking institution, it may take three to five additional business
(c

days.

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 Principles and Practices of Banking 269

Auto deposits can also be used to facilitate EMTs, eliminating the need to check
Notes

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your email and answer security questions. This is a service that a customer would sign
up for and set up using the appropriate security measures.

in
EMTs are also known as Interac e-Transfers because the service is provided by
Interac, a Canadian company that creates interbank networks to facilitate financial
transactions between banks.

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4.5 Cyber Security
Cyber security is the use of technologies, processes, and controls to defend

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against cyber attacks on systems, networks, programmes, devices, and data. Its goal is
to reduce the risk of cyber attacks and to protect against unauthorised use of systems,
networks, and technologies.

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4.5.1 Protecting the Confidentiality and Data
While banks have always kept large amounts of personal and financial data on

si
their customers, that data is now easily accessible to anyone with permission. Over the
last few decades, the advancement of financial technology has resulted in numerous
innovations and changes, such as wire transfers, credit/debit cards, online banking, and

r
mobile payments. Banks have had to not only upgrade their systems to accommodate
these changes, but also transform their processes in order to maintain security when
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implementing new technology.

Banking regulations are constantly changing to meet the demands of modern

banking systems. Banks have a legal obligation to keep customer data secure and
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prevent it from falling into the hands of unauthorised individuals. In this article, we’ll look
at how modern banks make sure they’re up to the task.

Best Data Security Practices for Banks

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To secure data, banks must take a 360-degree approach to ensure that no

security breach occurs, either internally or externally. This entails safeguarding both
the customer-facing end of banking processes as well as internal processes involving
ity

employees, vendors, systems, and processes. Here are a few examples of how this is
accomplished.

1. Verification: Authentication requires that every transaction in the bank take place
only after the identity of the person initiating the transaction has been confirmed. This
m

applies to customers who use online or mobile banking systems, visit the bank in
person, or use credit/debit cards at POS terminals and ATMs. It also applies to bank
employees who have access to customers’ and the bank’s information. Previously,
)A

authentication required only an ID and a password or PIN; however, many banks

have now implemented two-factor and multi-factor authentication to ensure that the
person is who he or she claims to be. Banks are also using biometric authentication
techniques, such as behavioural biometrics, to verify customers’ identities when they
interact with banking systems such as IVR.
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2. Audit Trails: A record of all banking transactions was always available in the form
of a statement or passbook. Furthermore, banking systems keep an audit trail for
every event that occurs during a customer’s interaction with the systems. Whether a
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 270 Principles and Practices of Banking

customer uses phone banking or online banking, the time of the interaction, as well
Notes

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as the details of the interaction, are recorded. This data is backed up daily and is
never completely purged, instead being archived at predetermined intervals of time.

in
3. Infrastructure Security: Secure infrastructure refers to the database systems and
servers where data is stored, as well as the boundaries that are set up to secure
these. In most core banking systems, production data is encrypted. Important data

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such as account number, customer name, and address must be masked if testing
is required. Access to manufacturing systems is restricted. Infrastructure vendors
are generally distinct from those who deal with applications. Bank employees are
typically provided with specialised equipment that restricts access to social media,

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personal emails, and USB ports. When using public Wi-Fi, employees can only
connect to the banks’ network via VPN.
4. Secure Processes: Banks have many processes in place to ensure that security is

ty
implemented and tested. KYC (Know Your Customer) updates for customers, NDA
(Non-disclosure agreement) for employees and vendors, securing special zones
within the premises, and remote data centres are all part of this. Banks can mitigate
insider threats and protect sensitive customer data such as name and credit card

si
numbers by implementing Data Loss Prevention (DLP) solutions. Processes related
to global and local regulations are also implemented, and risk assessments are
performed to ensure that these processes are in compliance.
5.
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Constant Communication: In addition to the periodic account statements that are
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generated and sent to customers, banks communicate with customers on a regular
basis about system upgrades, the implementation of new authentication procedures,
and so on. Customers can also set limits and alerts based on various conditions
to ensure that they are notified if any unusual activity occurs with regard to their
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accounts. While there are multiple channels of communication available, the setup
is adaptable to the needs of the customers.
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4.5.2 Phishing Attack

Today, email has become a common mode of communication. We get all kinds of
email, including personal, official, and marketing mailers. Subject lines that are cleverly
ity

written may catch our attention. As a result, it may be tempting to click on a link in an
email that says: “It’s your birthday, so we’re treating you to a free SPA treatment. To
take advantage of this offer, please click here “..

If you do click the malicious link in the email newsletter, you will be directed to a
m

website that will ask for your personal information under the guise of registering for the
service. Worse, it may install malware (malicious software) in the background, snooping
for sensitive information and sending it back to a hacker. This is referred to as phishing.
)A

Phishing is a fraudulent act in which victims are duped into disclosing sensitive
information such as bank account information, logins, PINs, passwords, or biometrics to
the attacker. In 2017, there was a record increase in phishing sites (fake websites), with
over 1.3 million of them appearing on the internet. With the recent breach of security
firm RSA, it is clear that even experts are vulnerable.
(c

On websites, hackers and scammers post fraudulent links. Clicking on these

links will either install malicious software on your computer or redirect you to a bogus

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 Principles and Practices of Banking 271

banking website. These fraudulent links can also be delivered via email in the form of
Notes

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a convincing newsletter. You may also receive an email from someone impersonating
a bank official asking you to click a link and change your password. So be alert and on
the lookout for warning signs.

in
How to Protect Yourself from Phishing Scams
Phishing is an ever-present risk on the internet, but taking certain precautions

nl
can keep you safe from such attacks. Unlike a direct invasive attack, phishing requires
the victim’s cooperation – they must initiate some sort of action or volunteer sensitive
information. Here’s how to avoid such con artists:

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Recognize the following signs of fraud: Phishing websites and emails are
frequently riddled with grammatical errors and impersonated branding. These are often
tell-tale signs of a phishing attack, so inspect a website carefully before interacting with

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it. If an email or website contains offers and services that appear to be too good to be
true, they are usually intended to entice unsuspecting victims.

Examine the URL or website address carefully. Is there a typo in the bank’s name?

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A legitimate bank’s website address will always begin with ‘https.’ That means that all
data exchanged between your browser and the bank’s website is encrypted.

Click with caution: Most phishing sites spread their reach on the internet by
r
posting flashy and lucrative links on popular websites. Clicking on these can jeopardise
ve
your security. Before interacting with links, it is best to inspect them. If they appear
suspicious, conduct a quick web search to find the bank’s official website address, also
known as the URL.

Use extreme caution: When banking online, only use reputable software and
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services. Use only official links and sources to access websites, and follow proper
security procedures. Examine the URL for the SSL certificate (the web address will be
prefixed with ‘https’) to see if the website is secure. It is best to have two devices – one
U

for work and one for personal use – to ensure that the security of the work device is
never jeopardised.

How to Get Rid of a Phishing Attack

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Phishing scams can cause a tremendous amount of harm to the victim. As a result,
if you are the victim of a phishing attack, it is critical that you implement a strategy to
mitigate the damage.
m

Replace all of your passwords: Because the scammers may have access to all of
your accounts, the first step should be to change your login credentials and passwords
in order to keep them out of the system and prevent further damage.
)A

Please contact the following officials: The next step is to contact your bank and
explain the situation. They will then freeze your account, preventing any further
transactions. Most states’ police departments have a cybercrime division that needs to
be informed as well.
(c

Examine your system: After you’ve secured your system, run a scan to ensure the
attacker didn’t install any malware or backdoor software on the device in preparation for
future attacks.

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 272 Principles and Practices of Banking

Don’t be alarmed if you find yourself the victim of a phishing scam. Even the most
Notes

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complex attack can be resolved with the assistance of your bank and law enforcement.
Above all, remember to be cautious in all of your online transactions!

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Emails from unknown senders should be deleted: Once a week, go through your
inbox and delete marketing emails and emails from unknown sources.

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4.6 Others
Banks and credit unions are increasingly turning to cloud computing solutions to
store data and support applied analytics in order to meet the demand for capacity and

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speed. As a result, customer insights may improve, efficiency may improve, innovation
may improve, agility may increase, and the risk of security or business continuity
breaches may decrease. Cloud solutions can augment human productivity as an
overarching organisational advantage, providing insights that can positively impact both

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front-office and back-office transformation.

It is critical for financial institutions to replace outdated on-premise infrastructure

si
that has become increasingly difficult to update and costly to maintain. Successful
organisations must look for flexible, scalable solutions that are both responsive and
efficient now more than ever. Technology is now available to assist smaller banks in
competing. It is not a winning strategy to put off implementing these new solutions.
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4.6.1 Cloud Computing
Cloud computing is the on-demand delivery of computing services such as
software applications, data storage, and processing power via the internet. Rather
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than owning modern computing infrastructure, banks or credit unions can use cloud
computing solutions to replace or supplement what a current data centre provides.
This assists organisations in avoiding the initial cost and complexity of owning and
maintaining increasingly complex IT infrastructures.
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Spending on cloud computing solutions is increasing due to the need for

modernised back office technology, while spending on traditional, in-house IT is
decreasing. Options include vendor-provided public cloud services, private clouds
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built by a financial institution, and hybrid cloud solutions that combine a private cloud
with one or more public cloud services, utilising proprietary software to facilitate
communication between the two.

Cloud service models enable financial institutions to transition from a capital-

m

intensive approach to a more flexible business model that reduces operational costs.

In a variety of ways, cloud computing can help financial institutions improve their
performance.
)A

Cost-cutting and usage-based Billing: Using cloud computing, financial institutions

can convert a large upfront capital investment into a smaller, ongoing operational
cost. There is no need to make significant investments in new hardware and software.
Furthermore, because of the unique nature of cloud computing, financial institutions can
(c

pick and choose the services they require on a pay-as-you-go basis.

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 Principles and Practices of Banking 273

Business Continuity: In cloud computing, the technology is managed by the

Notes

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provider. Financial institutions can improve their data protection, fault tolerance, and
disaster recovery. Cloud computing also offers greater redundancy and backup at a
lower cost than traditional managed solutions.

in
Business Agility and Concentration: Because of the flexibility of cloud-based
operating models, financial institutions can experience shorter product development

nl
cycles. This enables a more rapid and efficient response to the needs of banking
customers. Because the cloud is available on demand, less infrastructure investment
is required, resulting in a shorter initial set-up time. Cloud computing also enables new
product development to proceed without the need for capital investment.

O
Cloud computing also enables businesses to move non-critical services, such as
software patches, maintenance, and other computing issues, to the cloud. As a result,
firms can concentrate on the business of financial services rather than IT.

ty
Green IT: Organizations can use cloud computing to move their services to a
virtual environment, reducing the amount of energy consumed and the carbon footprint
associated with establishing a physical infrastructure. It also results in more efficient

si
computing power utilisation and less idle time.

The Advantages of Cloud Computing

r
Cloud computing solutions have acted as a catalyst for digital banking
ve
transformation, delivering benefits to both front and back office operational models.
These advantages will help financial institutions become more future-ready while also
providing a springboard for increased customer value and revenue.

Improved Customer Insights Customer data contains insights that can only be
ni

discovered through advanced analytics. Real-time data analysis can lay the groundwork
for a level of personalization and proactive engagement across all channels that would
otherwise be impossible with legacy infrastructure. With instant analysis, a bank or
U

credit union can understand individual customer behaviour and trigger ideal actions that
drive conversion, engagement, and loyalty.

Enhanced efficiency. Many financial institutions struggle to streamline, automate,

ity

and connect back-office processes that influence customer experiences. Cloud

technology has the potential to bring together disparate data and operational systems
that have previously existed in silos and hampered efficiency. This can redirect time
spent looking for insights to more productive and impactful analysis and decision
making.
m

Improved Innovation. Cloud technology has the potential to shorten product

deployment cycles and simplify product testing, allowing financial institutions to test new
)A

innovations in real-time and respond quickly to market acceptance (or rejection). Cloud
solutions also enable open banking, broadening the solution set available to consumers
across traditional and non-traditional financial services.

Increased agility. Cloud technology enables organisations to respond instantly to

changing market conditions, leveraging data and applied analytics to achieve customer
(c

experience and operational productivity benefits for banks and credit unions seeking

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 274 Principles and Practices of Banking

greater business agility. The opportunities range from responding to changing consumer
Notes

e
or competitive dynamics to allowing for the scalability of technology use.

Data and continuity risks have been reduced. What was once thought to be a

in
weakness of cloud technology has now become one of its greatest strengths. Cloud
computing offers a viable alternative to out-of-date systems that are becoming
increasingly vulnerable to data tampering. Cloud solutions can provide added security

nl
by allowing for the instant identification of potential breaches and embedding security to
protect banking data. Cloud solutions can also provide a high level of redundancy and
backup, which can help with disaster recovery.

O
4.6.2 Mobile Banking
The act of conducting financial transactions on a mobile device is known as mobile
banking (cell phone, tablet, etc.). This activity can range from as simple as a bank

ty
sending fraud or usage activity to a client’s cell phone to as complex as a client paying
bills or sending money overseas. The ability to bank from anywhere and at any time is
one of the benefits of mobile banking. When compared to banking in person or on a

si
computer, disadvantages include security concerns and a limited range of capabilities.

In today’s digital age, mobile banking is very convenient, with many banks
providing impressive apps. People choose mobile banking for a variety of reasons,
r
including the ability to deposit a check, pay for merchandise, transfer money to a
ve
friend, or locate an ATM quickly. However, it is critical to establish a secure connection
before logging into a mobile banking app, or else a client’s personal information may be
compromised.
ni

Mobile Banking Service Types

Mobile banking services are classified as follows:

1. Account information access: Account information access allows clients to view their
U

account balances and statements by requesting a mini account statement, review

transactional and account history, track term deposits, review and view loan or card
statements, access investment statements (equity or mutual funds), and manage
ity

insurance policies for some institutions.

2. Transactions: Transactional services allow clients to transfer funds between accounts
at the same or different institutions, perform self-account transfers, pay third parties
(such as bill payments), and make purchases in collaboration with other applications
or prepaid service providers.
m

3. Investments: Clients can use investment management services to manage their

portfolios or get a real-time view of their investment portfolios (term-deposits, etc.)
)A

4. Support services: Clients can use support services to check on the status of their
loan or credit facility requests, follow up on their card requests, and locate ATMs.
5. Content and news: Content services provide finance-related news as well as the
most recent offers from the bank or institution.
(c

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 Principles and Practices of Banking 275

The Difficulties of Mobile Banking

Notes

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Some of the difficulties associated with mobile banking are as follows: (but are not
limited to):

in
◌◌ Accessibility based on the type of handset being used
◌◌ Security concerns

nl
◌◌ Reliability and scalability
◌◌ Personalization ability
◌◌ Application distribution

O
◌◌ Upgrade synchronization abilities

Summary
●● Only a few years ago, technology was a major disruptor in the way banking

ty
was done. While the pandemic has accelerated the adoption of technology
across industries and sectors, our reliance on these advances has been greatly
increased. According to the Reserve Bank of India’s recent Annual Report 2020-

si
21, total digital transaction volume in 2020-21 stood at 4,371 crores, up from 3,412
crores in 2019-20, attesting to the resilience of the digital payment system in the
face of the pandemic.
●● r
As technological advancements continue to disrupt traditional banking methods,
ve
we see a plethora of newer and faster banking solutions emerge. Online deposits,
mobile wallets, e-bill payments, and other similar services have fundamentally
changed the way financial transactions are conducted today. With rising consumer
demand for digital banking services, artificial intelligence is at the heart of the
ni

digital banking transformation. These advancements are primarily accompanied

by the expansion of fintech and neo-banks, which are making the entire banking
process more convenient and hassle-free for customers.
U

●● One of the most significant changes has been the opening of the banking sector to
competition due to technological advancements.
●● Because of the rapid advancement of modern technology, traditionally slow-
moving financial institutions have had to invest billions to remain relevant to
ity

customers and competitive in the marketplace.

●● The implementation of computer and other electronic technologies in banks has
the following benefits, demonstrating the significance of such new technology in
banking:
m

●● Increased Efficiency: With the help of modern technologies, customers can be

served more efficiently and quickly.
)A

●● Information Handling: Creation of an up-to-date monitoring and information

system, as well as strengthening internal control, housekeeping, and reporting
functions are provided. Sorting information becomes simple.
●● Cost Reduction: Because of the use of modern technology, there is a cost
reduction, including floor space.
(c

●● Accuracy: With modern technology, the clearing of cheques, pass book entries,

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 276 Principles and Practices of Banking

inter-branch and inter-bank reconciliation, and other functions can now be

Notes

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completed quickly, correctly, and legibly.
●● Customer Service: With internet access, customers no longer need to visit the

in
bank. All banking transactions and account updates can be completed while at
home or on the go. Networking entails sharing information, sending messages,
and maintaining face-to-face contact even when physically separated. It’s a

nl
meeting that doesn’t move.
●● Simple Communication: The Internet connects thousands of computers that can
operate 24 hours a day, 365 days a year. Working hours are no longer a tyranny.

O
Banks’ interactions with customers, head offices, other banks, and branches are
being fully computerised in Western countries, and India must follow suit in order
to compete on a global scale.

ty
Glossary
●● Account information access: Account information access allows clients to view
their account balances and statements by requesting a mini account statement,

si
review transactional and account history, track term deposits, review and view loan
or card statements, access investment statements (equity or mutual funds), and
manage insurance policies for some institutions.
●● r
Transactions: Transactional services allow clients to transfer funds between
ve
accounts at the same or different institutions, perform self-account transfers, pay
third parties (such as bill payments), and make purchases in collaboration with
other applications or prepaid service providers.
●● Investments: Clients can use investment management services to manage their
ni

portfolios or get a real-time view of their investment portfolios (term-deposits, etc.)

●● Support services: Clients can use support services to check on the status of their
loan or credit facility requests, follow up on their card requests, and locate ATMs.
U

●● Content and news: Content services provide finance-related news as well as the
most recent offers from the bank or institution.
●● Email money transfer (EMT): It is a retail banking service that enables users to
ity

transfer funds between personal accounts via email and their online banking
service.
●● RTGS: The Reserve Bank of India operates and manages the Real Time Gross
Settlement (RTGS) fund transfer service (RBI). Its popularity stems from the fact
m

that it settles transfer requests on a gross or instruction-by-instruction basis rather

than the more common batch-clearing format. As a result, funds can be transferred
from one bank account to another quickly and easily.
)A

●● SWIFTS: The Society for Worldwide Interbank Financial Telecommunications

(SWIFT) system is at the heart of most international money and security transfers.
SWIFT is a massive messaging network that banks and other financial institutions
use to send and receive information such as money transfer instructions quickly,
accurately, and securely.
(c

●● Microfiche: Microfiche is a thin photographic film, typically four by five inches in

size, that can store information in a miniaturised form. This method is used

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 Principles and Practices of Banking 277

to preserve fragile materials such as archival documents, journals, books,

Notes

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newspapers, and magazines, as well as to save space in libraries and other
archives.

in
●● Cheque Truncation: Cheque Truncation System (CTS) is a method of clearing
cheques electronically rather than having the presenting bank process the physical
cheque while it is on its way to the paying bank branch. The Reserve Bank of India

nl
(RBI) has taken this step to expedite cheque clearance.
●● Smart Cards: A smart card is a card that stores information on a microprocessor or
memory chip instead of the magnetic stripe found on ATM and credit cards. Smart

O
cards contain embedded microprocessor chips, which add an additional layer of
security for users.
●● PINs: A PIN is a numerical code that is used in many electronic financial
transactions. Personal identification numbers are typically assigned to payment

ty
cards and may be required to complete a transaction.
●● Teller cash dispensers (TCDs): These are unidirectional devices in which cash is
manually loaded into a TCD under dual control and then dispensed to customers

si
as needed.

Check Your Understanding

1. r
The automation of traditional banking services is referred to as .............. banking.
ve
a) digital
b) modern
c) business
ni

d) international
2. PoS terminals are typically ............ devices that read a card to authorise and
U

complete a payment.
a) portable
b) fixed
ity

c) printing
d) commercial
3. Teller cash dispensers (TCDs) are ........... devices in which cash is manually loaded
into a TCD under dual control and then dispensed to customers as needed.
m

a) unidirectional
b) directional
)A

c) static
d) multi-functional
4. An e-payment system is a method of conducting transactions or paying for goods
and services via .............. means.
(c

a) electronic
b) banking
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 278 Principles and Practices of Banking

c) manual
Notes

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d) personal
5. ................ is altering how people interact and conduct business on a daily basis,

in
and advances in banking technology are continuing to shape the future of financial
services worldwide.
a) Digitalization

nl
b) Personalisation
c) Value marketing

O
d) Personal marketing
6. .............. banking has become the preferred method for users to make deposits,
account transfers, and track their spending and earnings, as well as a key differentiator

ty
for banking leaders.
a) Mobile
b) Multi-level

si
c) Single-level
d) Financial
7. r
A ............ is a numerical code that is used in many electronic financial transactions.
ve
a) PIN
b) MICR
c) IFSC
ni

d) LEI
8. A smart card is a card that stores information on a ..............chip instead of the
U

magnetic stripe found on ATM and credit cards.

a) microprocessor
b) magnetic
ity

c) RAM
d) memory
9. Cheque Truncation System (CTS) is a method of clearing cheques .............rather
than having the presenting bank process the physical cheque while it is on its way to
m

the paying bank branch.

a) Electronically
)A

b) Manually
c) Bi-weekly
d) weekly
10. Microfiche is a thin photographic film, typically four by five inches in size, that can
(c

store information in a ............form.

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 Principles and Practices of Banking 279

a) miniaturised
Notes

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b) detailed
c) pictorial

in
d) data
11. Email money transfer (EMT) is a .............. banking service that enables users to

nl
transfer funds between personal accounts via email and their online banking service.
a) retail
b) commercial

O
c) personal
d) business

ty
12. ................. computing is the on-demand delivery of computing services such as
software applications, data storage, and processing power via the internet.
a) Cloud

si
b) Software
c) Analytics
d) Database r
ve
Exercise
1. Define CBS.
2. Define electronic products in banking system.
ni

3. What are distribution channels used in banking services?

4. Define teller machines and cash dispensers.
U

5. What is electronic payment system?

6. What is PINs?
7. Define Cheque Truncation.
ity

8. What is Microfiche?
9. What is SWIFTS and RTGS?
10. What is role of e-banking?
m

11. Define DATANET and NICNET.

12. What are the best data security practices employed by Banks?
)A

13. Define Phishing Attack.

14. What is cloud computing?

Learning Activities
1. Discuss possible improvements that can be carried out in Home banking sector to
(c

conduct financial transactions from the convenience of your own home.

2. Discuss the role of digitisation in Global Development and Banking Technology.

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 280 Principles and Practices of Banking

Check Your Understanding - Answers

Notes

e
1. Digital
2. Portable

in
3. Unidirectional
4. Electronic

nl
5. Digitalization
6. Mobile

O
7. PIN
8. Microprocessor
9. Electronically

ty
10. Miniaturised
11. Retail

si
12. Cloud

Further Readings and Bibliography

1.
r
Banking Services & Information Technology, R.K. Uppal
ve
2. Information Technology, Data Communications and Electronic Banking, 3rd
Edition
3. Smart Banking: An Introduction (Driven by Information Technology (English,
Hardcover, Prof. Vinay K. Nangia, Sunil Aggarwal)
ni

4. Retail Banking Technology, Suresh Samudrala

U
ity
m
)A
(c

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 Principles and Practices of Banking 281

Module - V: Support Services and Different Channels

Notes

e
in Banking

in
Learning Objectives:
●● Support services - Cross Selling, Upselling, PLC

nl
●● Product Modification, Packing, Branding and Diversification
●● Factors influencing products - Direct Channels, Indirect Channels, Physical
Distribution

O
●● Promotion - Promotion Mix, Role of Promotion
●● IT in marketing - DSA/DMA, Channel Management

ty
●● Wealth Management, Portfolio Management and Telemarketing

Introduction

si
Changes in the banking sector have not only increased people’s needs, but they
have also altered the shape of human life. Various alternative delivery channels in the
banking sector have altered the bank’s day-to-day operations. With the introduction

r
of computer and internet facilities in the banking industry, all banks have adopted
the core banking solution (CBS) platform to provide banking services. The physical
ve
appearance of the banking industry has changed as a result of the use of the internet
and smartphones.

Alternative Delivery Channel (ADC) refers to channels that act as intermediaries

ni

between the bank and the customer, resulting in increased movement and execution of
banking services. These channels could be media, tools, or any application that allows
customers to conduct banking transactions.
U

From the perspective of banks, these Alternative Delivery Channels will enable
them to reach a diverse range of customers across the country. Banks also gain
points for lower operational and transaction costs. The most successful areas of this
Alternative Delivery Channel are digital banking and electronic banking (ADC). All
ity

banks try to bring banking services to every individual with the goal of providing
24x7 banking and providing banking systems to the unbanked with the help of these
alternative delivery channels in the banking sector.

Nowadays, the majority of customers are shifting away from branch banking
m

and toward other channels. Given the prevalence of internet use, smartphones and
mobile devices offer suitable options for online purchases, encouraging customers to
use online banking services. Customers can conduct banking transactions from their
)A

homes, offices, or any other location by using these channels. All channels contribute to
the banking system’s increased productivity.

In the banking industry, alternative delivery channels include: Internet Banking,

Mobile Banking, UPI (Unified Payment Interface), E-Wallet, ATM Card, Debit Card, and
(c

Credit Card are all available.

There was a need in the banking sector for alternative delivery channels to
properly handle the scattered banking products and services that were not in a specific
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 282 Principles and Practices of Banking

stream. As a result, all banks have decided to provide their customers with all of these
Notes

e
alternative delivery channels.

Keeping all of this in mind, we can use all of these alternative delivery channels in

in
the banking sector to make our financial operations easier.

5.1 Support Services

nl
In terms of business model, focus strategy, and execution, the banking industry
as a whole has undergone numerous transformations. While banks seek to transform
their business landscape in order to remain relevant, this process must be thoroughly

O
researched, planned, and executed in a systematic manner.

5.1.1 Marketing of Banking Services

ty
Marketing’s role in the banking industry is evolving. For many years, public
relations was the primary focus of bank marketing. The emphasis then shifted to
advertising and sales promotion. The emphasis then shifted to the creation of a sales

si
culture.

Although all aspects of the marketing concept – customer satisfaction, profit

integrated framework, and social responsibility – will continue to be important, customer
r
satisfaction must be prioritised in the coming years.
ve
According to most surveys, the primary concerns of most bank executives remain
legal and regulatory issues. Community banks are particularly concerned with removing
barriers that give financial services competitors, such as credit unions, an unfair
advantage. Another concern, however, is related to technology: keeping nonblank
ni

competitors out of the payment system.

When this gateway system was first proposed, Internet access was still relatively
new, and few banks had the resources or knowledge to set up their own direct-access
U

lines for customers. Customers have expressed an increasing interest in online banking
services, and banks have quickly responded by establishing proprietary sites on the
World Wide Web and offering PC banking.
ity

Within the next five years, 93 percent of community bank executives polled intend
to offer telephone banking, and 79 percent intend to offer PC banking.

When asked which technology has the most future potential, bank executives
named call centres first. As customers continue to migrate to a high-tech world where
m

they expect information and answers faster and more accurately than ever before,
call centres provide the ideal bridge. Customers can check their accounts and apply
for loans 24 hours a day, seven days a week, thanks to 24-hour access to either
)A

automated information or live operators. Bank executives also identified PC banking as

having the most future potential, followed by interest access and broad-function kiosks.

Marketing and Rivalry

Given the banking sector’s declining profitability and productivity, as well as its
(c

extremely low profit percentage, determining the system’s financial health necessitates
drastic corrective measures not only to build investor confidence, but also to combat

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 Principles and Practices of Banking 283

competition from all directions. It is past time to properly understand the benefits and
Notes

e
drawbacks of the upcoming banking era and to take advantage of various opportunities.
This will necessitate an efficient marketing approach to bank management in which
target markets are successfully addressed as well as effective satisfaction levels, and

in
in which the usual basic elements – product, pricing, promotion, and distribution – are
addressed in the proper format of an efficiently working marketing organisation.

nl
Private banks, non-banking financial institutions, foreign banks, and others must
compete with nationalised banks. Deposits and credits, foreign trade, consumer credit,
and other banking activities are all subject to competition. Customers will benefit from
competition, and the banking system will be forced to increase productivity, reduce

O
expenses, and remain sensitive to changing issues. While recommending internal
autonomy while adhering to prudential norms, the Narasimham Committee Reports
also suggested rule-based credit policies, fiscal balance, and a gradual move toward

ty
liberalisation.

In order to compete with foreign banks, Indian banks should diversify and expand
their services, as well as expand their products and business. Economic freedom and

si
an entrepreneurial spirit have greatly contributed to the success of the market-oriented
financial sector in Western countries. Directed credit and investment have had the
opposite effect. Interventionism is not always bad if it is accompanied by committed

r
leadership. For more than four decades, the Indian financial sector had neither full
economic freedom nor well-disciplined interventionism, which cost operational flexibility
ve
and functional autonomy, both of which were concerned with profitability performance
and related factors.

Marketing Ideas
ni

When marketing is applied to the banking industry, the bank marketing strategy can
be said to include the following –
U

●● A clear definition of your target customers.

●● Creating a marketing mix that will satisfy customers while making a profit for the
bank.
ity

●● Planning for each of the’source’ markets and each of the ‘use’ markets (A bank
must be market – oriented in both directions – it must attract funds as well as be a
provider of funds and services.
●● Administration and organisation.
m

Bank Promotion
We define bank marketing as “the aggregate of functions directed at providing
)A

services to satisfy customers’ financial (and other related) needs and wants more
effectively and efficiently than competitors while keeping the bank’s organisational
objectives in mind.” Marketing activity by the bank This function aggregate is the sum of
all individual activities that comprise an integrated effort to discover, create, arouse, and
satisfy customer needs. This means that, without exception, every individual working
(c

in the bank is a marketer who contributes to total customer satisfaction, and the bank
should eventually develop customer orientation among all bank personnel. Different

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 284 Principles and Practices of Banking

banks provide different benefits by offering various schemes that can meet the needs of
Notes

e
their customers.

Marketing aids in the achievement of the bank’s organisational goals. Indian

in
banks have dual organisational objectives: commercial profit and social development,
particularly in rural areas.

The marketing concept is primarily concerned with the following factors that

nl
contribute to the success of banks:

◌◌ The bank cannot exist without customers.

O
◌◌ The bank’s purpose is to create, win, and retain customers.
◌◌ The customer is and should be the centre of everything the bank does.
It is also a method of bank organisation. The customer should be the starting point
for organisational design, and the bank should ensure that services are performed

ty
and delivered in the most efficient manner possible. Service facilities should also be
designed with the customer in mind.

si
The ultimate goal of a bank is to provide complete customer satisfaction. Customer
satisfaction is influenced by the performance of all bank employees.

All marketing techniques and strategies are employed in order to persuade people
r
to do business with a specific bank. Marketing is a business philosophy. Customers’
ve
needs must be met as a precondition for the bank’s existence and survival, according
to this philosophy. The first and most important step in implementing the marketing
concept is for all employees to commit wholeheartedly to customer orientation.
Marketing is a mental state. This means that the customer is at the centre of all of a
bank’s activities. Marketing is not a distinct function of banks. The marketing function in
ni

an Indian bank must be integrated with the operations function.

Marketing is much more than just advertising and promotion; it is an essential

U

component of any business’s overall operation. What the bank needs is market
orientation and customer consciousness among all of its employees. To ensure
customer satisfaction, a bank may require a marketing coordinator or integrator at
the head office reporting directly to the Chief Executive for effective coordination of
ity

various functions such as marketed research, training, public relations, advertising,

and business development. In Indian public sector banks, the Executive Director is
the best person to do this coordination work, though the Chief Executive is ultimately
responsible for the entire marketing function.
m

As a result, the total marketing function includes the following:

(a) Market research: Identifying customers’ financial needs and desires, as well
as forecasting and researching future financial market needs and competitors’
)A

activities.
(b) Product Development: Developing appropriate products to meet the financial
needs of consumers.
(c) Service pricing: Promotional activities and distribution system in accordance
(c

with the Reserve Bank of India’s guidelines and rules, while also looking for
opportunities to better satisfy customers.

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 Principles and Practices of Banking 285

(d) Creating a market: marketing culture – through training – among all customer-
Notes

e
conscious ‘Personnel’ of the bank.
As a result, it is critical to understand the fundamentally different functions that

in
bank marketing must perform. Because banks must attract deposits as well as users of
funds and other services, marketing problems in banks are more complex than in other
commercial concerns.

nl
Marketing’s Growing Importance in the Banking Industry
Other factors that have contributed to the growing importance of marketing in the

O
banking industry are as follows:

Initiatives of the Government: The economy began a process of economic reform

and various policy measures initiated by the government, which resulted in increased
competition in the banking industry, highlighting the importance of effective marketing.

ty
Interest Rate Deregulation: In order to attract customers, the bank may lower
their Minimum Lending Rates (individual and corporate). Such a reduction in lending
rates reduces the spread between deposit rates and lending rates, implying that banks’

si
margins would fall and they would need to increase volumes or provide more appealing
services to maintain profits. This necessitates bank marketing.

r
Increased Focus on Bank Profitability: The Bangladesh Bank Report has directed
banks to improve their efficiency, productivity, and profitability. Self-sufficiency is
ve
required of banks. In fact, the report has adopted the BIS capital adequacy standards
(though in a phased manner).

Banks from other countries: Foreign banks compete fiercely with Bangladeshi
ni

banks, and their superior services and technologies give them a competitive advantage.
As a result, in order to attract customers, indigenous banks must effectively apply
marketing concepts.
U

New Private Banks Enter the Market: In the early 1990s, new competition emerged
in the form of new Private Banks, who brought with them a high technology-based
banking matching International Standards and have made a significant dent in the
banking business by capturing a significant share of the banking industry’s profits.
ity

5.1.2 Marketing of Banking Products

Customers are becoming more sophisticated in their choices and the quality
of service they receive. Customers strive to meet their needs throughout their lives.
m

The market is the location where items are exchanged or common needs are met.
Marketing is the process of making people aware of your offerings, inspiring them to
deal with you, and making them believe that by doing so, they are meeting their needs
)A

to the best of their abilities.

Following the improvements in the banking sector, marketing has established itself
as a more integrated function within financial services. Financial institutions, particularly
banks, have experienced rapid changes in their operational environments. Bank
(c

product marketing has become a very difficult subject because it requires knowledge
of economics, sociology, psychology, and essential marketing concepts. In marketing,
the customer has the power of choice, and the key to effective marketing of banking

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 286 Principles and Practices of Banking

products is a consistent and professional approach to meeting the needs of the

Notes

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customer.

A product is defined as “anything that has the capacity to provide the customer

in
with the satisfaction or profit desired.” In banking, the terms product and service are
used interchangeably. Bank products are deposits, borrowing, or other tangible and
measurable products such as credit cards or foreign exchange transactions, whereas

nl
service can be such products plus the way/manner in which they are offered that can be
expressed but cannot be measured, i.e. intangibles.

Any service or facility provided to any Loan Party by any Lender or its Affiliates,

O
including bank products, is referred to as a bank product:

(a) Credit cards

(b) Credit card processing services

ty
(c) Debit cards
(d) Purchase cards

si
(e) ACH Transactions
(f) Cash management, including controlled disbursement, accounts or services
(g) Hedging Agreements
r
ve
Strategies for the Enhancement of Bank Marketing
Customers’ needs are constantly changing in today’s fiercely competitive market.
As a result, in order to adapt to changing conditions, our marketing strategy must be
dynamic and adaptable. Here are the steps that go into developing a successful and
ni

effective marketing strategy for bank products.

Deposits are highlighted: The emphasis should be placed, albeit discretely, on

mobilising more term deposits, as they are more profitable for the bank in comparison
U

to demand. The introduction of products similar to the post office’s “Kisan Vikas Patra”
and products with the option of tax rebate under Section 88 of the Income Tax Act will
be extremely beneficial in this regard.
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Create a Scheme for a Saleable Product: The bank should develop a scheme that
meets the needs of its customers. A collection of such schemes can also be combined
to form a product. A bank product could be a deposit scheme, an account with more
flexibility, technically sound banking, tele/mobile/net banking, or an innovative scheme
m

aimed at a specific group of customers such as children, women, the elderly, business
owners, and so on. In short, a bank product can be anything you offer to customers.

Branding that works: Man is a jumble of feelings and emotions. This can be
)A

extremely beneficial in terms of branding our products. Taking into account the features
of the product and the target audience, the product can be effectively branded to
sound catchy and appealing. Apna Ghar, Dhan Laxmi, Kuber, Flexi Deposit, Smart Kid,
Sapney, Vidya, and other well-known examples include Apna Ghar, Dhan Laxmi, Dhan
Laxmi, Dhan Laxmi, Dhan Laxmi, Dhan Laxmi Branding should be done in such a way
(c

that the brand name draws customers’ attention. It should be simple to recall. The target
group and the product’s silent feature should be similar to the brand name. This will be

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 Principles and Practices of Banking 287

extremely beneficial to the brand’s success. All of our employees and campaigns should
Notes

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only refer to the product by its brand name in order to make the same impression on the
customer.

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Customer Understanding: Customers must be educated about bank products.
Attempts should be made to broaden and deepen the information flow process for the
benefit and education of Indian customers. Customers today have no idea how long it

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takes to complete any type of banking service. The rural customers are unaware of the
purpose of the loans and how to obtain them. Customers are unaware of the bank’s
full set of rules, regulations, and procedures, and bankers keep them to themselves
rather than educating customers. Customers must be educated from the ground up

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in the banking industry. It is past time for each bank branch to take steps to educate
customers on all banking functions, which will facilitate banking growth on both
qualitative and quantitative lines.

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Advertisement: Advertisement is a critical component of marketing bank products.
Advertisements should be appealing to people. It should not adhere to the conventional
pattern of narrating a product. Banks must understand people’s preferences and

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choices in order to effectively advertise.

Product Information for Customers: The bank should engage in aggressive

marketing of its products, particularly when launching a new product, which will inform
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prospective customers about the product while relieving branch staff from explaining the
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product to all customers.

Client Convenience: In a service industry like banking, where product differentiation

is difficult to maintain and service quality is dependent on the service provider, which
cannot be separated. As a result, bank employees must provide services to the
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customer’s satisfaction rather than their own conveniences or whims.

5.1.3 Product Research and Development

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Because it is related to everything financial, including money and how it is

managed, the banking and finance industry plays a critical role in shaping any country’s
economic growth. This industry has a lot of potential because it has the potential
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to change how money is regulated across the country. As a result, market research,
whether online or in-person, is an essential component of any bank or financial
organisation.

As one of the world’s leading industry research firms, we have provided market
m

research services to a wide range of industrial sectors. One of the major industries we
have served has always been banking and finance. Our unrivalled expertise in market
research, whether through an online survey or data analysis, has helped numerous
banking and financial organisations understand how to grow their business more
)A

effectively.

A well-organized market research study can actually help banking and financial
organisations understand their customers, their needs, and how their preferences are
changing. Not only that, but it also opens up potential investment opportunities for
(c

rapidly growing organisations all over the world. As a result, market research benefits
not only organisations but also the entire industry. Insurance, pensions, personal loans,

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 288 Principles and Practices of Banking

property, credit cards, mortgages, current & savings accounts, and business banking
Notes

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are some of the most commonly researched areas in the banking & financial industry
worldwide.

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Things can fall apart in this industry without extensive market research, so
thorough market research not only helps to cater to changing customer needs but also
helps to keep the industry going and flourishing. When it comes to banks and financial

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institutions, economic research is a critical component of market research.

The primary goal of economic research is to provide a conceptual perspective on

policymaking, as well as to assist in determining which models and tools are required

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for monetary policies and other tasks. Banks require research-driven professionals
to implement the most recent developments and identify potential relevance. It also
bridges the gap between policymakers and academics, allowing for interactions with
people of different perspectives. Banking organisations and financial institutions require

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business or industry research companies for adequate growth because research is
improved by knowledge of the most recent developments in the field and ideas.

It also provides banks and financial institutions with a competitive advantage over

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their competitors. As a result, the better and more experienced the market research
company with which you’ve collaborated, the more impactful and worthwhile the
collaboration is for your organisation. When you work with a company that can handle
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the research for you, you realise you have more time to focus on other important
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tasks. A reputable, dependable market research firm is a boon to any banking or
financial institution that wishes to expand responsibly and be equipped with all of the
technological advancements and expertise required to excel in this industry.
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5.1.4 Test Marketing

Most businesses use test marketing to determine whether their products and
marketing strategies are efficient and valid enough to be implemented. Businesses
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use test marketing to learn about what their customers expect and want. Performing
test marketing is essentially conducting market research (testing the market) without
customer participation.
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Requirement of Test marketing

Test marketing allows you to see how your product or marketing strategy will fare
with customers and the market. It also assists you in understanding your competition
and how you can improve the way you develop, promote, and maintain specific
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services.

The following is how the test is carried out:

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◌◌ Trial – if the customer intends to purchase the product at least once.

◌◌ Repurchase – whether the customer will repurchase the product after the
initial trial.
◌◌ Adoption – whether the customer accepts and enjoys the product.
(c

◌◌ Frequency – how frequently will the customer purchase that product?

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 Principles and Practices of Banking 289

Businesses can Benefit from Test Marketing

Notes

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Test marketing allows the product to sell itself in a more favourable market.
Customers will prefer to buy your product over any competitor product once the value of

in
the product is clear. Test marketing increases the likelihood that the products will leave
a favourable impression on customers, who will then return as loyal customers.

Test marketing also provides you with a competitive advantage over other

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competing products. Offering a free product trial to customers may not always be in
your best interests, but you must do so because of what your competitors are offering
them at the same time. If a free trial is not provided, the company’s image may suffer as

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a result. The emphasis here should be on how you present your product to them so that
they progress past the trial stage and choose to purchase it again.

Invest time in your brand: Test marketing encourages people to devote more

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time and effort to testing products and marketing strategies. Examining your product’s
performance, branding, and marketing will only help you get to know your target
audience better.

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The following product feedback was received: Customers who use the product
for a trial period are more likely to provide honest feedback. For all the right reasons,
you should use this honest feedback during the test marketing phase rather than

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launching the product on a large scale and later discovering the issues people have
with your services. You can request that each trialist upload photos and videos of their
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experience, as well as any reservations they have. This allows you to still change and
improve your product.

Provide incentives to trialists: When a customer on the fence tries your product and
provides honest feedback, they are more likely to purchase the final product. As a thank
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you for taking part in the trial, you can offer them some incentives or discounts on those
products. Giving them referral incentives and discounts is another way to promote and
increase your sales.
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Customers are given a sense of urgency through test marketing: After the free trial
period expires, customers feel compelled to purchase the product and consider the
benefits and drawbacks of doing so. And one thing we do know about urgency is that
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it forces us to make decisions. When customers sense that a product is running out of
stock, they are compelled to purchase it as soon as possible.

It assists you in aligning customer interests with company values: When you offer a
free trial of a product to customers, make sure they understand what the product is for.
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Make them see how their interests align with the value that the company is looking to
provide.

More information about your leads can be obtained through test marketing: When
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you offer free trials and the audience shows no signs of responding or purchasing the
product, you know your lead has gone cold. Many participants, however, will take the
trial with no intention of purchasing the final product. Nonetheless, many trialists are
eager to see how the product performs. This will reveal a lot about your lead’s location
and what they think of your product.
(c

Customers provide the following information based on their spending: Based on

customer feedback, the trial products can be replicated. Brands will have an idea of

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 290 Principles and Practices of Banking

how the product will perform once it is released to the market. The information gathered
Notes

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from the customer reveals the cost of packaging, size, and price of the product once it
is on the market.

in
Test marketing lowers the likelihood of a full-scale launch: The costs of launching
the product on a large scale in the market are higher. Testing the market before taking
that risk will show you all of the areas where the product needs to be improved and how

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it can be improved. This will assist you in lowering the risk associated with full-scale
production and supply of the products.

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5.1.5 Cross Selling
When it comes to banking products and services, the terms cross-selling and
upselling are frequently used interchangeably. Cross-selling occurs when a bank sells a
product or service that is not the same as one that has already been sold to an existing

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customer. Upselling, on the other hand, occurs when banks offer high-end products to
customers in order to meet their needs.

The term ‘cross-selling’ refers to banks and non-banking financial institutions

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(NBFC) that offer or sell more than one product and/or service in order to promote
different products and services to customers based on their needs. Thus, cross-
selling encourages customers to purchase a related or complementary product and/or
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service. However, the products and/or services must be complementary to those that
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the customers have already purchased from the banks. Cross-selling and upselling
are concepts that are similar in that they both focus on providing additional value to
customers by offering products and services that meet their needs.
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Banks Engage in Cross-selling

Cross-selling is the practise of offering a variety of products and services to
existing customers. It is the provision of the appropriate product to the appropriate
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customer at the appropriate time. Cross-selling establishes a retailer’s reputation as the

best retailer for meeting a specific customer need. A cross-selling program’s success is
dependent on a number of factors, including a well-defined business strategy, effective
execution, regular marketing, and an effective targeting strategy. It has proven to be a
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successful or distinguishing strategy for profitable growth in the banking industry.

●● It entails selling multiple products and/or services that are provided by a single
product.
●● It is similar to upselling in that both provide the most value to customers.
m

●● It benefits both new customers and businesses, and it helps to increase revenue
without incurring any recurring costs.
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Cross selling and Upselling in Banks - Benefits

For the customer:

◌◌ Maximum satisfaction
(c

◌◌ Right product at the right time and right place

◌◌ Better services and varied choices of products and/ or services

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 Principles and Practices of Banking 291

◌◌ Effective products at reasonable prices

Notes

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◌◌ Reduced cost of acquisition

For the Firm -

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◌◌ Growth of new and existing customers
◌◌ Penetration into new and competitive markets

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◌◌ Promotes innovation and diversification of new product
◌◌ Enhanced customers satisfaction
◌◌ Increased customer loyalty and equity

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Process of Cross-selling in Banks
◌◌ Identification of the opportunity

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◌◌ Eligibility
◌◌ Business strategy
◌◌ Decision on analytics approach

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◌◌ Next best product to buy recommendation
◌◌ Strategy implementation
◌◌ tracking of cross -sell campaigns
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Effective Tips
●● Banks should ensure that their customers are aware of the additional products
and/or services that they provide. Customers would be unaware of the banks’
additional products and/or services if the banks did not notify them of the same.
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●● Banks are expected to recommend to customers only relevant products and/or

services that they may require and value. Selling them something they don’t really
need has no long-term value because customers are less likely to buy from such
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sellers again.
●● Banks should recommend the appropriate product at the appropriate time.
Perhaps, cross-selling is best done before the checkout to maximise the potential
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for impulsive purchases. It is preferable to upsell early in the sales process, before
the customer has completed their purchase.
●● In banks, upselling and cross-selling should only take the form of
recommendations. Any attempt to force products and/or services on customers
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can fail.
●● Banks should ensure that all of their employees are well-versed in the product line
so that they can advise their customers on which products can be combined.
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5.1.6 Upselling
Banks and financial institutions that provide more than one product or service can
promote different products and services to customers based on need, behaviour, or
(c

demographics. By encouraging multiple product holdings by individual customers, this

type of cross selling can be a highly effective tool for growing business, acquiring new
bank clients, and increasing customer lifetime value.

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 292 Principles and Practices of Banking

When you cross-sell, you offer a product or service that is related to what the
Notes

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customer is already purchasing. It can be as simple as recommending a credit card and
internet banking to a customer with a savings or current account. Upselling allows you
to increase the amount you spend on an existing product or add new products to your

in
cart. Both methods of encouraging clients to use additional services and invest a little
more can significantly increase sales, revenue, and help you meet your goals.

nl
Upselling occurs in banks when banks sell additional or more expensive products/
services to their customers in addition to what they have already purchased. It all
comes down to selling the value that comes with purchasing the upgraded version of a
product or service. Upselling typically entails using comparison charts to demonstrate

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how much more a customer can get for their money if they purchase up a level.

When selling memberships, the upselling technique comes in handy. By displaying

a comparison of the various membership levels to a customer, they can see how much

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more they will get for their money by selecting a level-one membership over a basic
one. Benefits of Cross-selling and Upselling in Banks Cross-selling and upselling in
banks both contribute to the development of the customer-firm relationship. As a result,

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it benefits both the customer and the banks.

Banks’ Upselling
●● r
It entails selling higher-value products and/or services to an existing customer; it is
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similar to cross-selling in that it benefits both customers by offering them products
and/or services that meet their needs.
●● It benefits existing customers by offering them the right comparable higher end
product; and • It helps increase revenue by offering products and/or services
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based on customer value.

How can banks and non-bank financial institutions improve and create
opportunities for upselling?
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●● Maintain your relevance. You may blow it if you bombard customers with too
many unrelated cross-selling suggestions. Offering Tikiri accounts to parents with
children under the age of 15 is a natural fit. However, if your cross-selling attempts
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are unrelated to the original purchase, they are far less likely to succeed.
●● Distribute expert advice. Specific recommendations from professionals, experts, or
other customers on social media channels, PR, testimonials, and online opinion
can help facilitate successful cross-selling and up-selling.
m

●● Teach employees how to cross-sell and up-sell. The strategy must be based on
serving the customer rather than simply selling more products. For example, you
could describe how the additional products or services would complement the
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original purchase and help the customer solve their problem further.
●● Timing is crucial. Depending on the products and services you provide, cross-
selling and up-selling may occur at different times. In some cases, when there is
a special promotion of a product or service, advising the client of another scheme
increases the chances of convincing and a high string sale.
(c

●● Experiment with product or service bundles. Bundling has long been used to
entice prospective or existing customers to purchase not just a single product or

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 Principles and Practices of Banking 293

service, but an entire set of related items. Offering a discount on package deals
Notes

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will help you close the deal.
●● Integrate an effective customer relationship system (a combination of Social CRM)

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with your core banking system to identify changing customer behaviour, needs,
and extract timely information in order to promote the required product or service
to target groups.

nl
●● Provide staff with a 360o view of the customer at various omnichannel touch
points, indicating the current products and services used, what could be sold,
purchase patterns, future potential, and predicting what comes next.

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Suggestions for Effective Upselling
Upselling is an important part of sales and can provide your customers with a
valuable service. Here are some pointers for effective upselling:

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●● Pay attention to your customer’s needs and goals: You can tailor your upsell
suggestions to the goals that your customers want to achieve. When customers
see how the more expensive product meets their needs, they are more likely to

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upgrade their order.
●● Showcase your more expensive products and services: Customers respond

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positively to visual displays and information about premium services. Having them
on display also makes it easier to refer to them for upselling.
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●● Provide side-by-side contrasts: Customers are more likely to purchase an
upgraded service if they see the value it provides. Showing them what the more
expensive package or product has to offer will help them decide to upgrade.
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●● Educate your client: Inform your customer about the risks they can avoid and the
benefits they can obtain by upgrading their purchase. Approach the upsell with the
goal of assisting them in getting the most out of their experience.
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●● Accept your customer’s response: By avoiding pushy sales tactics, you will
strengthen your relationship with your customer. If they decide not to upgrade,
provide them with a brochure with the option to do so later.
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●● Keep in mind the price: Customers will be more receptive to upgrades that are
relatively close in price to the product they are considering. You can also entice
customers to upgrade by providing sales and discounts on your premium
packages.
●● Customers may be more interested in adding individual functions to their current
m

package if you offer a la carte add-ons. Customers can customise their packages
by offering a la carte options for a small fee.
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●● Keep in touch: Keeping in touch with your customers is essential for maintaining
and growing your relationship with them. You can use email marketing, social
media, and direct mail to inform them about new products, keep them up to date
on sales, and provide incentives for upgrading.
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5.1.7 PLC
In the United Kingdom, a public limited company (PLC) is a type of public company.
PLC is the equivalent of a publicly traded company in the United States that bears the
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 294 Principles and Practices of Banking

Inc. or corporation designation. The use of the PLC abbreviation after a company’s
Notes

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name is required, and it informs investors and anyone dealing with the company that it
is a publiclytraded corporation.

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What Is a Public Limited Company (PLC)?

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A PLC denotes a company that has issued stock to the general public. The
purchasers of those shares are only liable up to a certain amount. That is, they cannot
be held liable for any business losses that exceed the amount they paid for the shares.

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A PLC in the United Kingdom operates similarly to a public corporation in the
United States. Its operations are regulated, and it is required to publish periodic reports
on its true financial health to shareholders and prospective shareholders.

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The Benefits and Drawbacks of a PLC
The most significant advantage of forming a public limited company (PLC) is the
ability to raise capital by issuing public shares. Individual investors, hedge funds, mutual

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funds, and professional traders are all interested in a listing on a public stock exchange.
As a result, a public limited company has greater access to capital for investment in the
company than a private limited company.
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On the other hand, a PLC in the United Kingdom is subject to far more regulation
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than a public corporation in the United States. They are required to hold annual general
meetings open to all shareholders and to adhere to higher accounting transparency
standards. Because they are public, they are vulnerable to shareholder pressure and
takeover bids from competitors.
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The company gains greater access to capital and shareholders gain liquidity by
becoming a PLC. These are similar advantages of a company going public in the United
States. On the negative side, becoming a PLC entails increased scrutiny and reporting
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requirements. The company will have more shareholders, and the company’s value
may become more volatile as it is determined by financial markets.

5.1.8 Product Modification

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Product modification is the process of improving existing products by making

necessary changes to the characteristics, nature, size, packing, and colour, among
other things, so that changes in consumer demand can be dealt with effectively. The
m

goal of product modification is to maintain existing demand, attract new users, and
effectively compete with competitors. It aids in increasing the enterprise’s sales, which
leads to an increase in the enterprise’s profits. The following eminent authors have
defined the term “Product Modification.”
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Philip Kotler: “A product modification is any deliberate alteration for the physical
attributes of a product or its packing”.

Stanton: “Even a slightly changed product either in colour, design or in quality is a

completely new product”.
(c

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 Principles and Practices of Banking 295

Strategies of Product Modification

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The following are some important product modification strategies:

Quality improvement strategy: In this strategy, product quality can be improved by

in
changing the engineering process or the material from which it is made. The goal of this
strategy is to successfully compete in the market.

nl
Style enhancement strategy: The appearance of the product is altered in this
strategy. However, the product’s quality remains constant. The packaging of the
product, as well as its size, shape, colour, and so on, may be changed here. The
fashion industry frequently employs this strategy.

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Strategy for improving functional features: All changes that improve the product’s
functionality or meet additional needs are referred to as functional changes. The
product’s design is altered in such a way that the new design is more appealing to

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consumers and they find it easier to use.

Packaging improvement strategy: This is a strategy in which the product’s

packaging is changed. These enhancements may be required as a result of the

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development of new packaging techniques, a flaw in the product’s current packaging, or
consumer suggestions for changes.

5.1.9 Packing and Branding r

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Branding is a strategy for attracting customers’ attention by creating a unique
name, logo, and image for a product. It assists customers in differentiating a product
from other sellers’ products, establishing fondness, and building trust. It not only creates
an impression in the minds of customers, but also informs them of what to expect from
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the brand. Branding is one of the marketing tools used by a company to raise customer
awareness of a product.

Several departments are involved in the creation of a brand, including advertising,

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customer service, promotional merchandise, logo, and so on. All of these areas work
together to create a unique brand.

Packaging is a creative process that involves producing an appealing cover,

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packet, or wrapper in which the product is wrapped and sold to customers. Proper
packaging not only involves the creation of visually appealing packaging, but it also
ensures that the product is protected from damage. Packaging is an important part of
marketing because it is the first thing that customers see.
m

The primary goals of packaging and branding are as follows:

●● Brand identification
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Packaging is being strategically used by top financial brands as part of the

customer experience. With so many digital banking solutions available, it can be difficult
to stand out. Bank marketing strategies are constantly evolving. To remain relevant
to the modern consumer, bank marketing strategies must evolve at the same rate as
change. Digital marketing tools are now used in packaging and branding.
(c

◌◌ Online banking experience

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 296 Principles and Practices of Banking

◌◌ Digital media and content (everything from YouTube videos to Facebook

Notes

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posts)
◌◌ Online advertising through SEM or Social Media

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◌◌ Online communication such as chatbots, email, and SMS marketing
◌◌ Apps
◌◌ Your website

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Banks, like any other industry, must digitise in order to reach customers who are
almost always online. As physical banking declines, digital sales could account for up
to 40% of new bank revenue within the next five years. In short, banks only have a

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few years to enter and capitalise on a growing digital market, and developing a digital
marketing strategy for financial services is critical to establishing a brand presence.

Marketing of Financial Content

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Content marketing can help your bank build an invaluable asset: trust. You’ll have
no trouble acquiring new customers and growing existing accounts if you provide useful
information that helps people feel in control of their financial future.

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Many banks are already utilising content marketing. They have a blog, a presence
on the major social media platforms, and they may occasionally post a video. What’s

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missing is a unified strategy and direction to ensure that you’re creating the right
content and reaching the right audience at the right time.
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Trends in Financial Marketing Strategy
It’s difficult to tell which exciting new opportunity is a true game changer and
which is just a fad. Knowing the difference between the two is critical when it comes to
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prioritising your marketing efforts.

There are some recent trends in financial marketing that we’ve noticed developing
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that you should definitely keep an eye on. If your competitors aren’t already offering
these things, they will be soon, and if you don’t plan ahead of time, you may find
yourself playing catch up.

The following are some of the most important trends in financial marketing:
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◌◌ Digitization
◌◌ Personalization
◌◌ Content Marketing
m

◌◌ Data Use
◌◌ Chatbots
)A

Financial Education as a Marketing Strategy for Banks

Financial education is now a part of the marketing strategy for the vast majority
of financial services marketers. Marketing budgets also reflect the importance of
financial education in the marketing toolkit; more than half of marketers report that their
organisation has a budget specifically designated for financial education.
(c

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 Principles and Practices of Banking 297

Financial Content Marketing’s Difficulties

Notes

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While bank marketers understand the importance of incorporating financial
education into their marketing strategy, they also understand the challenges their

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organisations face when it comes to implementing financial education.

Marketers cited the following as their top challenges when asked to name them:

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◌◌ Lack of measurable ROI (51 percent )
◌◌ Difficulty engaging customers (47%)
◌◌ Difficulty finding or creating quality content (21 percent )

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◌◌ Inadequate content (10%) and unclear value for meeting regulatory
requirements such as the Community Reinvestment Act (15 percent of
respondents).

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◌◌ Only 8% of marketers reported that obtaining senior executive buy-in is a
significant challenge.

The Advantages of Financial Content Marketing

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Despite the challenges, marketers are enthusiastic about the advantages of
incorporating financial education into the marketing mix. The following are the top
benefits:

◌◌ Improving consumer financial capability

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◌◌ Strengthening public reputation
◌◌ Supporting business opportunities
By far the most important benefits listed by bank marketers are improved customer
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or member knowledge and community relations.

5.1.10 Diversification
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One of the most important investing principles is to have a well-diversified

portfolio. This entails spreading your capital across multiple investments so that you
are not reliant on a single investment for all of your returns. The main advantage of
diversification is that it reduces the risk of capital loss in your investment portfolio.
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The Advantages of Diversification

Diversification has three major advantages:
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Minimizing loss risk – if one investment performs poorly over a specific period,
other investments may perform better over that same period, reducing the potential
losses of your investment portfolio from concentrating all of your capital in one type of
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investment.

Capital preservation – not all investors are in the accumulation phase of life; some
nearing retirement have goals oriented toward capital preservation, and diversification
can help protect your savings.
(c

Return generation – investments do not always perform as expected; by

diversifying, you are not reliant on a single source of income.

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 298 Principles and Practices of Banking

Diversification promotes:
Notes

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Reduced Portfolio Risk: A regulatory study published a few years ago by the
Division of Banking Supervision and Regulation confirmed a significant relationship

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between loan portfolio concentrations and bank failures. Based on this study and
numerous other research papers, financial experts have concluded that capital levels
and portfolio risk management practises evolve positively with portfolio diversification

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rather than the level and nature of portfolio concentrations.

Banks typically obtain funding from a variety of sources, including depositors,

debt holders, and equity holders, and allocate funds to portfolios comprised of various

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products, such as stocks, bonds, currencies, commodities, loans, mortgages, mutual
and hedge funds, and so on. On the one hand, a more diverse portfolio allows banks
to improve asset quality, performance, and resilience; on the other hand, it reduces
portfolio risks and the need for external financing, as well as the high costs associated

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with it.

A Higher Rate of Return: While some industry observers argue that concentrated,
large cap value strategies are associated with lower risks and higher profit margins, this

si
theory is only valid in certain situations. An earlier study conducted at the University of
South Carolina found that portfolio size does not affect portfolio returns. The profitability
ratio for the risk taken is more affected by the portfolio’s composition.
r
Simply put, the greater the proportion of non-correlated asset classes in a portfolio,
ve
the lower the risk of suffering significant financial losses as a result of negative market
events. Another critical point that bank executives should be aware of is that a diverse
portfolio can have a negative impact on returns if it contains a high level of risk. A high
rate of return is only possible when there is moderate exposure to “downside risks”
ni

(e.g., when returns are lower than expected) and efficient risk monitoring practises are
in place, as demonstrated by the white paper “Should Banks Be Diversified?” published
by New York University.
U

Portfolio Outperformance During Market Downturns: A diversified portfolio that

optimally combines a variety of loan products from different asset classes will help a
bank weather an economic storm much easier than if it only provided loans from the
same asset class. While we recognise that a bank will always have concentrations,
ity

taking a proactive, strategic approach to portfolio management and partnering with

a reputable loan origination and servicing company will help you improve portfolio
performance and meet new regulatory requirements.

Market Share Expansion: Portfolio diversification can assist banks in avoiding

m

densely populated industry sectors and identifying underserved markets, such as the
secondary market for manufactured home loans. This not only exposes a bank to a
larger investment universe with a broader range of asset classes, but it also provides
)A

more appealing and lucrative opportunities for growth.

For example, the entire manufactured housing industry is expected to grow

exponentially over the next few decades, owing to two major factors:

1) Manufactured homes are an important source of affordable housing

(c

2) An increasing number of prospective home buyers are priced out of other housing
options.

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 Principles and Practices of Banking 299

Many people believe that loan portfolios naturally diversify as banks expand their
Notes

e
service offerings to meet more lending needs. However, this is not always the case.
Concentrating on increasing portfolio size without adding new asset classes results in a
concentrated portfolio with a high risk level. In contrast, when a bank builds a diversified

in
portfolio, negative economic events will affect only a subset of its segments. As a result,
the bank will be less vulnerable to failure.

nl
5.2 Factors Influencing the Products
Today, the development of the banking system and the improvement of interbank

O
competition have made it a priority for commercial banks to improve commercial
banking services and introduce new banking services. As a result of increased inter-
bank competition, commercial banks must improve the retail banking services they
provide to the public.

ty
5.2.1 Direct Channels
The rapid development of information technology (IT) has profoundly altered the

si
way banking is conducted around the world. Customers do not need to visit the bank’s
brick and mortar structure to obtain service. All of the Bank’s services can be accessed
through alternate channels from any location other than the Bank. The impact of IT on
r
banking allows customers to perform all major operations/decisions regarding deposits,
ve
withdrawals, and investments by simply clicking a mouse on a computer, an Automatic
Teller Machine (ATM), or a mobile device.

A customer with a bank account in city x can use the internet to conduct business
from anywhere in the world. Customers can now access banking services at the tip of
ni

their fingers thanks to mobile banking applications. Those who do not want to use the
Internet or mobile can transact over the phone using IVR, which connects the customer
to his or her account. Customers of bank x can withdraw money from bank Y’s ATM that
U

was previously unavailable at the branch.

Direct Banking Channels and Their Importance: Banks can use direct banking
channels or alternate banking channels to acquire, track, and serve customers through
multiple channels. Direct banking channels can be used to perform a wide range of
ity

services such as account opening, fund transfers, third-party transfers, utility payments,
and cash deposits.

Customers can use their banking privileges whenever and wherever they want,
according to their preferences. Direct banking channels eliminate the middlemen
m

between banks and customers, resulting in direct interaction between the customer and
the bank. The first direct banking experience for the customer was the use of an ATM,
where the customer did not need to see a teller to withdraw or deposit money, followed
)A

by a visit to the branch. This was followed by the introduction of Internet banking,
mobile banking, RTGS, NEFT, and CTS.

RBI report on India’s payment and settlement system. The share of electronic
transactions (in terms of value) is greater than that of paper transactions, and the
(c

volume is increasing, indicating that individual customers are increasingly using direct
banking channels. Because the value factor is contributed by the corporate/HNI and the
volume is contributed by the individual customer.

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 300 Principles and Practices of Banking

Managing Customer Relationships Through Direct Banking

Notes

e
Customer Relationship Management (CRM) is a method of managing and
improving customer relationships that combines methods, technology, and

in
e-commerce. Traditional marketing collects customer information such as demographic
and psychographic data, which can be used to develop a suitable broad marketing
strategy, forecast demand, and determine the type and value of service required

nl
by customers. CRM combines the power of relationship marketing strategies and
information technology to build profitable, long-term relationships with customers and
other key stakeholders. Customers of banks, on the other hand, can manage their
accounts and pass instructions directly through direct banking channels.

O
The following are some of the primary drivers of the emergence of direct
channels:

ty
◌◌ As such, technological/digital possibilities
◌◌ The need for – and potential for – cost reduction and process optimization
◌◌ Shifting consumer demand and behaviour (empowered, digital, and

si
demanding)

Related to the preceding:

◌◌ r
The need to prioritise the channel-agnostic consumer and consistently provide
ve
the right interaction opportunities and information when and where people
want it
◌◌ The emergence of disruptive players offering different experiences, products,
and channel strategies
ni

◌◌ The growing success of direct banking pure players

◌◌ The disappearance of data and telephony silos
The RBI’s annual report for 2012-2013 placed a strong emphasis on customer
U

empowerment through improved information dissemination. This is done to provide

customers with more efficient and transparent services. The RBI has implemented a
number of measures, including the involvement of direct banking channels. The RBI’s
policy document for its member banks recommends using direct banking channels such
ity

as informing customers online for debits and credits and ATM withdrawals.

Furthermore, the RBI has commissioned a survey to assess customer satisfaction

on alternate channels, demonstrating the RBI’s growing interest in alternate channels.
Banking has seen changes in recent years, not only in customer expectations of
m

perceived service quality, but also in new technological innovations and the entry of
players from other industries. Alternative banking, also known as direct banking, is a
method of banking operations that allows customers to gain access without entering
)A

a physical structure. It includes non-traditional banking methods and mediums that do

not require human intervention, such as Internet banking, mobile banking, ATMs, debit
cards, POS, and so on.

Alternative banking channels are an effective means of keeping customers

(c

connected to their bank. ATM was the first alternative channel used by CITI bank
in New York in 1939. Banking services have seen a dramatic increase in the use of
alternative banking channels since then. HSBC Bank was the first bank in India to
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 Principles and Practices of Banking 301

introduce ATMs. According to an RBI report, India may become the world’s third largest
Notes

e
in terms of asset size by 2025, resulting in an increase in the depth and breadth of
financial products as well as a high level of service delivery. This will necessitate a shift
from cash transactions to non-cash transactions via alternate channels. (RBI Annual

in
Report 2012-2013).

A close examination of the RBI Indicator on Payment and Settlement Systems

nl
(SIPS) will provide additional insight. High-value clearing, which involved paper-based
transactions, has been replaced by RTGS, which can be initiated by the customer.
Retail electronic clearing is increasing significantly, as is debit and credit card clearing.
This indicates that the customer is directly involved in the transaction.

O
The broader channel-agnostic retail banking perspective on digital and direct

The rise of direct and digital channels in retail banking, with mobile playing an

ty
increasingly important role, clearly does not stand alone. Consumers are channel-
agnostic, and it is clear that retail banks must align their channel distribution approach
and transition from multi-channel to omnichannel distribution strategies as a result.
Channels do not exist in the minds of consumers.

si
The need to align distribution strategies is not new, but in practise, retail
banks face significant challenges in making it a reality. Banks face well-known other

r
transformational challenges in a digital context, as well as specific challenges regarding
legislation, security, and so on, in addition to traditional integration and alignment issues
ve
that we see in virtually all industries (silos, legacy systems, disconnected processes, a
channel-centric mentality, culture, etc.).

Many of the digital transformational challenges are directly related to direct

ni

channels as such (think about mobile banking, which comes with specific security
priorities too). Others are more concerned with the introduction of new payment
methods and business models.
U

With face-to-face interaction and the “human touch” remaining important in retail
banking, a customer-oriented channel mix that considers the customer life cycle rather
than individual behaviour is essential.
ity

In a digital/direct context, for example, it’s not about mobile or online (or even
telephony): it’s about everything because the consumer is one.

Furthermore, consumers expect a consistent banking experience as they move

from channel to channel. Which channel they use, when and where is determined
m

by a number of contextual factors (e.g., which screen do they use at a given point in
time), which also includes the actual intent or task at hand. As the chart below from the
previously mentioned Nielsen report shows, there is also a clear preference for specific
channels for some interactions.
)A

5.2.2 Indirect Channels

In an indirect distribution channel, intermediaries perform the distribution functions
of a company. Indirect distribution relieves the manufacturer of certain startup
(c

costs and responsibilities, which can reduce the time required to run the business.
Furthermore, with the right vendor relationships, it can be far easier to manage than

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 302 Principles and Practices of Banking

a direct distribution channel. It can provide a company with much-needed support and
Notes

e
distribution expertise that the company may lack. However, indirect distribution can
introduce new layers of cost and bureaucracy, increasing consumer costs, slowing
delivery, and taking control away from the manufacturer.

in
The marketer uses an indirect distribution system to reach the intended final user
with the assistance of others. These resellers usually take ownership of the product,

nl
though in some cases they may sell it on consignment (i.e., only pay the supplying
company if the product is sold). Under this system, intermediaries may be expected to
take on a variety of responsibilities in order to assist in the sale of the product.

O
Among the Indirect Methods are:
Single-Party Selling System - In this system, the marketer hires another party to
sell and distribute to the final customer. This is most likely to happen when the product

ty
is sold through large store-based retail chains or online retailers, in which case it is
known as a trade selling system.

Multiple-Party Selling System – The product in this indirect distribution system

si
passes through two or more distributors before reaching the final customer. The most
likely scenario is that a wholesaler purchases the product from the manufacturer and
sells it to retailers.
r
Banks and building societies are now tied intermediaries for other financial
ve
products, such as insurance products, in the current financial services context.
Bancassurance refers to collaborations between banks and insurers to distribute
insurance products or to banks themselves distributing their own insurance products.
Bancassurance is a type of distribution that originated in France, and it consists
ni

primarily of banking organisations providing life, pension, and investment products.

According to recent reports in the United Kingdom, bancassurance has gradually
increased its market share from 12.5 percent in 2001 to nearly 18 percent in 2005.
U

In the United Kingdom, bancassurance is also more popular for the sale of life
products than it is for the sale of pension products. In contrast to the United Kingdom,
banassurance is the most common insurance product distribution channel in other
European countries such as Portugal, Italy, France, and Spain. Bancassurance is
ity

becoming an important channel of distribution in developing markets such as China and

India, particularly for foreign players, and local insurers are following suit.

Governmental and sector distribution regulation frequently limits the type of

distribution channel available in any given geographic region, as well as the type
m

of inducement that can be used to convert consumers to a preferred channel.

Nonetheless, changes in the distribution of financial services are occurring at a rapid
pace in response to regulatory and societal demands, as well as industry competitive
)A

demands.

5.2.3 Physical Distribution

Customers’ interactions with retail banks are being fundamentally altered by
(c

emerging digital distribution channels. Customers who are tech-savvy use mobile
and online to meet their day-to-day banking needs, but they save their most complex
questions for branches.
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 Principles and Practices of Banking 303

The New Banking Model

Notes

e
Previously, bank transactions took place in-branch, and branch managers worked
hard to build strong relationships with their customers. A straightforward business

in
model. However, technological advancements have coincided with a significant shift
in customer preferences. As a result, the environment has become significantly more
complex.

nl
According to a recent survey, 71% of US retail bank customers believe their
banking relationship is transactional rather than relationship driven. Customers
increasingly value the ability to access their banks at any time and from any location

O
– and they are doing so via mobile devices. Mobile banking is now the most popular
banking channel in terms of transaction volume. According to estimates, mobile banking
users will number 1.8 billion by 2019, accounting for a staggering 25% of the world’s
population.

ty
Customers are increasingly swayed by sophisticated apps, according to retail
banks. Delivery methods are becoming as important as the products themselves in
the banking industry. This shift has created significant opportunities for retail banks.

si
Migrating transactions to digital channels, transforming physical distribution networks,
and revamping go-to-market strategies can all benefit retail banks. Lower operational
costs and greater penetration of marketing strategies are examples of these.
r
ve
There is no such thing as a one-size-fits-all solution
Despite the growing importance of mobile, many customers still value the ability to
access information through a variety of channels. Customers interact with their banks
via multiple channels in 65 percent of cases, with traditional channels typically handling
ni

the most complex queries. As a result, bank branches may need to reconsider their
hiring, training, and development strategies to meet increasingly complex needs.

It is no longer enough to simply provide a diverse range of channels. Customers

U

are increasingly expecting a unified experience across the growing number of channels
at their disposal. Banking executives now recognise the importance of a cross-channel
strategy, with 45 percent stating that their digital efforts will be centred on cross-
channel capabilities. This will necessitate a unified customer service strategy across all
ity

distribution channels.

The newcomers
Emerging distribution channels are allowing interesting new entrants into the
m

market. Atom Bank, Smile, and Cahoot are among the new entrants into the market
with digital-only offerings. New entrants are not limited to financial firms. Growing
interest in digital distribution channels provides FinTechs with a distinct advantage, and
)A

millennials are increasingly feeling their pull.

The magnitude of the challenge

Changing distribution channel preferences have created an intriguing fork in the
(c

road for retail banks. Banks that fully understand the various yet integrated ways in
which their customers want to interact with them will be the most successful. Failure to
recognise this will result in market shares being eroded by innovative new players.

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 304 Principles and Practices of Banking

Customers are becoming more reliant on digital distribution channels. Customers,

Notes

e
on the other hand, want more out of their human interactions with retail banks.
Responding to this challenge will necessitate a strong emphasis on digital channel
innovation. Traditional channels will also need to be redesigned to meet the increasingly

in
complex needs. This is no easy task. Those who are able to meet the challenge, on the
other hand, will reap the benefits.

nl
5.3 Promotion
In this day and age of instant gratification, banks must step up their game to create

O
a ‘omnichannel’ presence where they can provide a seamless experience to their
customers 24 hours a day, seven days a week. It is also necessary to simplify financial
transactions and bring them online in order to avoid having your clients or potential
clients jump through hoops, which can significantly improve your customer satisfaction

ty
rates.

5.3.1 Promotion Mix

si
Bank professionals are also expected to blend the promotion mix, in which various
components of promotion such as advertising, publicity, sales promotion, word-of-mouth
promotion, personal selling, and telemarketing are given equal weightage. The various
r
components of promotion aid bank professionals in the promotion of their banking
ve
business.

Advertising: Banking organisations, like other businesses, use this component of

the promotion mix with the goal of informing, sensing, and persuading customers. While
advertising, it is critical that we understand the key decision-making areas so that its
ni

utility can help bank organisations at both the micro and macro levels.

Finalizing the Budget: This is related to the creation of an advertisement budget.

Bank professionals, senior executives, and even police planners have been discovered
U

to be involved in the process. To remove the financial constraint in the process, a solid
budget must be developed. The size of a bank’s advertising budget is determined by its
business.
ity

Choosing an Appropriate Vehicle: There are numerous advertising devices

available, including broadcast media, telecast media, and print media. In light of
budgetary constraints, we must choose an appropriate vehicle. Print media has become
more effective as print technology has advanced. Messages and appeals can be
m

delivered in an extremely effective manner.

Making creativity possible: It is the responsibility of advertising professionals to

make the appeals, slogans, and messages more creative. Banking organisations
)A

should seek the assistance of top advertising professionals for this purpose.

Branch managers’ instrumentality: At the micro level, a branch manager is

responsible for advertising locally in his or her command area so that messages and
appeals reach the command area’s target customers. Of course, there is a budget
for advertising at the highest level, but the business of a specific branch is heavily
(c

influenced by local advertisements. When it comes to cause-related marketing, it is the

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 Principles and Practices of Banking 305

role of a branch manager that allows for the identification of local events, moments, and
Notes

e
the creation of condition-oriented advertisements.

Public Relations: Almost all organisations need to develop and strengthen their

in
public relations activities in order to promote their products and services. Even in
banking organisations, we find this component of the promotion mix to be effective. We
can’t deny that public relations has a high level of effectiveness in the banking industry.

nl
In this context, we notice a slight difference in the design of the mix of promoting
banking services. Of course, advertisements play an important role in the consumer
goods manufacturing industries, but when it comes to service-generating organisations
in general, and banking organisations in particular, public relations and personal selling

O
play a significant role. This is not to say that banking organisations are not required
to advertise, but rather that bank executives, unlike executives of other consumer
goods manufacturing organisations, place a premium on public relations and personal

ty
relationships.

Personal Selling

si
Personal selling has been found to be useful in promoting the banking business.
It is simply a communication process in which an individual uses his or her personal
potentials, tact, skill, and ability to influence customers’ impulse purchases. Because
we receive immediate feedback, personal selling activities effectively energise the
communication process. r
ve
Personal selling is a persuasion art. It is a very distinct way of promoting a sale.
We find inter-personal or two-way communication in personal selling, which allows
for feedback. When the outstanding properties are well told, there is no doubt that
the goods or services are found half sold. This type of telling and selling is known
ni

as personal selling, and it involves an individual attempting to convert prospects into

customers based on his or her expertise.
U

Personal Selling Dynamics: Personal selling dynamics have been found to be

useful in activating selling activities. Sales preparations are regarded as the most
important aspect of actual sales. To improve marketing activities, pre-sale activities
and post-sale services must not be overlooked. Customers may be interested in
ity

learning about the main features of the services, how a specific service can help them,
the rationale behind the technical services, and proof of its applications. If adequate
preparations are made, pre-sale activities will yield positive results.

Some customers are found to be very aware of current events and to be well
m

informed. On the other hand, we also encounter customers who are in the dark. Branch
managers are expected to match the level of customer awareness. For example, Mr. A
moves up the matrix, but Mr. B does not have enough time for the branch managers.
)A

Branch managers are expected to prepare a synopsis of their sales presentation. Not
surprisingly, highly informed customers are unable to make independent decisions
and are well-versed in the subject. Managers should emphasise the main features of
the services and the expected benefits of these services when selling to less informed
customers.
(c

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 306 Principles and Practices of Banking

5.3.2 Role of Promotion

Notes

e
Consumers must be able to reach financial institutions through multiple channels
in order for banks to attract new business and retain existing customer loyalty. With

in
consumer interest shifting away from branch banking and toward mobile and internet
banking, the level of popularity and number of possible services it offers has enormous
potential.

nl
The combination of Mobile and wireless technologies, as well as the wide variety
of portable devices available today, enables new revenue opportunities for financial
services organisations through the use of wireless banking as a customer channel

O
as well as an internal tool within financial institutions. This opens up a new channel
for refreshing and expanding the customer base, attracting prime customers, and
increasing loyalty.

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Promotional Strategies’ Role
These are some of the most important role promotion strategies used in
organisations:

si
●● To target the market: Promotion is the information communicated by a marketer to
its target customers about a product or service. It is unilateral in advertising, sales
promotion, and publicity. In terms of personal selling, it is entirely bilateral, but in
r
terms of public relations, it is only partially bilateral. No marketer can rely entirely
ve
on any type of promotion, such as advertising, personal selling, sales promotion,
publicity, or public relations. The marketer must use an effective combination of
three basic elements of sales promotion, advertising, personal selling, and sales
promotion while keeping in mind the type of product, number of customers, and
ni

geographical market area.

●● To Facilitate Effective Communication: Advertising is the non-personal
communication of a message about a product, service, or product through the
U

media. When it comes to consumer goods, advertising plays an important role.

Personal selling is when a salesperson contacts a prospective buyer on a one-on-
one basis. Personal selling is more effective in the case of long-lasting consumer
items, products with high technical value, and industrial products. All other
ity

methods, such as advertising and personal selling, sales promotion, and so on,
that are used to increase the sale of a product or service.
●● To Make an Appropriate Selection of Techniques: The role of effective technique in
promotion is critical. There are several techniques for motivating consumers and
m

dealers to buy more of the company’s product. Public relations is also important
in the promotion of a product or service. To increase sales, promotional strategies
such as advertising, sales promotions, and public relations are used. Customers
)A

are encouraged to try the company’s products and services through promotions.
The main goal of promoting high-quality products or services is to get customers
to return and spend more money. Finally, businesses use promotions to build a loyal
customer base, which boosts both sales and profits. Television, radio, and magazine
advertisements were used to provide information about the brand and product. People
(c

will be aware of a company’s brand and product if they hear and see it frequently.

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 Principles and Practices of Banking 307

Promotional Strategies in the Banking Industry

Notes

e
Here are some examples of promotional strategies used in the banking industry:

●● To raise brand awareness: Promotional strategies are used to raise brand

in
awareness. You can provide information about your brand and company through
various media such as television, billboards, radio, or local newspaper news,
which allows people to learn more about you, research your products, and make

nl
purchases.
●● To provide relevant information: Banks use promotional strategies to provide
relevant information to potential customers about banking products.

O
●● Increasing Customer Traffic: Promotional strategies are used to increase customer
traffic. The more you promote your brand, the more customers will know about
you and your company, and the more interested they will be in your products.
Customers are given free samples by promotion companies, who then use the

ty
product before returning to you to make purchases.
●● To increase sales and profits: The purpose of using promotional strategies is to
raise awareness about the banking product, which aids in increasing the bank’s

si
sales and profits.
●● To Segment Identification: The purpose of implementing promotional strategies is

r
to identify target segments. A promotional strategy and marketing plan can assist
you in identifying different consumer segments in the market that provide better
ve
results.

Blueprint for Effective Promotional Strategy Implementation in the Banking

Sector
ni

●● Banking institutions must identify the most effective media, tactics, tools, and
channels for reaching their goals.
●● Banks should use online marketing to reach out to potential customers.
U

●● It is necessary to determine which communication tools and components are

required at each stage.
●● Banking institutions must determine which media and channels are best suited for
ity

the message and each target audience.

●● The need to grow a business through social media platforms such as Facebook
and Twitter.
m

●● Banking institutions should use public relations tools such as press releases,
sponsorship, and so on to create a positive image of themselves.
●● Proper use of direct marketing to reach customers is required.
)A

●● Banks must determine the flow/continuum of actions from inquiry to sale to

customer retention.

5.4 Information System in Marketing

(c

Creating effective marketing strategies necessitates careful planning and extensive

research. It is critical to collect the necessary information and data, but it is also critical
to properly organise, analyse, and disseminate the findings.

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 308 Principles and Practices of Banking

A marketing information system, or MIS, is a system for collecting, storing,

Notes

e
analysing, and disseminating valuable marketing data to assist marketers in making
better decisions. A marketing information system’s input focuses on gathering
relevant internal and external data to analyse and interpret. The output of a marketing

in
information system is the distribution of findings to all necessary internal marketing
team members and managers. Marketers can then use the data to make more informed
marketing decisions to help the business succeed.

nl
5.4.1 DSA/DMA

O
The majority of goods and services are sold in stores. Non-store retailing is divided
into four categories: direct selling, direct marketing (including telemarketing and internet
selling), automatic vending, and purchasing services. Non-store jobs have gradually
shifted to the service sector, such as banks and insurance companies.

ty
Direct selling is the practise of selling products directly to consumers in a non-
retail setting. Instead, sales take place at home, work, online, or in other non-store
settings. Direct marketing is a type of advertising that relies on the individual distribution

si
of a sales pitch to potential customers. Among the delivery methods used are mail,
email, and texting. Direct marketing is so-called because it generally eliminates the
middleman, such as advertising media.
r
Banks’ Requirements for Direct Selling and Direct Marketing
ve
The IT Revolution has had a significant impact on banking marketing activities.
Banks’ attitudes have shifted from branch-centric to technology-centric, allowing them
to become more customer-centric. As an example, consider the core banking system.
ni

Banks frequently conduct award programmes and club programmes to maintain good
customer relationships. Banks offer a variety of deposit products with various tags of his
choice for convertibility, transfer, and so on. The use of the internet, email, and mobile
phones has enabled banks to more effectively implement direct selling/marketing and
U

maintain good customer relations.

As a DSA/DMA, a banker
ity

In a bank, the Direct Selling Agent or Direct Marketing Agent are the Branch
Manager, Officers, Managers, Front Office Staff, and Marketing Managers. Their job is
to collect information about the customer with all details and create a database, raise
customer awareness about the bank’s various products, and persuade them about the
security of their deposits and other transactions.
m

Delivery Channels in a Bank

Customers can access the banks’ services via the channels listed below.
)A

◌◌ ATM Counters
◌◌ Net Banking
◌◌ Phone Banking
(c

◌◌ Mobile Banking
◌◌ Real Time Gross Settlement

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 Principles and Practices of Banking 309

◌◌ SWIFT
Notes

e
◌◌ Single Window System
◌◌ On line trading account

in
◌◌ Cash Management Schemes/CMS
◌◌ Linking Banking and Insurance Related Products
◌◌ POS Machine

nl
◌◌ Kiosks

5.4.2 Channel Management

O
The term “Channel Management” is commonly used in sales marketing. It is
defined as a process in which a company develops various marketing techniques as
well as sales strategies in order to reach the greatest number of customers possible.

ty
The channels are simply methods or outlets for marketing and selling products. Any
organization’s ultimate goal is to improve the relationship between the customer and the
product.

si
Banking channel management has emerged as a critical component in the quest
for greater efficiency. Because the channel serves as the intermediary between
customers and products, banks are leveraging their channel knowledge to address the
r
perfect product portfolio through the most cost-effective and profitable channel. Channel
ve
management is arguably one of the most important functions in today’s banking
industry, as institutions struggle to balance the viability of traditional branches with the
need to accommodate emerging channels such as mobile.

Channel management aids in the development of a programme for selling and

ni

servicing customers through a specific channel. The goal is to simplify communication

between a company and its customers. To accomplish this, you must segment your
channels based on your customers’ characteristics, such as their needs, purchasing
U

patterns, success factors, and so on, and then customise a programme that includes
goals, policies, products, sales, and marketing programmes

(1) Channel management seeks to establish direct communication with customers

through each channel. If the company is successful in achieving this goal,
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management will have a better understanding of which marketing channel is best

suited to that specific customer base. The techniques used in each channel may
differ, but the overall strategy must consistently brand the business throughout the
communication
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(2) A company must decide what it wants from each channel and clearly define the
framework for each channel to produce the desired results.
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Identifying the population segment associated with each channel also aids in
determining the best products to pitch to those channels.

Channels are classified into three types:

The Direct Channel

(c

The manufacturer organises and establishes a direct channel. They are typically
more expensive to set up at first because they necessitate a larger capital investment.

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 310 Principles and Practices of Banking

Direct selling is especially beneficial when selling an art form because it allows people
Notes

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to appreciate your work and build your brand over time.

●● It is the shortest and simplest channel of distribution.

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●● The absence of intermediaries leads to higher profit margins.
●● It allows the brand to have greater control over the customer experience.

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Disadvantages of Direct Channel:
●● You compete against vast networks of wholesalers and retailers

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●● Even though the costs are lower, customers must pay the total price in some
cases because the manufacturer has a mapped price, which he often respects
more than the retail price.

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Indirect Routes
The products are sold by intermediaries rather than by sellers in this country.
Indirect channels allow you to sell in larger volumes, but they have an impact on

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product prices due to the commission that must be paid to the intermediaries.

Channels with Hybrid Components

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Hybrid channels, as the name implies, are a combination of direct and indirect
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channels. The use of authorised distributors is one example of this. In this case, the
brand has a partnership with intermediaries but retains control over the customer
experience.

Channel Management’s Purpose

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Channel management enables you to maximise the effectiveness of your sales

and marketing channels. The primary goal of any company’s sales team is to sell its
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products or services to as many people as possible while attending to their customers’

needs as best they can. Why? Obviously, this is due to the company’s desire to
maximise profits while also building its brand for future sales. However, producing
a high-quality product is insufficient to ensure a company’s success. The products
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must find the right buyers in order to be targeted with the appropriate messaging –
differentiated or undifferentiated – and approach for successful conversions. That is
where your marketing channel comes into play.

Channel Management Channel Functions

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Marketing relies heavily on channels. Some of their functions are as follows.

Transactional Functions: Channel partners purchase your products and resell them
)A

to their customers. They carry out the following transactional tasks:

◌◌ Increase overall revenue

◌◌ Lower transaction costs
◌◌ Maintain inventory
(c

Facilitating Functions: Channel partners assist and support your product sales.
They perform the following facilitating functions:

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 Principles and Practices of Banking 311

◌◌ Interacting with customers

Notes

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◌◌ Negotiating sales
◌◌ Providing customer service

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◌◌ Gathering marketing intelligence
Logistical Functions: Channel partners such as distributors and wholesalers are in
charge of your products’ distribution. To meet customer expectations, they assist with

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storage and transportation.

5.5 Selling Function

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Cross selling occurs when you sell a different product or service to an existing
customer than the one you’ve already sold. Cross-selling products or services should
be complementary to those already purchased by your customers.

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Cross-selling techniques are used to their full potential in the banking industry. This
method of selling assists financial advisors, bankers, and tax professionals in increasing
their sales. After you’ve established a trusting relationship with your clients, there’s a

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great opportunity to sell other products you believe they’ll find useful.

It is critical to note that cross selling in banking must be done correctly and with
knowledge. Financial advisors must be careful to only sell products that their clients can
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afford and understand. If a financial advisor sells something to a client that causes them
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financial problems, the trust and credibility are lost.

5.5.1 Wealth Management

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Wealth management is a financial advisory service that combines investment

advice with other financial services to meet the needs of affluent clients. The advisor
gathers information about the client’s wants and specific situation through a consultative
process, then tailors a personalised strategy that includes a variety of financial products
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and services.

Within wealth management, a holistic approach is frequently used. A wide range

of services, such as investment advice, estate planning, accounting, retirement, and
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tax services, may be provided to meet a client’s complex needs. While fee structures
differ among comprehensive wealth management services, fees are typically based on
a client’s assets under management (AUM).

Wealth management entails more than just financial advice. It can refer to any
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aspect of a person’s financial life. Rather than attempting to integrate advice and
products from multiple professionals, high net worth individuals may benefit more from
an integrated approach. A wealth manager uses this method to coordinate the services
)A

required to manage their clients’ assets, as well as to create a strategic plan for their
current and future needs, such as will and trust services or business succession plans.

Many wealth managers can provide services in any aspect of finance, but some
prefer to specialise in specific areas, such as cross-border wealth management. This
could be based on a wealth manager’s expertise or the primary focus of the business in
(c

which the wealth manager operates.

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 312 Principles and Practices of Banking

In some cases, a wealth management advisor may need to coordinate input from
Notes

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outside financial experts as well as the client’s own service professionals (such as an
attorney or accountant) in order to craft the best strategy for the client. Some wealth
managers also offer banking services or philanthropic advice.

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In general, wealth management offices have a team of experts and professionals
on hand to provide advice in a variety of fields. Consider a client who has $2 million

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in investable assets, as well as a trust for their grandchildren, and a partner who has
recently died. A wealth management office would not only invest these funds in a
discretionary account, but would also provide will and trust services to help with tax
planning and estate planning.

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Wealth management advisors who work directly for an investment firm may be
more knowledgeable about investment strategy, whereas those who work for a large
bank may be more knowledgeable about trust management and available credit

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options, overall estate planning, or insurance options. In short, expertise may differ
between firms.

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Structures of Wealth Management Companies
Wealth managers may work for a small business or a larger firm, both of which
are typically associated with the finance industry. Wealth managers may work under
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a variety of titles, including financial consultant or financial advisor, depending on the
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industry. A client may be served by a single designated wealth manager or by members
of a specified wealth management team.

5.5.2 Portfolio Management

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Portfolio management is the art and science of selecting and supervising a group
of investments that meet a client’s long-term financial objectives and risk tolerance.
Individuals may choose to build and manage their own portfolios, while professional
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licenced portfolio managers work on behalf of clients. In either case, the portfolio
manager’s ultimate goal is to maximise the expected return on investment while
maintaining an appropriate level of risk exposure.
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Portfolio management necessitates the ability to weigh strengths and weaknesses,

opportunities and threats across the entire investment spectrum. Debt versus equity,
domestic versus international, and growth versus safety are all trade-offs.

Portfolio management can be both passive and active.

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●● Long-term passive management is a set-it-and-forget-it strategy. It may entail

investing in one or more exchange-traded funds (ETFs). Indexing or index
investing is a term used to describe this. Indexed portfolio builders can use
)A

modern portfolio theory (MPT) to help optimise the mix.

●● Active management entails actively buying and selling individual stocks and other
assets in order to outperform an index. Closed-end funds are typically managed
actively. Active managers can use a variety of quantitative and qualitative models
to help them evaluate potential investments.
(c

●● Long-term passive management is a set-it-and-forget-it strategy. Indexing, or index

investing, aims to replicate the return of a specific market index or benchmark and

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 Principles and Practices of Banking 313

may involve investing in one or more exchange-traded (ETF) index funds. Active
Notes

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management entails actively buying and selling individual stocks and other assets
in order to outperform an index. Closed-end funds are typically managed actively.

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Portfolio Management Essentials
Asset Allocation: The long-term asset mix is critical to effective portfolio
management. Stocks, bonds, and “cash” such as certificates of deposit are examples

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of this. Others, known as alternative investments, include real estate, commodities, and
derivatives. Asset allocation is based on the realisation that different types of assets do
not move in lockstep, and that some are more volatile than others. A diverse portfolio of

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assets provides balance and protects against risk. Investors with a more aggressive risk
profile allocate more of their portfolios to volatile investments such as growth stocks.
Conservative investors focus their portfolios on more stable investments such as bonds
and blue-chip stocks.

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Diversification: The only certainty in investing is that it is impossible to predict
winners and losers on a consistent basis. The prudent approach is to build a portfolio
of investments that provides broad exposure to a single asset class. Diversification is

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the process of spreading the risk and reward of individual securities within or between
asset classes. Diversification seeks to capture the returns of all sectors over time while
reducing volatility at any given time because it is difficult to predict which subset of an
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asset class or sector will outperform another. Diversification is achieved by investing in
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a variety of securities, sectors of the economy, and geographical regions.

Rebalancing: Rebalancing is the process of returning a portfolio to its original target

allocation at regular intervals, typically once a year. This is done to restore the original
asset mix when market movements throw it off-kilter. For example, a portfolio that
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begins with a 70 percent equity and 30 percent fixed-income allocation may shift to an
80/20 allocation after a prolonged market rally. The investor has made a good profit, but
the portfolio now contains more risk than the investor is willing to accept.
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Rebalancing typically entails selling high-priced securities and investing the

proceeds in lower-priced and out-of-favor securities. The annual rebalancing exercise
allows the investor to capture gains and expand the opportunity for growth in high-
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potential sectors while staying within the portfolio’s original risk/return profile.

5.5.3 Telemarketing
Telemarketing has grown in popularity as an effective tool for promotion in
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recent years. Telemarketing is the process of promoting banks through the use of
sophisticated communication networks. This includes advertising on television, the
phone, the radio, and, increasingly, cell phones. This is the most common type of
)A

promotion. Banks have begun to use ‘SMS’ and other cell phone-enabled services to
provide benefits to their customers and, as a result, have attempted to increase their
sales. In today’s competitive and modern environment, it is critical that banks use
telemarketing techniques efficiently in order to achieve desirable results.

Telemarketing is the direct sale of goods or services to potential customers via

(c

phone, Internet, or fax. Telemarketing can be done by telemarketers or, more recently,
by automated phone calls or “robocalls.” Telemarketing’s intrusive nature, as well as

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 314 Principles and Practices of Banking

reports of scams and fraud perpetrated over the phone, has fueled a growing backlash
Notes

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against this direct marketing practise. Telemarketing is also known as “telesales” or
“inside sales.”

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The practise of contacting, screening, and approaching potential customers is
known as telemarketing. It excludes the use of direct mail marketing techniques.
The term first appeared in the 1970s, with the introduction of a new, lower-cost

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class of outbound long-distance telephone services and inbound toll-free services.
Telemarketing can be done from a call centre, an office, or, increasingly, from home.
Often, telemarketing entails a single call to assess interest or suitability, followed by
follow-up calls to pursue a sale. Telemarketing is used by for-profit businesses, non-

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profit charities, political groups and candidates, surveying, donation solicitation,
marketing research, and other types of organisations to narrow down large databases
of names to a small number of higher-probability customer prospects.

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Financial telemarketing is used by financial institutions, banks, investment firms,
and credit card companies, some of which are now also banks, because it is the most
cost-effective and productive way of reaching customers. A financial telemarketing

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service, unlike some members of their sales staff, is not afraid to make those necessary
calls. Cold calls and informative calls are both simple to make. A financial telemarketing
service, which is available upon request, documents their efforts and results through
call reports.
r
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A financial telemarketing service is a specialised outsourcing solution that can
aid in sales stimulation. By making the necessary telemarketing calls, financial
telemarketers persuade customers to switch banks or stock trading accounts. A
financial telemarketing service can be a beneficial and productive form of outsourcing.
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They can act as an extension of a financial institution’s sales force without the
payroll and benefit costs, not to mention the phone equipment and support services that
the financial institution does not have to worry about.
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Telemarketing Operations
Telemarketing can be broken down into four subcategories:
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●● Outbound telemarketing calls, also known as “cold” calls, are used to actively
reach out to customer prospects and existing customers.
●● Inbound: These telemarketing calls are based on inbound product or service
inquiries generated by advertising or sales efforts. Customers who have submitted
m

an interest form online or are already familiar with the company are considered
“warm” calls.
●● Lead generation is the gathering of information about potential customers’ profiles,
)A

interests, and demographic data.

●● Sales: The persuading activity of salespeople, in which telemarketers are trained
to close a deal over the phone.
●● Surveying, appointment-setting, telesales, database maintenance and cleaning,
(c

and providing a call to action are all examples of telemarketing activities.

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Summary
Notes

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●● In recent years, technology has permeated every aspect of our lives, including
banking. Massive advances in information technology have enabled banks to

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provide much higher levels of service to their customers at significantly lower
costs. The adoption of technology has also altered the channels through which
customers interact with their financial institutions.

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●● Banking channels now offer both financial and non-financial services. Banks
provide financial services such as fund transfers, third-party payments, bill
payments, opening bank accounts, closing loan accounts, loan part payments,

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issuing demand draughts, ATM services, mobile services, and non-financial
services such as viewing account information, requesting a cheque book, and
creating standing instructions.
●● Channel banking refers to a set of formats and channels made available by a

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bank to its customers in order for them to access the various services (Collections
and Payments) offered by the bank without the assistance of a bank officer via a
variety of modes.

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●● Modern service delivery formats differ greatly from the branch-based model.
First and foremost, the emphasis is on efficiency. This means that banks strive
to provide more and more services at the lowest possible cost. Second, the
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emphasis is on educating customers and getting them used to banking through
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these new channels.
●● Computing technology advancements will almost certainly find more applications
in the baking world. As a result, the banking industry’s forerunners recognise that
their business has become intertwined with technology, and the next industry
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leader will be someone who can maximise the use of technology.

Glossary
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●● Rebalancing: Rebalancing is the process of returning a portfolio to its original

target allocation at regular intervals, typically once a year. This is done to restore
the original asset mix when market movements throw it off-kilter.
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●● Wealth management: It is a financial advisory service that combines investment

advice with other financial services to meet the needs of affluent clients.
●● Channels with Hybrid Components: Hybrid channels, as the name implies, are a
combination of direct and indirect channels. The use of authorised distributors is
m

one example of this. In this case, the brand has a partnership with intermediaries
but retains control over the customer experience.
●● Single-Party Selling System: In this system, the marketer hires another party to
)A

sell and distribute to the final customer. This is most likely to happen when the
product is sold through large store-based retail chains or online retailers, in which
case it is known as a trade selling system.
●● Multiple-Party Selling System: The product in this indirect distribution system
passes through two or more distributors before reaching the final customer.
(c

The most likely scenario is that a wholesaler purchases the product from the
manufacturer and sells it to retailers.

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 316 Principles and Practices of Banking

●● Advertisement: Advertisement is a critical component of marketing bank products.

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Advertisements should be appealing to people. It should not adhere to the
conventional pattern of narrating a product. Banks must understand people’s
preferences and choices in order to effectively advertise.

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Check Your Understanding
1. ............. telemarketing is used by financial institutions, banks, investment firms, and

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credit card companies, some of which are now also banks, because it is the most
cost-effective and productive way of reaching customers.

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a) Financial
b) Bank
c) Business

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d) Banking
2. .................. is the process of promoting banks through the use of sophisticated
communication networks.

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a) Telemarketing
b) Marketing
c) Brochures r
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d) Video calling
3. ................... management is the art and science of selecting and supervising a group
of investments that meet a client’s long-term financial objectives and risk tolerance.
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a) Portfolio
b) Business
c) Market
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d) Banking
4. The RBI’s annual report for the year .......... placed a strong emphasis on customer
empowerment through improved information dissemination.
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a) 2012-2013
b) 2010-2011
c) 2009-2010
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d) 2013-2014
5. A diversified portfolio that optimally combines a variety of loan products from different
)A

asset classes will help a bank weather an economic storm much easier than if it only
provided loans from the ............ class.
a) same asset
b) different asset
(c

c) multiple asset
d) mixed asset

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 Principles and Practices of Banking 317

6. .............. is a strategy for attracting customers’ attention by creating a unique name,

Notes

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logo, and image for a product. It assists customers in differentiating a product from
other sellers’ products.

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a) Branding
b) Marketing
c) Business marketing

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d) Print marketing
7. A .............. denotes a company that has issued stock to the general public.

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a) PLC
b) MLC
c) BLC

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d) SLC
8. .................. is the practise of offering a variety of products and services to existing

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customers.
a) Cross-selling
b) Multiple selling
c) Mixed selling
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d) Bouquet selling
9. ............... marketing allows the product to sell itself in a more favourable market.
a) Test
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b) Multi-level
c) Business
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d) Tele

Exercise
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1. What are the strategies for the enhancement of bank marketing?

2. What is test marketing?
3. Define cross selling and upselling.
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4. What is PLC and its benefits?

5. What is importance of packaging and branding in attracting customers?
6. What is diversification and its advantages?
)A

7. Define direct banking channels and their importance.

8. What is indirect distribution channel?
9. Define promotion mix.
(c

10. What is role of promotion iin financial institutions?

11. What is channel management?

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 318 Principles and Practices of Banking

12. Define wealth and portfolio management.

Notes

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13. How is telemarketing grown in popularity as an effective tool for promotion in banking
sector?

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Learning Activities
1. Discuss how marketing for the banking services can be further improved.

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2. Discuss the role of Product Research and Development in banking sector.
3. Discuss the strategies of product modification followed by the banks.

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Check Your Understanding - Answers
1. Financial
2. Telemarketing

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3. Portfolio
4. 2012-2013

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5. same asset
6. Branding
7. PLC
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8. Cross-selling
9. Test

Further Readings and Bibliography

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1. Reinventing Banking and Finance: Frameworks to Navigate Global Fintech

Innovation 1st Edition, by Helene Panzarino
2. Management of Banking and Financial Services, Padmalatha Suresh (Author),
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Justin Paul (Author)

3. Modern Commercial Banking, H.R. Machiraju
4. Customer Service & Banking Codes and Standards, Indian Institute of Banking
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& Finance
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)A
(c

Amity Directorate of Distance & Online Education