Chapter – 1 Banking History and Evolution


ROLE OF BANKS IN INDIAN ECONOMY - SAILENT FEATURES

Banks play a crucial role in the economic development of any country. Many developed countries such as Japan, Germany etc. owe their growth and development to strong financial system including banking system. In most of the growing economies including India strong healthy banks are pivotal to development. In countries with growing economies like India, banks are important from four angles. These are:

One, banks help in developing other financial intermediaries and markets as per the need of the country.

Two, help the corporate sector to meet its money needs because of less developed equity and bond markets.

Third, banks help mobilize the savings of large number of savers, which look for assured income and liquidity and safety of funds, and

Lastly, Banks also provide financial stability in the economy.

Banks play a crucial role in the economic development of any country. Many developed Countries such as Japan, Germany etc. owe their growth and development to strong financial system including banking system. In most of the growing economies including India strong healthy banks are pivotal to development. In countries with growing economies like India, banks are important from four angles.

1] Banks help in developing other financial intermediaries and markets as per the need of the country.
2] Help the corporate sector to meet its money needs because of less developed equity and bond markets.
3] Banks help mobilize the savings of large number of savers, which look for assured income and liquidity and safety of funds.
4] Banks also provide financial stability in the economy

In more details if we can go to identify Role of Commercial banks in india Like Developing Countries than we have to focus on these factors also.

Besides performing the usual commercial banking functions, banks in developing countries play an effective role in their economic development. The majority of people in such countries are poor, unemployed and engaged in traditional agriculture. There is acute shortage of capital. People lack initiative and enterprise. Means of transport are undeveloped. Industry is depressed. The commercial banks help in overcoming these obstacles and promoting economic development. The role of a commercial bank in a developing country is discussed as under.

Mobilising Saving for Capital Formation:

The commercial banks help in mobilising savings through network of branch banking. People in developing countries have low incomes but the banks induce them to save by introducing variety of deposit schemes to suit the needs of individual depositors. They also mobilise idle savings of the few rich. By mobilising savings, the banks channelise them into productive investments. Thus they help in the capital formation of a developing country.

Financing Industry:

The commercial banks finance the industrial sector in a number of ways. They provide short-term, medium-term and long-term loans to industry. In India they provide short-term loans. Income of the Latin American countries like Guatemala, they advance medium-term loans for one to three years. But in Korea, the commercial banks also advance long-term loans to industry.

In India, the commercial banks undertake short-term and medium-term financing of small scale industries, and also provide hire- purchase finance. Besides, they underwrite the shares and debentures of large scale industries. Thus they not only provide finance for industry but also help in developing the capital market which is undeveloped in such countries.

Financing Trade:

The commercial banks help in financing both internal and external trade. The banks provide loans to retailers and wholesalers to stock goods in which they deal. They also help in the movement of goods from one place to another by providing all types of facilities such as discounting and accepting bills of exchange, providing overdraft facilities, issuing drafts, etc. Moreover, they finance both exports and imports of developing countries by providing foreign exchange facilities to importers and exporters of goods.

Financing Agriculture:

The commercial banks help the large agricultural sector in developing countries in a number of ways. They provide loans to traders in agricultural commodities. They open a network of branches in rural areas to provide agricultural credit. They provide finance directly to agriculturists for the marketing of their produce, for the modernisation and mechanisation of their farms, for providing irrigation facilities, for developing land, etc.

They also provide financial assistance for animal husbandry, dairy farming, sheep breeding, poultry farming, pisciculture and horticulture. The small and marginal farmers and landless agricultural workers, artisans and petty shopkeepers in rural areas are provided financial assistance through the regional rural banks in India. These regional rural banks operate under a commercial bank. Thus the commercial banks meet the credit requirements of all types of rural people.

Financing Consumer Activities:

People in underdeveloped countries being poor and having low incomes do not possess sufficient financial resources to buy durable consumer goods. The commercial banks advance loans to consumers for the purchase of such items as houses, scooters, fans, refrigerators, etc. In this way, they also help in raising the standard of living of the people in developing countries by providing loans for consumptive activities.

Financing Employment Generating Activities:

The commercial banks finance employment generating activities in developing countries. They provide loans for the education of young person’s studying in engineering, medical and other vocational institutes of higher learning. They advance loans to young entrepreneurs, medical and engineering graduates, and other technically trained persons in establishing their own business. Such loan facilities are being provided by a number of commercial banks in India. Thus the banks not only help inhuman capital formation but also in increasing entrepreneurial activities in developing countries.

Help in Monetary Policy:

The commercial banks help the economic development of a country by faithfully following the monetary policy of the central bank. In fact, the central bank depends upon the commercial banks for the success of its policy of monetary management in keeping with requirements of a developing economy.

Thus the commercial banks contribute much to the growth of a developing economy by granting loans to agriculture, trade and industry, by helping in physical and human capital formation and by following the monetary policy of the country.

How Banks have changed over last decade of India?

Banking has changed with the needs of the economy over the years and evolved as a strong instrument of development. The various phases of changes that have made banks an instrument of development are given below:

1] Countries world over have been divided into two major groups viz. “underdeveloped” (backward) and “developed” (advanced) countries.

FYP defined “underdeveloped” economy as one where the economy has not been able to unutilize the given available resources or have underutilized the resources like natural resources, manpower resources etc. “Developed” economy on the other hand means where full or large utilization of such resources have taken place for the growth and development of the economy. Underdeveloped or growing economies like India, are also characterized by nature of occupational pattern which in India is mainly agriculture, and the population is largely “agrarian population”.

Reason for non-utilization of resources could be:

• non-availability of technology;

• prevailing socio-economic factors that may hinder the use of available resources etc.

Under-developed economies are normally characterized by “poverty”.

2] Agriculture largely remains labour intensive in India. Most farmers as well as labourers live at subsistence level or even below subsistence level. In order to increase agricultural production, investment in agriculture is necessary which will generate surplus to form capital base of the farmers.

At present majority of farmers and farm labourers are unable to save anything because of poor to low surplus. Poor Capital level results in low to even no reinvestment in the business which may lead to poor standard of living. Addition in population is also one of the many major causes of poor savings and poor standard of living

3] Common basis for comparing underdeveloped economies and developed economies has been per capital income. India’s per capital income as compared to many developed and even underdeveloped countries has been low.
4] Capital–Output ratio is also a determinant of economic development. It means number of units of capital required to produce one unit of output. In other words, this term refers to the productivity of capital in various economic sectors at a point of time
5] In order to reduce the economic disparity, it is necessary to increase capital–out ratio and improve public savings. For this, investment level is required to increase. For investments to increase there is need for generating surpluses and savings.To avoid diversification of savings there is need to mobilize public or community savings.

Purpose of mobilization of savings are:

(i) to help improve production through reinvestment thus improving capital output ratio .

(ii) to channelise the idle funds from the public into the productive channels

STEPS TAKEN TO MOBILIZE RESOURCES
6] In order to mobilize public savings, Government initiated many steps through Five Year Plans.
(i)  Taxation is first measure.
(ii)  Other measures to mobilize monies from the people by spreading of banking facilities in the needed areas.
(iii) Other steps included encouraging surplus of public sector enterprises, and
(iv)  mobilization of internal and external loans/deposits.
7] Public sector and other organizations like Banks and private organizations became major source of mobilizing small savings of the people from all sectors of the economy as well as fro every corner of the country.
8] There may not always be dearth of savings in the rural areas but it may be failure of deposit mobilization efforts which allow the savings being put into unproductive channels. Government found enough scope of deposit mobilization, both in the rural and non-rural areas and took decisions to create infrastructure for collecting savings.
9] As a step towards such mopping up of savings, banking industry took the initiative to open up new banks and branches all over the country
BANKING HIGHLIGHTS ON HISTORY AND EVOLUTION STAGES

For reaching the modern day banking business, banking industry has to pass through various stages of evolution and development.The stages are briefy discussed below:

Stage-1 Indigenous Banks

• Business of banking has been reported origin in Vedic period. Records show giving and receiving of credits during that period

• Indigenous money lenders were known as Seths or Shahs existed during that period and ran lucrative business in money lending.

• Discounting of bills was common in those times.

• Hundi (traditional bills) system was in vogue during that time.

• During 17th century, a foreign traveller quoted the existence of money changer in India known as Shroffs.

• Moghul period also refers to Jagat Seth called Manak Chand. Lord Clive also mentioned about him around 1859.

Defects of Indigenous Banking

Certain shortcomings were observed in the indigenous banking in India via-via the requirement of trade and commerce. Some important shortcomings that existed at that time are listed below:

(i) Indigenous banking is unorganized and does not sensitize the need and working of the different sectors of the economy, including banking sector.

(ii) They only do business for trade and commerce and work on commission basis resulting into trade risk in their financial business.

(iii) They did not distinguish between short term and long term finance purposes.

(iv) Methods of accounting was based on local practices and hence could not match with modern methods of financial accounting.

(v) Many of the indigenous bankers charged very high rate of interest.

Stage-2 Opening of Presidency Banks

(a) Bank of Hindustan established in 1770 was founded by M/s Alexander & Co., an English agency in Calcutta.

(b) First Presidency Bank namely Bank of Calcutta came up in 1806 in Calcutta in collaboration with Government of Bengal and East India Company. Total capital was Rs.50 lakh of which Rs.10 lakh was share of East India Company.

(c) However, in 1809, Bank of Calcutta was renamed as Bank of Bengal.

(d) Bank of Bombay, as second Presidency Bank was established in 1840 in the then Bombay (now Mumbai).

(e) Third Presidency bank came up in Madras (now Chennai) in the year 1843.In 1860, concept of limited liability       was introduced in India leading to the establishment of Joint Stock Banks.

All banks in India are registered under the Indian Companies Act as Joint Stock Company.

MODERN BANKING - ADVENT AND DEVELOPMENT

The commercial banking industry in India started in 1786 with the establishment of the Bank of Bengal in Calcutta.
It was only with the establishment of Reserve Bank of India (RBI) as the central bank of the country in 1935 under the Reserve Bank of India Act (1934) that the quasi-central banking role of the Imperial Bank of India came to an end.
In 1865, the Allahabad Bank was established with Indian shareholders.
Punjab National Bank came into being in 1895 by purely Indian nationalist people like Lala Lajpat Rai, Babu Purshotam Lal Tandon, S.Dayal Singh and others.

Between 1906 and 1913, other banks like Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, Bank of Mysore etc. were set up.

• The brand ambassador of bank of Baroda is Rahul Dravid.
• The branding line of Bank of Baroda is ‘India’s International Bank’.
• The logo of Bank of Baroda is known as ‘Baroda Sun’.

In 1921, the three Presidency banks were amalgamated to form the Imperial Bank of India, which took up following roles:

(i)   role of a commercial bank,
(ii)  a bankers’ bank, and
(iii) a banker to the Government. (quasi central banking role)

The Imperial Bank of India was established with mainly European shareholders.

Reserve Bank of India was established in 1935 under RBI Act (1934)

After independence, the Government of India started taking steps to encourage the spread of banking in India that led to the stage -3 of banking development in India

Stage-3 Banking in Post Independence Period

After independence, in order to serve the economy better, the All India Rural Credit Survey Committee was set up by RBI. This Committee recommended that Imperial Bank of India be taken over and with it are merged / integrated former state-owned and state-associate banks. Accordingly, State Bank of India (SBI) was constituted in 1955 under the State Bank of India Act (1955).Subsequently in 1959, the State Bank of India (subsidiary bank) Actwas passed, enabling the SBI to takeover five major former state- Associatebanks as its subsidiaries. These were State Bank of Patiala; State Bank of Hyderabad; State Bank of Travancore; State Bank of Bikaner & Jaipur and State Bank of Mysore.

After creating a subsidiary of SBI, arrangement made was that 55 per cent of the capital will be owned by the SBI and rest 45 per cent remains with old shareholders.

However,this arrangement also saw some weaknesses like reduced bank pro tability,weak capital base, and banks getting / burdened with large amounts of bad loans (un-recovered loans).

Commercial banks in India have traditionally focused on meeting the short-term financial needs of industry, trade and agriculture but long term financial needs were left for other agenciesor government to meet. There was no coordination between commercial banks and long term lending organizations. Hence when one was available the other was not available.

• As such with the growing need for long term funds for financing industrial projects Government established Industrial Development Bank of India (IDBI) in 1964 to help industrial sector with long term financial resources to boost industrial growth.

ADVENT OF MODERN BANKING - STAGES OF DEVELOPMENT

• Present day banking is the result of continuous research and development in the field of financial and economic aspects of Indian banking system.

• After independence of the country, today’s banking has passed through various stages of development. Banking was held to be a strong institution to respond to the growing financial needs of various sectors of the economy. Many policy decisions,a mendments in laws, new enactments etc. were initiated to make banking industry respond to growing financial requirements of different sectors of the economy

Broadly, four stages could be identified that Indian banking has passed through or is passing through after independence. These are as follows:

Stage-1
Period covering 1948 onward still late sixties (say 1969), identies with the foundation stage. During this period government ensured the enactment of necessary legal legislative framework for consolidating and reorganization of the banking system. Banking during this period was cautious, selective and securitized. Loans were advanced against tangible securities only i.e. to persons who were able to offer good securities and deposits to the bank. Banks overlooked the importance of project (purpose), person (borrower) and repayment capacity.

• In order to overcome above dificulties and others, social control on banks was initiated in 1968 on the recommendations of the National Credit Council in 1967. (Gadgil Study Group, established by RBI).

SOCIAL CONTROL AND NATIONALIZATION OF BANKS – NEED AND OBJECTIVE

Factors that led to the decision to nationalize commercial banks were:

1. Ownership and control in few hands.

2. Concentration of wealth and power by few big industrial houses who used the bank funds to build their own empires.

3. Failure of banks to mobilize resources from small towns and villages by not opening branches in small towns and villages

4. Misutilization of resources and powers by some vested interests. In other words money mobilized by banks was not being used for the economic benefit or development.

5. Discrimination against small business units.

6. Needs of the agriculture sector of the economy was neglected by banks by ignoring small farmers taking the plea that it is risky sector.

7. Misuse of funds by banks. Some banks were financing anti-social elements who in order to get large profits created shortages of essential commodities, thus affecting the general public at large.

8. Banks failed to follow the objectives of the five year plan policies and framework where in priority sectors of the economy were given priority. Private control of the banks led to various development obstacles to the achievement of the plan objectives.

NATIONALIZATION OF BANKS

• To make banking system align itself to the needs of economy and policies of the Government, on July 19, 1969 fourteen (14) of the major private sector banks were nationalized as a part of social control over banks. This was an important milestone in the history of Indian banking. This was followed by the nationalization of another six private banks in 1980.

• The 14 banks were nationalized under the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970. Criterion for selection of these banks was that those which had deposit of Rupees 50 crores and above as on the date of Ordinance issued on 19th July, 1969.

These banks were :
1. Allahabad Bank
2. Bank of Baroda
3. Bank of India
4. Central Bank of India
5. Dena bank
6. Canara Bank
7. Indian Overseas Bank
8. Bank of Maharashtra
9. Punjab National Bank
10. United Bank of India
11. Union Bank of India
12. Syndicate Bank
13. Indian Bank
14. United Commercial Bank

This process was followed again in 1980 when another lot of six banks were nationalized under Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980. Banks nationalized in second stage were:

1. Punjab & Sind Bank
2. Oriental Bank of Commerce
3. New bank of India (now merged with Punjab National Bank)
4. Vijay Bank
5. Andhra Bank
6. Corporation Bank

With the nationalization of these banks, the major segment of the banking sector came under the control of the Government. The nationalization of banks imparted major impetus to branch expansion in un-banked, rural and semi-urban areas, which in turn resulted in huge deposit mobilization, thereby giving boost to the overall savings rate of the economy. It also resulted in scaling up of lending to agriculture and its allied sectors.

In 1975 five Regional Rural banks were established on 2.10.1975 through an Ordinance. The ordinance was replaced by Regional Rural Banks Act, 1976, with the main objective to extend banking facilities to the un-banked rural areas along with commercial banks and cooperative banks.

Stage-2 Expansion Stage

This stages phase covers the period from late sixties (1969 to mid eighties). There was rapid expansion, both vertical and horizontal i.e. geographical spread as well as administrative spread. There was effort to fulfill nationalization objectives of expansion.

There was re-orientation of credit flow policy during this period so as to benefit the neglected sectors of the economy, like agriculture, small scale industries and small borrowers.

Stage-3 Consolidation Phase

This phase started from early eighties to start nineties when rapid expansion of banks faced with certain serious problems of control and economic viability of certain branches, more particularly rural branches. This phase also saw the problem of manpower, their training and positioning of branches. Branch expansion was slowed down during this period and banks started addressing the gaps that occurred during period. Staff productivity, recovery of advances, profitability etc. were some major problems.

Stage-4 Banking Reform Phase

To create a strong and competitive banking system, a number of reform measures were initiated in 1991. The thrust of the reforms was on increasing operational efficiency, strengthening supervision over banks, creating competitive conditions and developing technological and institutional infrastructure. These measures led to the improvement in the inancial health, soundness and efficiency of the banking system.

One important feature of the reforms of the 1990s was the permission to open new private sector banks. Following this decision, new banks such as ICICI Bank, HDFC Bank, IDBI Bank,Development Credit Bank (DCB), Kotak Mahindra Bank, InduSind Bank, Yes Bank and UTI Bank (now Axis bank) were set up.

From 1991 onwards till today, banking industry has seen the reforms in terms of their management and business policies. The main aim of reforms is to create a vibrant financial sector that is efficient, competitive and responsive to the needs of the economy and the people at large.

(a) Main focus of the reforms was:

(b) Strengthening of financial institutions, and integration of domestic financial system with global system of banking and economic system.

Policies were made in such a way that it could provide banks with :-

(a) greater flexibility in banking operations

(b) greater accountability to shareholders, and

(c) greater control over bank functions, and

(d) safety through prudential norms and supervision.

Based on the happenings in the domestic and international market, Indian banking system is gearing up for meeting new challenges like:

(i) Banks entering into greater specialized business like retail, housing, personal sector, corporate sector etc.

(ii) Banks have to look for more non-fund based business (NFB), like advisory services. merchant banking advisory services, guarantee business, consultancy business services etc.

(iii) Creating a strong image of the organization (brand image); customer delight and excellence etc.

(iv) The concept of Universal Banking is catching up fast. (Universal bank means where a bank takes up both the functions of long term lending development financial institutions as well as that of commercial banks. In other words a universal bank lends both short term (working capital) as well as term loan (long tern finance).

• Export-Import Bank (Exim Bank) was established in 1982 (1.1.1982) to help entrepreneurs financially, in terms of long term and short term funds, to increase exports and to act as a controller of the business of the export and import.

• Then came the National Bank for Agriculture & Rural Development (NABARD) in 1984 on the recommendation of Committee to Review Arrangements for Institutional Credit for Agriculture and Rural Development (CRAFICARD). NABARD was set up under the Parliament Act 61 of 1981.

FINANCE COMMISSION AND ITS ROLE

The Finance Commission was established in 1951 to look into the following aspects:

• To suggest as to how the revenues earned by the government through taxes etc. at centre could be shared between the States and the Centre.

• Finance Commission is set up under Articles 280 of the Constitution of India.

• Since 1951, 13 Finance Commissions have been set up. The Fourteenth Finance Commission has been set up under the Chairmanship of ex-Governor of Reserve Bank of India, Y V Reddy. Thirteenth Finance Commission was headed by Finance Secretary Vijay Kelkar. The first Finance Commission was constituted in 1951 and was headed by K C Neogy.

• Period of Commission is five years.

• Finance Commission has four other members. Finance Commission is appointed by the President of India.

• Main focus of the Finance Commission is to reduce the imbalances between taxation fixation and expenditure controls of the Centre and the States respectively.

• Presently the 13th Finance Commission has recommended that States share from the Central Revenue should be 32 per cent