ICAI Notes 8.2 - Commercial Banks | Business Economics for CA Foundation PDF Download

Learning Objectives

• understand the meaning of commercial banks and their role in India.
• understand the functions carried out by commercial banks.
• know about developments in commercial banking in India.

 2.0 INTRODUCTION

A modern industrial society cannot be run by self-financing of entrepreneurs. Some institutional assistance is necessary to mobilise the savings of the community and to make them available to the entrepreneurs. The people, a large majority of who save in small odd lots, also want an institution which can ensure safety of their funds together with liquidity. Banks assure this with a further facility - that the funds can be drawn back in case of need.

From a broader social angle, banks act as a bridge between the users of capital and those who save but cannot use the funds themselves. The idle resources of the community are thus activated and brought to productive use.

Besides, the banking system has capacity to add to the total supply of money by means of credit creation. The bank is a dealer in credit - its own and other people’s. It is because of the ability to manipulate credit that banks are used extensively as a tool of monetary policy.

2.1 ROLE OF COMMERCIAL BANKS

Banks play a very useful and dynamic role in the economic life of every modern state. Their economic importance may be viewed in the followed points :
(1) A developing economy needs a high rate of capital formation to accelerate the tempo of economic development. But the economic development depends upon the rate of savings. Banks offer facilities for keeping savings and thus encourage the habits of thrift in the society.

(2) Not only do the banks encourage savings but they also mobilise savings done by several households and make them available for production and investment to the entrepreneurs in various sectors of the economy. Without banks these savings would have remained idle and would not have been utilised for productive and investment purposes.

(3) Allocation of funds or economic surplus among different sectors, users or producers so as to make maximum social return and thus to ensure optimum utilization of savings is another important function performed by the banks. However, it may be mentioned, that commercial banks do not always work and allocate resources in the way that maximises production or social welfare. For example, before nationalisation in 1969, the commercial banks in India neglected socially highly desirable sectors such as agriculture, small scale industries and weaker sections of the society. Therefore, it was thought necessary to nationalise them so that they should allocate resources in socially desirable directions.

(4) By encouraging savings and mobilising them from public, banks help to increase the aggregate rate of investment in the economy. Banks not only mobilise saved funds from the public, but they also themselves create deposits or credit which serve as money. The new deposits are created by the banks when they lend money to the investors or other users. These deposits are created by the banks in excess of the cash reserves they obtain through deposits from the public. These days, the bank deposits, especially demand deposits are as much good money as the currency issued by the government or the central bank. This creation of credit, if it is used for productive purposes greatly enlarges production and investment and thus promotes economic growth.

2.2 FUNCTIONS OF A BANK

The functions of a bank can be summarised as follows :

(a) Receipt of deposits : A bank receives deposits from individuals, firms, and other institutions. Deposits constitute the main resources of a bank. Such deposits may be of different types. Deposits which are withdrawable on demand are called demand or current deposits, others are called time deposits. Savings deposits are those from which withdrawals are not restricted as regards the amount and the period. Deposits withdrawable after the expiry of an agreed period are known as fixed deposits. Interest paid by banks is different for each kind of deposit - highest for fixed deposits and lowest or even nil for current deposits.

(b) Lending of money : Banks lend money mainly for industrial and commercial purposes. This lending may take the form of cash credits, overdrafts, loans and advances, or discounting of bills of exchange. Interest charged by banks on such lending varies according to the amount and period involved, social priority-nature of security offered, the standing of the borrower, etc.

(c) Agency services : A bank renders various services to consumers, such as : (i) collection of bills, promissory notes and cheques; (ii) collection of dividends, interests, premiums, etc.; (iii) purchase and sale of shares and securities; (iv) acting as trustee or executor when so nominated; and (v) making regular payments such as insurance premiums.

(d) General services : A modern bank performs many services of general nature to the public, e.g. (i) issue of letters of credit, travellers cheques, bank drafts, circular notes; etc. (ii) safe keeping of valuables in safe deposit vaults; (iii) supplying trade information and statistics; conducting economic surveys; and (iv) preparation of feasibility studies, project reports, etc. Banks in some foreign countries also underwrite issue of shares and make loans for long-term purposes.

2.3 COMMERCIAL BANKING IN INDIA

At the time of Independence, India had a fairly well-developed banking system with more than 645 Banks having more than 4800 branch offices. These banks although developed but they could not conform to social needs of the society. These banks generally catered to the needs of industries and that too big ones. Other priority sectors like agriculture, small-scale industries, exports etc., were almost neglected. To overcome these deficiencies, the Government announced the nationalisation of 14 major commercial banks with effect from July, 1969. The objectives of nationalisation were to control the heights of the economy and to meet progressively the needs of development of the economy, in conformity with national policy and objectives. Six more banks were nationalised in 1980. (Two banks were merged in 1993, so at present there are 19 nationalised banks).

2.4 NATIONALISATION OF COMMERCIAL BANKS

The following factors were responsible for nationalisation of commercial banks in 1969.

(i) Private ownership of commercial banks and concentration of economic power : Until nationalisation, all major banks were controlled by one or more business houses. These business houses used the resources contributed by the mass of the people for their own personal benefits. They financed those projects which ultimately enhanced their own financial resources. Thus, private ownership of banks resulted in concentration of income and wealth in few hands.

(ii) Urban-bias : Prior to nationalisation, commercial banks had shown no interest in establishing offices in semi-urban and rural areas. More and more branches were opened in cities resulting in concentration of banking facilities in urban areas. For example, out of about 5.6 lakh villages in India, only 5000 were being served by commercial banks and five major cities (Ahmedabad, Bombay, Calcutta, Delhi and Madras) together had oneseventh share in the number of bank offices and about fifty percent share of bank deposits and bank credit. This urban biased nature of commercial banks led to slow rate of growth in the rural areas.

(iii) Neglect of agricultural sector : There was a total neglect of the agricultural sector and its finance prior to nationalisation of banks. The banks increasingly advanced finances to commerce and industry with the result their share in the scheduled banks advances increased from 70 per cent in 1951 to 87 per cent in1968. Agriculture accounted for only 2.2 per cent of the total advances.

(iv) Violation of norms : Commercial banks often violated the norms and priorities laid down in the plans and granted loans to even those industries which figured no where in the priority list.

(v) Speculative activities : Private commercial banks earned large profits and indulged in speculative activities. They even extended advances to hoarders and black marketers against high rates of interest.

(vi) Neglect of priority sectors : Not only there was a complete neglect of agricultural sector, other sectors such as export, small-scale industries etc. were also completely neglected. In order to discipline the commercial banks so that they do not over look the national priorities, nationalisation of banks was undertaken first in 1969 and then in 1980. Objectives of nationalisation : Nationalisation was meant for an early realisation of the objectives of social control which were as follows : (i) removal of control by a few; (ii) provision of adequate credit for agriculture and small industry and export; (iii) giving a professional bent to management; (iv) encouragement of a new class of entrepreneurs; and (v) the provision of adequate training as well as terms of services for bank staff.

2.5 PROGRESS OF COMMERCIAL BANKS AFTER NATIONALISATION

After the nationalisation of banks in 1969, commercial banking operations have become an integral part of India’s economic policy. Following development have taken place since nationalisation in 1969 :

(i) Expansion of branches : There has been an unprecedented growth in the branch network since nationalisation. Compared to just 8262 branch offices in 1969, the number of branch office in 2008 has increased to 76885 indicating a greater access to banking facilities to the common man. As a result, the population per bank office has reduced from 55,000 in 1969 to around 15,000 in 2008.

(ii) Branch opening in rural and unbanked areas : There has been a qualitative change in branch expansion programme ever since the nationalisation of banks. Before nationalisation, there was a clear urban bias in the operations of banks. But after nationalisation they have started moving towards rural and less developed areas. This will be clear from the fact that compared to just 22 per cent bank offices in rural areas in 1969, the percentage of rural branches bank improved to about 41 per cent in June, 2008. This has helped in checking imbalances in disbursement of banking finance in India.

(iii) Deposit mobilisation : There has been a substantial rise in the rate of deposit mobilisation since nationalisation. The aggregate deposits of commercial banks have increased from Rs. 4,665 crore in 1969 to around Rs. 31,97,000 crore in December, 2008 forming more than 80 per cent of the national income. Considering state-wise deposit mobilisation, we find Maharashtra leads all other states and accounts for around one-fifth of the aggregate deposits received by the banks. It is followed by Delhi, Uttar Pradesh, West Bengal, Tamil Nadu, Karnataka and Andhra Pradesh. These all together account for 65 per cent of the aggregate deposits of the banks.

(iv) Bank lending : There has been a spectacular rise in the bank lending since nationalisation of banks in 1969. It has gone up from Rs. 3,399 crore in June, 1969 to about 23,62,000 crore in June, 2008.

The bank have taken special care of the priority sectors in their lending operations. In 1969, agriculture, small scale industries and small retail trade accounted for about 15 per cent of the commercial banks credit. This percentage has gone up to about 44 per cent in March, 2008.

(v) Promotion of new entrepreneurship : Banks, of late, have been financing the schemes which promote entrepreneurship. For example, they have been activity participating in schemes such as IRDP, TRYSEM, JRY, NRY etc. Moreover, in their lending operations they now give high priority to the relevance of the project for the economy as a whole along with genuine business productive requirements of the borrowers.

2.6 SHORTCOMINGS OF COMMERCIAL BANKING IN INDIA

(i) Although the commercial banks have spread their wings to every corner of the country, but considering the huge population of India, their growth in numerical terms in insufficient. This is specially so with regard to rural areas who have just 41 per cent of the bank branches but where more than 70 per cent of the population of the country reside.

(ii) There are regional imbalances in the coverage of bank offices. Only few states have well developed banking facilities : Arunachal Pradesh, Jammu and Kashmir, Uttaranchal, Manipur, Tripura on an average have lesser number of banks compared to other states. Even from the states which are well banked like Maharashtra, West Bengal and Tamil Nadu, if big metropolitan cities are excluded the population per bank office is larger than the average for these states.

(iii) As a result of increasing advances and loans to unemployed and weaker sections the commercial banks are facing the problem of bad debts, doubtful debts and over dues. This seriously affects the process of recycling of funds by the commercial banks. Bad and doubtful debts of scheduled commercial banks, called non-performing assets (NPAs) have swelled over a period of time. Gross NPAs were more than Rs. 50,000 crore in 1997-98 they increased to more than Rs. 70,000 crore in 2001-02, but of late due to stringent credit norms and improved financial health of the economy the gross NPAs have fallen and stood at around Rs. 51,000 crore in 2006-07. As a percentage of gross advances, they have fallen from 15 per cent to 10.5 per cent and further to 2.5 per cent over the above period.

(iv) The quality of services rendered by commercial banks has deteriorated overtime. This has happened because of staff indiscipline and absence of the system of accountability. There is a problem of effective management and control especially over the branches which are located in remote areas. This has hampered the overall efficiency of the commercial banks.

(v) The absolute profits of the banks are rising but the profitability ratio (in terms of return on investment, return on equity) has not improved much. Six factors have been identified for declining trends in profitability. These are (i) lower interest on Government borrowings from banks (ii) subsidisation of credit to priority sector (iii) rapid branch expansion (iv) locking up of funds in low-term low yielding securities resulting from directed credit programmes of banks (v) lack of competition (vi) Increasing expenditure resulting from over staffing and mushrooming of branches some of which are non-viable.

Concerned with the problem of declining profitability and high incidence of non performing assets (NPA), the RBI has started fine-tuning its regulatory and supervisory mechanism. Measures have been taken to reduce NPAs. These include, reschedulement, restructuring at the bank level, corporate debt restructuring and recovery through Lok Adalats, civil courts and debt recovery tribunals.

(vi) The public sector banks although entered into merchant banking and agricultural financing, yet they lack expertise in these areas. There is a need for professional touch in these areas.

To sum up, although after nationalisation the commercial banks have played an important role in achieving national goals of the economy yet these is a need for :-

(a) Spreading their activities to the untouched remote corners of the country.

(b) Keeping up their profitability.

(c) Looking after the growing needs of the priority sectors of the economy.

(d) Improving the performance of rural/semi-urban branches.

(e) Improving the quality of loan portfolio.

SUMMARY

A bank has many functions to perform-receipt of money lending of money, collection and payment of bills, cheques etc. preparation of feasibility studies, project reports, issue of letters of credit, travellers cheques and so on. Lending and borrowing functions of banks result in a credit creation in the economy. Credit creation helps in improving money circulation without resorting to any increase or decrease in the quantity of currency or legal tender money.

After Independence most of the banks neglected the priority sectors (agriculture, small industries exports etc.) and mostly financed the industrial units. In order to have social control on banks, banks were nationalised in 1969 and 1980. After nationalisation, banks have spread their wings all over the country. They cater to the needs of all - agriculture, industry and commerce. However, they still have to go a long way for removing inter-regional, inter-sectoral imbalances.