Role of Banks in Indian Economy Report

September 16, 2017 | Author: souravsaha86 | Category: Errors And Residuals, Reserve Bank Of India, Banks, Financial Crisis Of 2007–2008, Money
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role of banks in indian economy - Project by Sourabh Kumar Saha - Calcutta Business School , PGDM 2008-2010 . Email : so...


Role of Banks in Indian Economy

Macroeconomics Research Paper Prepared by : Sourabh Kumar Saha PGDM : 2008-2010 Calcutta Business School , West Bengal , India Email : [email protected]

Abstract: Banks play an important role in development of Indian economy. After liberalization, the banking industry under went major changes. The economic reforms totally have changed the banking sector. RBI permitted new banks to be started in the private sector as per the recommendation of Narasimham committee. The Indian banking industry was dominated by public sector banks. But now the situations have changed. New generation banks with used of technology and professional management has gained a reasonable position in the banking industry. In this paper we look at the type of banks , their role and functioning , Establishment and Role of India‟s Central Bank - RBI and the recent banking reforms . We perform a comparative data analysis between GDP and total advances & deposits . We also check whether the Credit Deposit Ratio has any relationship with the GDP . We then perform a regression analysis to check whether there is any relationship between GDP and Bank lending interest rates. We also compare the Flow of credit to Agricultural Sector with the Growth of Agriculture Sector. We conclude the analysis by an overview and analysis of the sectorial deployment of gross bank credit over the last two financial years.

Index Title 1. Introduction 1.1. Motivation 1.2. Hypothesis 1.3. What is a Bank 1.4 Functions of a Bank 1.5. Types of Banks 1.6. Banking Sector in India 2.0 Role of Banks 2.1. Role of Banks in Indian Economy 2.2. Role of Central Bank (RBI) 2.3. Evolution of Indian Banking 2.4. Narasimham Committee Banking Reforms 2.5. Performance of Indian Banking Sector Post Reforms 3.0. Methodology 3.1. Data Analysis 3.2. Remarks 3.3. The challenges Ahead 3.4. Conclusion References Acknowledgement

Page 3 3 4 4 4 6 7 8 9 9 10 10 12 15 15 25 26 26 27 28

1. Introduction Banks over the years, have become a significant aspect of an economy. With the ongoing financial depression, the position of banks have become all the more important in the course of working of the money market and hence the economy of a nation. The banking sector forming a portion of the financial sector primarily works as a financial intermediary generating money supply. From the different macro economic models , banks have been found to be a part of the supply side of the economy . However, over time banks have transformed from merely money generating organizations to a multi tasking entity. In this paper, we shall deal with the role of banks in the context of the world economy as well as the Indian economy . The first section will illustrate the functions of a bank along with its classification. In the second section, we shall discuss the role of a banks as a major component of the service sector rendering to the economy as a whole. In the third section, we would like to empirically validate our hypothesis with a comprehensive data analysis.

1.1 Motivation The recession in the US market and the global meltdown termed as Global recession have engulfed complete world economy with a varying degree of recessional impact. World over the impact has diversified and its impact can be observed from the very fact of falling Stock market, recession in jobs availability and companies following downsizing in the existing available staff and cutting down of the perks and salary corrections. Various steps taken by RBI to curb the present recession in the economy and counter act the prevailing situation. The sudden drying-up of capital inflows from the FDI which were invested in Indian stock markets for greater returns visualizing the Potential Higher Returns flying back is continuing to challenge liquidity management. At the heart of the current liquidity tightening is the balance of payments deficit, and this NRI deposit move should help in some small way. To curb the liquidity crises the RBI will continue to initiate liquidity measures as long as the current unusually tight domestic liquidity environment prevails. The current step to curb these being lowering of interest rates and reduction of PLR . The BOP- Balance of Payment deficit – at a time when domestic credit demand is very high – is resulting in a vicious loop of reduced access to liquidity, slowing growth, and increased risk-aversion in the financial system. In present situation down fall in one sector one day leads to a negative impact on the other sector thus all together everyone feel the impact of the Financial crises with the result of the current recession which started in US and slowly and gradually due to linked global world have impacted everyone. Solution for the problem still remain at the top of the mind of every one, still everyone facing the impact of recession but how long is the major question which is of great importance.

1.2 Hypothesis In this research paper , I am trying to give an overview of the whole banking sector in India and the kind of financial functions they perform which help in the growth of the economic growth and progress of the country . I have tried to look for relationship if any between GDP and the following : Total advances/Total deposits , Credit Deposit Ratio , Lending interest rates , and the sectors in India which got more advances from the banks over the last 3 years .

1.3 What is a Bank While the question may seem elementary, the answer can be quite complex. Understanding what banking is all about will help the paper to illustrate the role of banks better. A bank is a financial institution where an individual can deposit money. Banks provide a system for easily transferring money from one person or business to another. Using banks and the many services they offer saves an incredible amount of time, and ensures that the funds of micro as well as macroeconomic agents "pass hands" in a legal and structured manner. There are also other types of financial institutions that operate just like banks.

1.4 Functions of a Bank Functioning of a Bank is among the more complicated of corporate operations. Since Banking involves dealing directly with money, governments in most countries regulate this sector rather stringently. In India, the regulation traditionally has been very strict and in the opinion of certain quarters, responsible for the present condition of banks, where NPAs are of a very high order. The process of financial reforms, which started in 1991 has cleared the cobwebs somewhat but a lot remains to be done. The multiplicity of policy and regulations that a Bank has to work with, makes its operations even more complicated, sometimes bordering on illogical. This section attempts to give an overview of the functions in as simple manner as possible. Banking Regulation Act of India, 1949 defines Banking as "accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheques, draft, order or otherwise". Deriving from this definition and viewed solely from the point of view of the customers, Banks essentially perform the following functions : 1. 2. 3. 4. 5. 6. 7.

Accepting Deposits from public/others (Deposits) Lending money to public (Loans) Transferring money from one place to another (Remittances) Credit Creation Acting as trustees Keeping valuables in safe custody Investment Decisions and analysis

8. Government business 9. Other types of lending and transactions. In addition to providing a safe custodian of money, banks also loan money to businesses and consumers. A large portion of a bank's business is lending. How do banks get the money they loan? The money comes from depositors who intend to save a portion of their wealth. Banks acting as intermediaries, use these deposits as loans to prospective borrowers. The objective of commercial banks like any other organization is profit maximisation. This profit generally originates from the interest differential between borrowers and lenders. In the present day, however, the banking operation has extended much beyond simple lending exercise. So there are other different channels of profit ensuing from other investment programmes as well. However, it should be mentioned in this context that the entire deposit held by a bank cannot be given as loans as the Central Bank retains a portion of this money in the form of cash-reserve for unforeseen circumstances. Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

In this way, money grows and flows throughout the community in a much greater amount than physically exists. That $100 makes a much larger ripple in the economy than you may realize! Other Services Offered by Banks

o o o o o o o o o

Credit Cards Personal Loans Home and Car Loans Mutual Funds Business Loans Safe Deposit Boxes Debit Cards Trust Services Signature Guarantees

…and many other investment services.

1.5 Types of Banks Central Bank: A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently. Commercial Banks : A commercial Bank performs all kinds of banking functions such as accepting deposits, advancing loans, credit creation & agency functions. They generally advance short term loans to their customers, in some cases they may give medium term loans also Industrial Banks : Ordinarily , the industrial banks perform three main functions : Firstly , Acceptance of Long term deposits : Since the industrial bank give long term loans , they cannot accept short term deposits from the public . Secondly, Meeting the credit requirements of companies : Firstly the industries require to purchase land to erect buildings and purchase heavy machinery . Secondly the industries require short term loans to buy raw materials & to make payment of wages to workers . Thirdly it does some Other Functions - The industrial banks tender advice to big industrial firms regarding the sale & purchase of shares & debentures Agricultural Banks : As the commercial & the industrial Banks are not in a position to meet the credit requirements of agriculture , there arises the need for setting up special types of banks to finance agriculture. Firstly, the farmers require short term loans to buy seeds, fertilizers, ploughs and other inputs . Secondly, the farmers require long term loans to purchase land, to effect permanent improvements on the land to buy equipment & to provide for irrigation works . Foreign Exchange Banks : Their main functions is to make international payments through the purchase and sale of exchange bills . As is well known , the exporters of a country prefer to receive the payment for their exports in their own currency . Hence their arises the problem of

converting the currency of one country into the currency of another . The foreign exchange banks try to solve this problem . These banks specialize in financing foreign trade . Indigenous Banks : According to the Indian Enquiry Committee , “ Indigenous banker is a person or a firm which accepts deposits , transacts business in hundies and advances loans etc ”.

1.6 Banking Sector in India Central Bank : The Reserve Bank of India is the central Bank that is fully owned by the Government. It is governed by a central board (headed by a Governor) appointed by the Central Government. It issues guidelines for the functioning of all banks operating within the country. Public Sector Banks a. State Bank of India and its associate banks called the State Bank Group b. 20 nationalized banks c. Regional rural banks mainly sponsored by public sector banks Private Sector Banks a. b. c. d. e.

Old generation private banks New generation private banks Foreign banks operating in India Scheduled co-operative banks Non-scheduled banks

Co-operative Sector The co-operative sector is very much useful for rural people. The co-operative banking sector is divided into the following categories. a. State co-operative Banks b. Central co-operative banks c. Primary Agriculture Credit Societies Development Banks/Financial Institutions IFCI, IDBI , ICICI Bank , IIBI SCICI Ltd. NABARD Export-Import Bank of India National Housing Bank Small Industries Development Bank of India North Eastern Development Finance Corporation

2. Role of Banks A proper financial sector is of special importance for the economic growth of developing and underdeveloped countries. The commercial banking sector which forms one of the backbones of the financial sector should be well organized and efficient for the growth dynamics of a growing economy. No underdeveloped country can progress without first setting up a sound system of commercial banking. The importance of a sound system of commercial banking for a developing country may be depicted as follows : Capital Formation: The rate of saving is generally low in an underdeveloped economy due to the existence of deep-rooted poverty among the people . Even the potential savings of the country cannot be realized due to lack of adequate banking facilities in the country . To mobilize dormant savings and to make them available to the entrepreneurs for productive purposes , the development of a sound system of commercial banking is essential for a developing economy . Monetization : An underdeveloped economy is characterized by the existence of a large non monetized sector , particularly , in the backward and inaccessible areas of the country . The existence of this non monetized sector is a hindrance in the economic development of the country . The banks , by opening branches in rural and backward areas , can promote the process of monetization in the economy . Innovations : Innovations are an essential prerequisite for economic progress . These innovations are mostly financed by bank credit in the developed countries . But the entrepreneurs in underdeveloped countries cannot bring about these innovations for lack of bank credit in an adequate measure . The banks should , therefore , pay special attention to the financing of business innovations by providing adequate and cheap credit to entrepreneurs . Finance for Priority Sectors : The commercial banks in underdeveloped countries generally hesitate in extending financial accommodation to such sectors as agriculture and small scale industries , on account of the risks involved there in . They mostly extend credit to trade and commerce where the risk involved is far less .But for the development of these countries it is essential that the banks take risk in extending credit facilities to the priority sectors , such as agriculture and small scale industries . Provision for Medium and Long term Finance : The commercial banks in underdeveloped countries invariably give loans and advances for a short period of time . They generally hesitate to extend medium and long term loans to businessmen. As is well known , the new business need medium and long term loans for their proper establishment . The commercial banks should , therefore , change their policies in favor of granting medium and long term accommodation to business and industry . Cheap Money Policy : The commercial banks in an underdeveloped economy should follow cheap money policy to stimulate economic activity or to meet the threat of business recession. In

fact , cheap money policy is the only policy which can help promote the economic growth of an underdeveloped country . It is heartening to note that recently the commercial banks have reduced their lending interest rates considerably . Need for a Sound Banking System : A sound system of commercial banking is an essential prerequisite for the economic development of a backward country .

2.1 Role of Banks in Indian Economy In India , as in many developing countries , the commercial banking sector has been the dominant element in the country‟s financial system . The sector has performed the key functions of providing liquidity and payment services to the real sector and has accounted for the Bulk of the financial intermediation process . Besides institutionalizing savings , the banking sector has contributed to the process of economic development by serving as a major source of credit to households , government , business and to weaker sectors of the economy like village and small scale industries and agriculture. Over the years, over 30-40% of gross household savings , have been in the form of bank deposits and around 60% of the assets of all financial institutions accounted for by commercial banks. An important landmark in the development of banking sector in recent years has been the initiation if reforms following the recommendations of the first Narasimham Committee on Financial System. In reviewing the strengths and weaknesses of these banks , the Committee suggested several measures to transform the Indian banking sector from a highly regulated to a more market oriented system and to enable it to compete effectively in an increasingly globalised environment . Many of the recommendations of the Committee especially those pertaining to Interest rate , an institution of prudential regulation and transparent accounting norms were in line with banking policy reforms implemented by a host of developing countries since 1970‟s .

2.2 Role of Central Bank ( RBI ) The main objectives for the establishment of the Central Bank were as follows : To manage the monetary and credit system of the country. To stabilizes internal and external value of rupee For balanced and systematic development of banking in the country For the development of organized in the money market in the country . For proper arrangement of agriculture finance. For proper arrangement of Industrial Finance . To establish monetary relations with other countries of the world & international financial institutions. For proper management of public debts . For centralization of cash reserves of commercial banks .

To maintain balance between the demand and supply of currency .

2.3 Evolution of Indian Banking Prior to 1969 , all banks , except State Bank of India and its seven associate banks were privately owned /. However there was a perception among policy makers that under private ownership , too many rural and semi urban-areas remained un-served by banks , whereas the banking industry has to be developed to “touch the lives of millions”. Further as India became an increasing planned economy , policy makers felt that „It would be difficult to undertake credit planning unless the link control of industry and banks in the same (private) banks is snapped by the nationalization of banks‟ (Hazari Report , 1967) . These considerations led to the Nationalization Act of 1969 which caused 14 largest privately owned domestic banks to be nationalized. In 1980 under the same Act , the Government of India acquired ownership of 6 more private banks , bringing the total number of nationalized banks to 20 . Notwithstanding the positive role played by the banking sector since nationalization in institutionalizing savings and becoming a source of credit to the small borrower , the cumulative effect of excessive focus on quantitative achievement and social obligations took a toll on profitability and efficiency . Rates of return became low by international standards , the capital base was eroded, NPS‟s were on the rise, and customer service was below expectation . These conditions led to gradual liberalization of banking sector operations since the mid 1980‟s and culminated in the initiation of fundamental banking sector reforms of 1992 with the acceptance of key recommendations of the Narasimham Committee .

2.4 Narasimham Committee Banking Reforms Restructuring of the banking system : The committee recommended 4-tier structure of the banking system consisting of : (a) : Three of Four Large (international) banks . (b) : Eight to ten national banks with a network of branches throughout the country . (c) : Local works with operations confined to a specific region. (d) : Rural Banks with operations confined to rural areas and business confined to agricultural and allied activities . Enhancement of Capital Base of Bank : The committee recommended that the banks should be allowed to raise fresh capital from the public . Mutual Funds , profitable public sector units and employees can also subscribe to these issues . Deregulation of Interest Rates : The committee recommended deregulation of interest rate on loan so that they reflect the actual market conditions . The interest rate on government borrowings may also be gradually deregulated to bring it in line with market rates . However interest rate on bank deposits may continue to be regulated . The first step was taken in October 1994 , when rates were deregulated for advances more than 2 lakh . In April 1998, under new regulations interest on credit limits up to Rs 25,000 was

prescribed at 12% and for credit limit between Rs 25,000 and Rs 2 lakh , the rate was not to exceed 13.5% per annum . Abolition of Licensing : The committee proposed no further nationalization of banks . It proposed abolition of branch licensing. It said that the banks should be allowed to decide for themselves. The foreign banks, private banks should be allowed to open branches in the country Cut in SLR , CRR : The committee recommended bringing down the SLR of banks in a phased manner period of five years . It also recommended reducing of CRR from its present high level . Trends in Cash Reserve Ratio (CRR) and statutory liquidity ratio (SLR) 1991-92 to 1997-98 Year CRR (As % of NDTL*) 1991-2 15 1992-3 15 1993-4 14 1994-5 15 1995-6 14 April 1996 13 July 1996 12 October 1996 11.5 January 1997 10 October 1997 9.75 January 1998 10.5 April 1998 10 Note: *Net demand and time liabilities

Base SLR (as % of NDTL*) 38.5 37.75 34.75 33.75 31.5 31.5 31.5 31.5 31.5 25 25 25

Source : RBI , Annual Report, Various issues and RBI Credit Policy October 97, April 98 The committee favoured of putting on end to dual control over banks by RBI and Banking division. It suggested that RBI should be the primary agency for regulations . Supervisory functions over banks and financial institutions should be given to a new quasi autonomous body under RBI . The committee favoured scrapping of prior approval of Government or Securities Exchange Board of India for any issue in the market . The issuing company should be free to decide on the nature of the instrument , its terms and lending. Foreign banks should be subject to same requirements as applicable to Indian banks . They should be permitted to open offices in India as branches or as subsidiaries . Computerization of Bank Operations needs to be stepped up .

The committee also proposed that its directed credited programme should be phased out . The priority sector should be redefined to comprise small and marginal farmers , the tiny sector of the industry , village and cottage industries , small business and other weak sections . A special tribunal should be set up to speed up the process of recovery of overdue loans . An asset reconstruction fund should be set up to speed up the process of recovery of overdue loans.

2.5 Performance of Indian Banking Sector Post Reforms We now look into the different aspects of bank performance which have been targeted by the reforms. These are : 1. 2. 3. 4. 5. 6. 7.

Deposit mobilization Portfolio Choice Competition Profitability Efficiency Capital Adequacy NPA‟s

Deposit Mobilization : Estimates of trends in real deposit growth post reforms reveal that the rate of growth has fluctuated, slackening between 1994-5 and 1995-6 but picking up during 1996-7 . Growth rates of key banking Variables (1981) Item

1980-81 to 1989-90 9.8

1990-91 to 1995-96 6.8

1993-94 to 1994-1995 10.7

1994-95 to 1995-96 4.1

1995-96 to 1996-97 6.3

Aggregate Deposits Time 10.2 6.5 8.1 5.8 7.2 deposits Bank Credit 8.7 4.2 -1.6 9.3 -1.9 Investments 10.5 10.3 22.9 4.3 9.6 in Govt Securities Note : Compound annual growth rates. All estimates are in real terms . Given in % forms . Sources : RBI annual report 1996-97 and RBI Bulletin Different issues In a nutshell , the present banking scenario with respect to deposits and advances can be observed from the following table :

Year 199900 200001 200102 200203 200304 200405 200506 200607

% Increase in Deposits 19.23

% Increase in Advances 31.5

% Growth in GDP 9.59






















Source : RBI Trend and progress of banking in India various issues Bank credit consists of food and non food credit and bank investments comprise of investment in Government securities, bonds, debentures , shares issued by public sector undertakings and private corporate sector and commercial paper . The rate of growth on non food credit between 1995-96 and 1996-07 was a negative 0.7 compared to a growth rate off 11.6% between 1994-95 and 1995-96 . A comparison of growth Rate on investment in government securities in real terms over the pre-reform and post-reform years does not reveal substantial differences . Competition : With the entry of new private banks , the market shares of public sector banks have declined by close to 4% points from around 90% in 1991-92 to around 85% in 1995-96 . This kind of competition has led to adoption of newer banking practices like ATM , Online transactions and others to fit in the global competitive market . Profitability : Estimates for 1996-97 show public sector banks turning a net profit of 30.95 billion wiping out the loss of 3.71 billion in 1995-96 . Efficiency : An increase in competitive pressures is expected to improve efficiency levels. However in this regard , there has been marginal improvement except the state bank group and old domestic private banks .

Capital Adequacy : In 1996-97 , out of the 27 public sector banks, 25 have attained the BIS norm of an 8% risk waited capital to asset ratio . Non performing Assets : In 1993-94 , the average percentage of NPA‟s to total advances for 27 public sector banks was 21.89 which declined to 9.8% of total advances in 1996-97 .

3 Methodology In this section, the objective of the paper will be to check whether there exists some kind of relation between the total deposits of all banks with respect to the GDP. We then look at the state wise Credit Deposit Ratio over the last 4 years and observe which states have higher ratios which in turn could possibly be because of the progressing industrial and economic growth of the states . In another observation we compare the interest lending rates v/s the GDP growth rate . We also compare the Flow of credit to Agricultural Sector v/s Growth of Agriculture Sector. We conclude the analysis by an overview and analysis of the sectorial deployment of gross bank credit over the last two financial years.

3.1 Data Analysis The logic behind this analysis is that, the service sector of the economy has been growing profoundly over the years. The financial sector is an important subsector of the service sector. So it can be assumed that if there is an improvement in the performance of the financial sector, it will have necessary spill over effects on the service sector and hence the GDP. GDP FC (Real) in Rs Crore at 1993-94 prices.

Years 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05

Financial, Insurance,Real Estate and business Services 66990 281156 75027 294643 79430 310411 90084 334216 95085 357890 102847 395312 109995 423774 122784 465228 131892 504307 145863 555059 150910 586190 157733 625090 171463 674572 183718 735696 196820 801468

Source : Handbook of Indian Statistics 1200000 1000000 800000 600000 400000 200000 0


Financial, Insurance,Real Estate and business services

Deposits-Advances : GDP Relationship Here, GDP is taken as the dependent variable which depends on the total deposits and total advances given by all banks together in the Indian economy from 1998-2007. The regression equation is framed as Z= α+βx+γy, where Z: GDP, x: total deposits, y: total advances Deposits-Advances : GDP Relationship Year 199899 199900 200001 200102 200203 200304 200405 200506 200607

Total Deposits 1425677.9

Total Advances 561184.32

GDP 18,942.53

























Source : Trend and Progress of Banking in India - Different issues,

SUMMARY OUTPUT Regression Statistics Multiple R 0.997954 R Square 0.995912 Adjusted R Square 0.994549 Standard Error 672.8468 Observatio ns 9

ANOVA df Regression





8 Coefficien ts

SS 6.62E+0 8 271633 7 6.64E+0 8



X Variable 1


Standar d Error 819.152 2 0.00079 1

X Variable 2



MS 3.31E+0 8 452722. 8

F 730.832 9

t Stat 14.6067 3 3.52135 4 5.22654

P-value 6.46E06 0.01249 8 0.00196 4

Significanc eF 6.83E-08

Lower 95% 9960.745 0.00085 0.002863

Upper 95% 13969.5 3 0.00472 2 0.00790 4

Lower 95.0% 9960.74 5 0.00085 0.00286 3

Upper 95.0% 13969.5 3 0.00472 2 0.00790 4

The analysis shows up a P-Stat value of 0.002 for Variable 2 which in this case is the total advances by banks . Therefore as per the hypothesis , the dependent variable GDP depends positively with the independent variable – Total Advances . However the values for deposits are not significant as t
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