Unit 1: Indian banking system

FIN203 — Commercial Banking 8 min read

The Indian banking system is a regulated, multi-tier network of institutions that mobilise deposits and channel credit, governed principally by the Banking Regulation Act, 1949 and overseen by the Reserve Bank of India (established 1935, nationalised 1949). The sections below assume the following defining features.

Statutory basis: Banks operate under the Banking Regulation Act, 1949 and the RBI Act, 1934; a "banking company" is one that accepts deposits withdrawable by cheque, draft or order.
Dual control: Commercial banks answer to RBI for monetary and prudential matters and to the Companies Act / cooperative statutes for corporate form.
Reserve discipline: Every bank maintains a Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) against its net demand and time liabilities (NDTL).
Financial intermediation: The core function is converting short-term deposits into longer-term loans, earning a spread between deposit and lending rates.
Priority sector obligation: 40% of adjusted net bank credit is directed to agriculture, MSMEs and weaker sections.

II. Banking Structure in India

The institutional map from the apex regulator down to the smallest cooperative.

A. Organisation of the system

The structure is pyramidal, with RBI at the apex and a widening base of scheduled and non-scheduled institutions.

Apex regulator: RBI sits at the top as central bank, note-issuer and controller of all banks.
Scheduled vs non-scheduled: A "scheduled bank" is listed in the Second Schedule of the RBI Act, 1934 and meets the paid-up capital and reserves test (₹5 lakh minimum); it gains refinance and clearing-house access. Non-scheduled banks fall outside this schedule.

B. Commercial banks

These are profit-oriented banks providing the full deposit-and-credit range.

Public sector banks: Majority government-owned (e.g. SBI, Punjab National Bank) after nationalisation of 14 banks in 1969 and 6 more in 1980.
Private sector banks: Owned by private shareholders (e.g. HDFC Bank, ICICI Bank), split into "old" and "new" private banks licensed post-1993.
Foreign banks: Branches of overseas banks (e.g. Citibank, HSBC) operating under RBI licence.
Regional Rural Banks (RRBs): Set up under the RRB Act, 1976; jointly owned by Centre (50%), sponsor bank (35%) and State (15%) to serve rural credit.

C. Cooperative and specialised tiers

These complete the base of the pyramid.

Cooperative banks: Three-tier rural structure (State → District Central → Primary Agricultural Credit Societies) plus urban cooperative banks; dual-regulated by RBI and Registrar of Cooperative Societies.
Small Finance & Payments Banks: Differentiated banks licensed from 2015; payments banks accept deposits up to ₹2 lakh but cannot lend.

III. Role of the Reserve Bank of India

The central bank as regulator, monetary authority and lender of last resort.

A. Nature and objectives

RBI is India's central bank, charged with price stability, orderly credit flow and currency management.

Monetary policy framework: Since 2016 a Monetary Policy Committee targets CPI inflation at 4% ± 2%.
Policy rate: The repo rate is the benchmark at which RBI lends overnight to banks against securities.

B. Monetary and credit control

RBI steers money supply through quantitative and qualitative tools.

TEXT

Quantitative tools:
  Repo / Reverse repo rate
  Bank Rate
  CRR  = cash with RBI ÷ NDTL
  SLR  = liquid assets (gold, G-secs) ÷ NDTL
  Open Market Operations (buy/sell G-secs)
Qualitative tools:
  margin requirements, moral suasion,
  selective credit control, directives

CRR: Portion of NDTL kept as cash with RBI, earning no interest; raising it tightens liquidity.
SLR: Minimum liquid assets each bank holds, ensuring solvency and funding government borrowing.
OMO: Selling securities absorbs liquidity; buying injects it.

C. Regulatory and developmental functions

RBI combines supervision with system-building.

Issuer of currency: Sole authority to issue notes (except ₹1 note/coins, issued by Government) under the minimum reserve system.
Banker to government and banks: Manages public debt, maintains banks' reserve accounts and acts as lender of last resort.
Supervisor: Licenses banks, conducts inspections and enforces prudential norms (capital adequacy under Basel III).
Developmental: Promotes financial inclusion, payment systems (RTGS, NEFT, UPI oversight) and foreign-exchange management under FEMA, 1999.

IV. KYC Norms

The customer-identification regime that underpins anti-money-laundering compliance.

A. Purpose and legal basis

Know Your Customer norms require banks to verify identity and monitor transactions to prevent misuse of accounts.

Statutory anchor: Mandated by RBI under the Prevention of Money Laundering Act (PMLA), 2002 and the KYC Direction, 2016.
Four pillars: Customer Acceptance Policy, Customer Identification Procedure, Risk Management, and ongoing Transaction Monitoring.

B. Documentation and verification

Identity rests on a defined set of officially valid documents (OVDs).

Officially Valid Documents: Passport, Aadhaar, voter ID, driving licence, NREGA job card — proving identity and address.
Proof split: CIP requires proof of identity and proof of address; a recent photograph and PAN complete the file.
e-KYC: Aadhaar-based electronic verification allows paperless, OTP or biometric authentication.

C. Risk categorisation and periodic update

Customers are classified by risk, driving the depth of due diligence.

Low/medium risk: Salaried individuals, government bodies — simplified due diligence; periodic re-KYC every 8–10 years (low) or 8 years (medium).
High risk: Politically exposed persons, non-resident or cash-intensive accounts — enhanced due diligence and re-KYC every 2 years.

CDD vs EDD: Customer Due Diligence is the baseline check; Enhanced Due Diligence adds source-of-funds scrutiny for high-risk profiles.
STR filing: Suspicious Transaction Reports go to the Financial Intelligence Unit (FIU-IND).

V. Cash Management

Techniques for optimising a bank's and its clients' holdings of liquid funds.

A. Concept and objectives

Cash management balances liquidity against profitability, since idle cash earns nothing while shortfalls risk default.

Twin goals: Maintain enough cash to meet obligations yet minimise idle balances.
CRR constraint: Statutory cash with RBI sets the non-negotiable floor on reserves.

B. Bank-level liquidity management

The bank forecasts and positions funds daily.

Reserve maintenance: CRR averaged over a fortnight, with a 90% daily minimum, lets banks smooth balances.
Call money market: Banks borrow/lend overnight to cover transient gaps at the call rate.
Liquidity ratios: Basel III Liquidity Coverage Ratio ensures 30 days of outflows are covered by high-quality liquid assets.

C. Corporate / customer cash management services

Banks sell cash-management as fee-based service to firms, compressing the cash cycle.

TEXT

Cash conversion cycle = DIO + DSO − DPO
  DIO = Days Inventory Outstanding
  DSO = Days Sales Outstanding
  DPO = Days Payable Outstanding

Collection acceleration: Lock-box and cheque-truncation reduce float, speeding receivables (lower DSO).
Disbursement control: Payable-through drafts and sweep accounts delay outflows (higher DPO) without default.
Concentration banking: Pooling branch collections into one account for investment of surplus.

VI. Role of Development Banks

Specialised institutions supplying long-term and project finance that commercial banks avoid.

A. Concept and rationale

Development banks provide medium- and long-term capital for industry and infrastructure, filling a gap left by deposit-funded commercial banks.

Funding mismatch solved: They source long-tenor funds (bonds, government lines) suited to long-gestation projects.
Dual role: Finance plus promotion — appraising, underwriting and nurturing enterprises.

B. Major development finance institutions

Each DFI targets a sector.

IDBI / IFCI / ICICI (historic): Industrial Finance Corporation of India (1948, India's first DFI) and IDBI (1964) funded large industry.
SIDBI: Small Industries Development Bank of India (1990), apex for MSME finance and refinance.
NABARD: National Bank for Agriculture and Rural Development (1982), apex for rural and cooperative credit.
NHB: National Housing Bank (1988), apex regulator and refinancier of housing finance.

C. Functions and significance

DFIs do more than lend.

Project finance: Appraisal of technical, financial and economic viability before term loans.
Underwriting and refinance: Guaranteeing share issues and refinancing primary lenders.
Developmental promotion: Entrepreneurship development, technology upgradation and balanced regional growth.

VII. Role of Specialized Agencies

Institutions created for a single functional mandate within the financial system.

A. Concept

Specialised agencies perform a narrow, dedicated role — insurance, trade finance, guarantees or market regulation — rather than general banking.

Mandate-driven: Each is set up by statute or RBI for one defined objective.

B. Key agencies and their mandates

Each agency plugs a specific risk or market gap.

DICGC: Deposit Insurance and Credit Guarantee Corporation insures bank deposits up to ₹5 lakh per depositor per bank.
EXIM Bank: Export-Import Bank of India (1982) finances and promotes foreign trade.
ECGC: Export Credit Guarantee Corporation insures exporters against buyer and country payment risk.
CGTMSE: Credit Guarantee Fund for Micro and Small Enterprises provides collateral-free loan guarantees.
SEBI: Securities and Exchange Board of India (1992) regulates capital markets, interfacing with bank-sponsored securities activity.

C. Significance to the banking system

These agencies reinforce confidence and reach.

Risk transfer: DICGC and ECGC shift depositor and exporter risk off bank balance sheets.
Inclusion and trade: CGTMSE widens credit to collateral-poor firms; EXIM extends banking reach into international markets.