Unit4 - Subjective Questions

Functions of Commercial Banks

Commercial banks perform two major types of functions:

1. Primary Functions:

• Acceptance of Deposits: Banks accept various types of deposits from the public, such as Savings Deposits, Current Deposits, Fixed Deposits, and Recurring Deposits.
• Granting Advances: Banks lend money to individuals and businesses in the form of overdrafts, cash credits, loans, and discounting of bills of exchange.

2. Secondary Functions:

• Agency Functions: Banks act as agents for their customers by collecting and paying cheques, bills, rent, and dividends. They also buy and sell securities on behalf of customers.
• Utility Functions: Providing locker facilities, issuing traveler's cheques, letters of credit, underwriting shares, and providing foreign exchange services.

Importance of Banks in Economic Development:

• Capital Formation: Banks mobilize idle savings from households and channel them into productive investments.
• Promotion of Entrepreneurship: By providing adequate and timely credit, banks encourage entrepreneurs to start new ventures.
• Regional Development: Banks help in the balanced regional development by providing credit facilities to backward areas.
• Agriculture and Rural Development: Through priority sector lending, banks support farmers, small-scale industries, and rural artisans.
• Employment Generation: By financing trade, commerce, and industry, banks indirectly create massive employment opportunities.

Concept of Development Bank:
A development bank is a specialized financial institution that provides medium and long-term finance to the industrial and agricultural sectors. Unlike commercial banks, they do not accept everyday deposits from the public.

Objectives:

• To promote industrial growth by providing long-term capital.
• To foster entrepreneurial development and support new entrepreneurs.
• To ensure balanced regional development by financing projects in backward areas.
• To modernize and technologically upgrade existing industries.
• To provide promotional activities like project formulation and technical assistance.

Functions and Role of IFCI:
IFCI was the first development bank in India, established in 1948.

Functions:

• Project Finance: Providing long-term loans for setting up new projects, expansion, and diversification.
• Underwriting: Underwriting the issue of shares and debentures by industrial concerns.
• Guaranteeing Loans: Guaranteeing loans raised by industrial units in the open market.

Role:

• It has played a pioneering role in the industrialization of India by supporting core sectors like textiles, paper, sugar, and cement.
• It provides promotional services like technical and administrative assistance to industrial concerns.

Objectives of IDBI:

• To serve as the apex institution for industrial finance in India.
• To coordinate the activities of other financial institutions.
• To plan, promote, and develop industries to fill gaps in the industrial structure.

Functions:

• Direct Assistance: Providing loans, underwriting shares, and guaranteeing deferred payments.
• Indirect Assistance: Refinancing loans given by State Financial Corporations (SFCs) and commercial banks.
• Promotional Activities: Conducting techno-economic surveys, providing entrepreneurship development programs, and supporting technical consultancy organizations.

Role of NABARD (National Bank for Agriculture and Rural Development):

• Apex Refinancing Agency: It acts as the supreme body for meeting the credit needs of agriculture and rural sectors by refinancing cooperative banks, RRBs, and commercial banks.
• Institutional Development: It helps in strengthening and developing the rural credit delivery system.
• Supervisory Functions: NABARD inspects and supervises Cooperative Banks and Regional Rural Banks (RRBs).
• Promotional Role: It promotes microfinance initiatives like the SHG-Bank Linkage Programme, and finances rural infrastructure through the Rural Infrastructure Development Fund (RIDF).
• Policy Formulation: It assists the government and the RBI in forming policies related to agricultural credit and rural development.

Significance of SIDBI (Small Industries Development Bank of India):

• Apex Institution for MSMEs: SIDBI is the principal financial institution for the promotion, financing, and development of the Micro, Small, and Medium Enterprises (MSME) sector.
• Refinancing: It refinances loans extended by primary lending institutions like commercial banks and SFCs to small-scale industries.
• Direct Finance: It provides direct assistance for specialized needs like technological upgradation, energy efficiency, and venture capital.
• Promotional and Developmental Activities: SIDBI conducts enterprise development programs, skill upgradation, and provides marketing support to MSMEs.
• Coordination: It coordinates the functions of other institutions engaged in similar activities.

Differences between SFCs and SIDCs:

• Establishment: SFCs are established under the State Financial Corporations Act, 1951, primarily to finance small and medium enterprises (SMEs). SIDCs are established under the Companies Act as entirely state-government-owned entities.
• Primary Role: SFCs focus on providing term loans for the acquisition of fixed assets like land, building, and machinery. SIDCs focus on industrial promotion, such as developing industrial estates, providing seed capital, and acting as co-promoters in joint sector projects.
• Target Audience: SFCs strictly target MSMEs within the state. SIDCs cater to medium and large-scale industries and heavily engage in infrastructural development for industries.

Concept of NBFCs:
An NBFC is a company registered under the Companies Act, engaged in the business of loans and advances, acquisition of shares/stocks/bonds, hire-purchase, insurance, and chit funds.

Differences from Commercial Banks:

1. Demand Deposits: NBFCs cannot accept demand deposits (like savings or current accounts), whereas banks can.
2. Payment and Settlement: NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on themselves.
3. Deposit Insurance: The deposit insurance facility of DICGC is not available to depositors of NBFCs, unlike in the case of banks.
4. Foreign Direct Investment: NBFCs can have 100% FDI under the automatic route, whereas FDI in banks is subject to stricter caps.

Banking Sector Reforms Post-1991 (Narasimham Committee Recommendations):

1. Reduction in SLR and CRR: Statutory Liquidity Ratio and Cash Reserve Ratio were gradually reduced to free up bank funds for productive lending.
2. Deregulating Interest Rates: Interest rates on deposits and advances were deregulated, allowing banks to determine their own rates.
3. Prudential Norms: Introduction of capital adequacy ratio (CAR), income recognition, and asset classification norms to ensure financial soundness.
4. Entry of Private Banks: Licensing of new private sector banks (like HDFC, ICICI) and allowing foreign banks to foster competition.
5. Board for Financial Supervision: Establishment of the BFS under RBI for comprehensive supervision of banks and financial institutions.
6. Technology Upgradation: Introduction of electronic clearing, RTGS, NEFT, and core banking solutions (CBS).

Definition of NPA:
An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. Typically, a loan is classified as an NPA if interest or principal installment remains overdue for a period of more than 90 days.

Main Causes of NPAs:

• Macroeconomic Factors: Economic slowdowns, inflation, and market recessions affecting business profitability.
• Willful Defaults: Borrowers intentionally not repaying loans despite having the capacity to do so.
• Poor Credit Appraisal: Inadequate evaluation of the borrower's creditworthiness and project viability before sanctioning the loan.
• Diversion of Funds: Borrowers using loan funds for purposes other than what they were sanctioned for.
• Policy Paralysis: Delays in government clearances (environmental, land acquisition) leading to stalled projects, especially in the infrastructure sector.

SARFAESI Act, 2002 (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act):

Features:

• Securitization: Allows banks to issue security receipts to Qualified Institutional Buyers (QIBs) to raise funds against their NPAs.
• Asset Reconstruction: Facilitates the setting up of Asset Reconstruction Companies (ARCs) to acquire NPAs from banks and resolve them.
• Enforcement of Security Interest: Empowers banks and financial institutions to take possession of the borrower's collateral and sell it to recover dues without the intervention of courts.

Significance:

• It acts as a powerful tool for banks to recover bad loans efficiently.
• It reduces the burden on civil courts and Debt Recovery Tribunals (DRTs).
• It has instilled financial discipline among borrowers, knowing that assets can be seized rapidly upon default.

Banking Sector Innovations during Covid-19:

• Video KYC: The RBI permitted Video Customer Identification Process (V-CIP), allowing banks to onboard new customers completely remotely.
• Contactless Payments: Enhancement of limits on contactless card payments (NFC) and widespread adoption of UPI and QR code-based payments to avoid physical contact.
• WhatsApp Banking: Many banks launched or expanded services on WhatsApp, allowing customers to check balances, request statements, and block cards via chat.
• Digital Lending Platforms: End-to-end digital processing of loans without physical paperwork or branch visits.
• Moratorium and Restructuring Portals: Banks deployed online portals for customers to easily opt-in for loan moratoriums and restructuring schemes announced by the RBI.

Rationale behind Merger of PSBs:

• Economies of Scale: Merging creates larger banks capable of financing mega-projects and absorbing shocks better.
• Global Competitiveness: Creating banks of global size to compete with international banking giants.
• Operational Efficiency: Reducing the cost of operations by rationalizing bank branches and ATMs, and optimizing technological infrastructure.
• Better Risk Management: Larger balance sheets allow for better provisioning and management of NPAs.

Impacts:

• Positive: Enhanced capital base, better technological synergy, and improved lending capacity.
• Challenges: HR integration issues, cultural differences between merging entities, branch rationalization leading to localized job redundancies, and temporary disruption in customer services during IT integration.

Causes of Scams in Banks:

• Lax Internal Controls: Failure of internal audits and concurrent audits to detect anomalies early.
• Collusion: Collusion between bank employees and rogue borrowers (e.g., Nirav Modi case via fake Letters of Undertaking).
• Cyber Vulnerabilities: Exploitation of loopholes in the core banking systems (CBS) and lack of integration with external networks like SWIFT.
• Political Interference: Pressure to sanction loans to unviable projects or individuals.

Preventive Measures:

• Strengthening IT Systems: Integrating CBS with SWIFT and implementing robust cybersecurity protocols.
• Strict KYC and Due Diligence: Rigorous verification of borrowers and continuous monitoring of fund end-use.
• Whistleblower Policies: Encouraging employees to report unethical practices without fear of retaliation.
• Rotation of Staff: Regular rotation of officers in sensitive positions to prevent vested interests.

Digital Rupee (e₹):
Digital Rupee is the Central Bank Digital Currency (CBDC) launched by the Reserve Bank of India (RBI). It is a legal tender issued in a digital form and is fundamentally equivalent to fiat cash.

Significance:

• Cost Efficiency: It reduces the operational costs associated with printing, managing, and distributing physical cash.
• Financial Inclusion: Provides an alternative, safe, and risk-free payment method, potentially reaching unbanked populations.
• Cross-border Transactions: It can make international remittances faster, cheaper, and more transparent.
• Traceability: Being digital, it leaves a trail, making it difficult to use for illicit activities like money laundering, compared to physical cash.
• Promoting Innovation: It fosters innovation in the payments space, creating a more robust digital economy.

Impact of NPAs on Commercial Banks:

1. Erosion of Profitability: Banks are required to set aside a portion of their operating profit as provisions for NPAs. Higher NPAs mean higher provisioning, which directly eats into the net profits.
2. Capital Adequacy: High NPAs reduce the capital base of the bank, making it difficult to maintain the regulatory Capital to Risk (Weighted) Assets Ratio (CRAR).
3. Reduction in Credit Creation: With capital locked in bad loans, banks become risk-averse. The availability of funds for fresh, productive lending decreases, slowing down economic growth.
4. Increased Cost of Funds: To maintain margins, banks might increase lending rates for good borrowers and lower deposit rates, making banking less attractive.
5. Reputational Damage: High NPAs negatively impact the stock prices of listed banks and shake investor and depositor confidence.

Role of ARCs under SARFAESI Act:

An Asset Reconstruction Company (ARC) is a specialized financial institution that buys the Non-Performing Assets (NPAs) from banks and financial institutions so that the latter can clean up their balance sheets.

Mechanism and Role:

• Acquisition of Assets: ARCs purchase bad loans from banks at a mutually agreed discounted price. They often issue Security Receipts (SRs) to the banks for the purchased assets.
• Resolution of Assets: Once acquired, the ARC steps into the shoes of the lender. They focus entirely on recovering the dues through various means.
• Methods of Recovery: They can restructure the loan, change the management of the defaulting company, or sell/lease the business or its seized assets to recover the debt.
• Systemic Cleanup: By taking over bad loans, ARCs allow commercial banks to focus on their core banking activities instead of debt recovery.

Categories of NBFCs:

1. Based on Liabilities:

• Deposit-taking NBFCs (NBFC-D): These are allowed to accept public deposits (subject to RBI regulations).
• Non-Deposit taking NBFCs (NBFC-ND): These rely on bank borrowings, debentures, and commercial papers rather than public deposits. They are further classified into Systemically Important (NBFC-ND-SI) based on asset size.

2. Based on Activities:

• Asset Finance Company (AFC): Financing physical assets supporting productive/economic activity.
• Investment Company (IC): Primarily engaged in the acquisition of securities.
• Loan Company (LC): Providing finance by making loans or advances.
• Infrastructure Finance Company (IFC): Deploys at least 75% of its total assets in infrastructure loans.
• Micro Finance Institution (NBFC-MFI): Provides credit to economically disadvantaged groups.

Changing Role of Development Banks Post-Liberalization:

Traditionally, development banks (like ICICI, IDBI, IFCI) were the primary sources of long-term project finance, heavily supported by concessional funds from the RBI and the government.

Changes Post-1991:

• Withdrawal of Concessional Funding: The government and RBI stopped providing cheap funds. Development banks had to raise funds at market rates, squeezing their margins.
• Conversion into Universal Banks: To survive without cheap funds and to access low-cost public deposits (CASA), major development banks like ICICI and IDBI transformed themselves into commercial banks.
• Shift in Focus: Remaining development banks shifted focus toward refinancing (e.g., SIDBI, NABARD) rather than direct lending.
• Rise of Capital Markets: Corporate borrowers increasingly turned to equity markets, ECBs (External Commercial Borrowings), and commercial banks for long-term funds, diminishing the monopoly of traditional development banks.
• New Specialized Institutions: The focus shifted to highly specialized entities like NaBFID (National Bank for Financing Infrastructure and Development) to cater specifically to massive infrastructure projects.