Module 2 :Commercial Banks and Central Bank

Types of Banks: Scheduled and Non Scheduled bank, Regional Rural Bank, and Development Bank: IFCI,
SFC, SIDC, ICICI, IDBI and NABARD.

Types of Banking system: Branch, Unit, Investment (Development), Universal (Mixed) Banking.

Understanding the basic purpose and functions of: Retail bank - Investment banking (Securities /trading),
corporate banking, private banking, co-operative banks.

Micro Credit: Meaning and importance, Islamic Financing – Meaning and Five Basic Principles.
Regulatory Authority – RBI Qualitative and Quantitative credit control measure (in detail).

The commercial banking structure in India consists of two major set of players scheduled
commercial banks and unscheduled banks.

(a) Scheduled Commercial Banks :

The scheduled commercial banks constitute those banks which have been included in the Second
Schedule of Reserve Bank of India (RBI) Act, 1934. RBI in turn includes only those banks in
this schedule which satisfy the below criteria laid down vide section 42 (60) of the Act. This sub
sector broadly consists of private sector banks, foreign banks.

1. The paid up capital and reserves of the bank must not be less than Rs.5 Lakh
2. Scheduled Banks need to maintain cash reserves with RBI, at the rates prescribed by it.
3. The banker concerned must be in the business of banking in India
4. It must satisfy the RBI that its affairs are not conducted in a manner detrimental to the
interest of the depositors
5. Scheduled banks must submit the periodic reports and statement of their financial affairs
to the Reserve bank of India.

Scheduled Commercial Banks are grouped under following categories:

1. State Bank of India and its Associates

2. Nationalized Banks

3. Foreign Banks

4. Regional Rural Banks

5. Other Scheduled Commercial Banks.

Note: Banks in the groups (1) & (2) above are known as public sector banks whereas, other
scheduled commercial banks mentioned at group (5) above are known as private sector banks.

(b) Non-Scheduled Commercial Banks: The Non-Scheduled commercial banks constitute

those banks which are not included in the Second Schedule of Reserve Bank of India (RBI) Act,
1934 . They may be classified in to four groups:

1. Banks with paid up capital and reserves in excess of Rs.5 lakh

2. Banks with paid up capital and reserves ranging between 1 Lakh and 5 Lakh
3. Banks with paid up capital and reserves ranging between Rs.50000 and 1 Lakh
4. Banks with paid up capital and reserves ranging below Rs.50000

Non-Scheduled Commercial Banks are not entitled to all the facilities that the scheduled banks
get from RBI. Since the enactment of the Banking regulation Act in 1949, non scheduled banks
have also come in the scope of the RBI control. It has become necessary that these banks also
prepare their annual accounts and balance sheets in accordance to the requirements of Section 29
under Banking Regulation Act

Examples :

Non-Scheduled State Co-operative Banks

Non-Scheduled Urban Cooperative Banks

Regional Rural Bank

In spite of the rapid expansion programmes undertaken by the commercial banks, a large
segment of the rural economy was still beyond the reach of the organized commercial banks. To
fill this gap it was thought necessary to create a new agency which could combine the advantages
of having adequate resources but operating relatively with a lower cost at the village level. After
the declaration of emergency, the then Prime Minister, Smt. Indira Gandhi, announced on July 1,
1975 the 20 point economic programme of the Government of India. One of the points of this
programme was the liquidation of rural indebtedness by stages and provide institutional credit to
farmers and artisans in rural areas. The Government of India promulgated on September 26,
1975, the Regional Rural Bank Ordinance, to set up regional rural banks throughout the country;
the Ordinance was replaced by the Regional Rural Banks Act, 1976. The main objective of the
regional rural banks is to provide credit and other facilities particularly to the small and marginal
farmers, agricultural labourers, artisans and small entrepreneurs so as to develop agriculture,
trade, commerce, industry and other productive activities in rural areas.

Objectives of Regional Rural Banks

The following are the main objectives of regional rural banks:
1. To provide credit and other facilities particularly to the small and marginal farmers,
agricultural labourers, artisans, small entrepreneurs and other weaker sections.
2. To develop agriculture, trade, commerce, industry and other productive activities in
the rural areas.
3. To provide easy, cheap and sufficient credit to the rural poor and backward classes
and save them from the clutches of money lenders.
4. To encourage entrepreneurship.
5. To increase employment opportunities.
6. To reconcile rural business aims and social responsibilities.

Capital Structure
50% of the issued capital is to be subscribed by the Central Government, 15%
by the concerned State Government, and 35% by the sponsoring commercial banks. The
shares of regional rural banks are to be treated as “approved securities.”

Features of Regional Rural Banks

The following are the features of the regional rural banks:
1. The regional rural bank, like a commercial bank, is a scheduled bank.
2. The RRB is a sponsored bank. It is sponsored by a scheduled commercial bank.
3. It is deemed to be co-operative society for the purposes of Income Tax Act, 1961.
4. The area of operations of the RRB is limited to a specified region relating to one or
more districts in the concerned state.
5. The RRB charges interest rates as adopted by the co-operative societies in the state.
6. The interest paid by the RRB on its term deposits may be 1% or 2% more than that
is paid by the commercial banks.
7. The regional rural bank enjoys many concessions and privileges.

Functions of Regional Rural Banks

The functions of Regional Rural Bank are as follows:
1. Granting of loans and advances to small and marginal farmers and agricultural labourers,
either individually or in groups.
2. Granting of loans and advances to co-operative societies, agricultural processing societies and
co-operative farming societies primarily for agricultural purposes or for agricultural operations
and other related purposes.
3. Granting of loans and advances to artisans, small entrepreneurs and persons of small means
engaged in trade, commerce and industry or other productive activities within a specified region.
4. Accepting various types of deposits.
5.The credit policy of regional rural banks is more liberal than co-operative banks. It is not
necessary for the borrower to mortgage property or deposit title deeds. It is not necessary to
produce “not encumbrance certificate” or get legal opinion.

Progress Achieved by Regional Rural Banks

The Regional Rural Banks have achieved significant progress in all directions. The progress
achieved is discussed below:
1. Number of Banks: The first, five regional rural banks were started at Moradabad
and Gorakhpur in Uttar Pradesh, Bhiwani in Haryana, Jaipur in Rajasthan and Malda in West
Bengal. There were, in June 2001, 196 regional rural banks, covering over 400 districts in the
country with 14,550 branches. The largest number of offices are started in Uttar Pradesh.
Currently, RRB's are going through a process of amalgamation and consolidation At present
there are 45 RRBs in India as on 01-04-2019
2. Deposits: The deposits of regional rural banks increased substantially over the years..
3. Advances: Over 90% of the advances of regional rural banks are direct advances to small and
marginal farmer, landless labourers and rural artisans.
4. Self-employment Schemes: The regional rural banks are making notable effort to
encourage self-employment schemes.
5. Creation of Local Employment Opportunities: Regional rural banks have been taking
active steps to create employment for the local people and achieved good success.
6. Participation in Various Programmes: During the last 22 years regional rural banks have
been active participants in programmes designed to provide credit assistance to weaker sections.
For instance, they are providing credit assistance to identified beneficiaries under the New 20-
Point Programme for scheduled castes and tribes.
7. Assistance to Physically Handicapped Persons: Physically handicapped persons
are provided finance for purchase of artificial limbs, hearing aids, wheel chairs etc.
8. Farmers Societies: Regional rural banks have also sponsored and financed about 90 farmers
societies.
9. Integrated Rural Development Programme (IRDP Scheme): Regional rural banks have
been taking active part in the Integrated Rural Development Programme.
Regional rural banks, thus, have achieved notable progress in expanding branch network and
extending credit support to weaker sections in rural areas. They exist as rural banks of the rural
people.

Development bank
Meaning
A development bank is a multipurpose financial institution with a broad developmental
objective. It is defined as a financial concern which is concerned with providing financial
assistance to business concerns. The financial assistance is provided in the form of loans,
underwriting shares and debentures, investment and guarantee activities. It also performs
promotional activities in a variety of ways. It renders several services like discovery of
investment projects, preparation of project reports, management services etc. Thus, development
banks provide capital, technology and entrepreneurship. Development banks are considered to be
the backbone of financial market. Industrial development depends on active role played by the
development banks.

Features
Following are the main characteristic features of a development bank:
(a) It is a specialized financial institution.
(b) It provides medium and long-term finance to business units.
(c) Unlike commercial banks, majority of development banks does not accept deposits from the
public.
(d) It is not just a term-lending institution. It is a multi-purpose financial institution.
(e) It is essentially a development-oriented bank. Its primary object is to promote economic
development by promoting investment and entrepreneurial activity in a developing economy. It
encourages new and small entrepreneurs and seeks balanced regional growth.
(f) It provides financial assistance not only to the private sector but also to the public sector
undertakings.
(g) It aims at promoting the saving and investment habit in the community.
(h) It does not compete with the normal channels of finance, i.e., finance already made available
by the banks and other conventional financial institutions. Its major role is of a gap-filler, i.e., to
fill up the deficiencies of the existing financial facilities.
(i) Its motive is to serve public interest rather than to make profits. It works in the general
interest of the nation.

Important Development Banks in India

There are about 60 development banks in India. The important development banks
functioning in our country are as follows:
1. The Industrial Finance Corporation of India.
2. The Industrial Credit and Investment Corporation of India.
3. The State Financial Corporations.
4. The Industrial Development Bank of India.
5. The Small Industries Development Bank of India.
6. The Industrial Reconstruction Bank of India.
7. The State Industrial Development Corporations.
8. The Unit Trust of India.
9. The Life Insurance Corporation of India.
10. The Export and Import Bank of India.
All these banks are being operated at national, state and local levels. They have been providing
all types of financial assistance to business units in the form of loans, underwriting, investment
and guarantee operations. They have also undertaken promotional activities. They are thus multi-
purpose financial institutions. They have done commendable service for the development of
industries in our country.
Development banks are those which have been set up mainly to provide infrastructure facilities
for the industrial growth of the country. They provide financial assistance for both public and
private sector industries.

The main objectives of the development banks are

1. To promote industrial growth,

2. To develop backward areas,

3. To create more employment opportunities,

4. To generate more exports and encourage import substitution,

5. To encourage modernisation and improvement in technology,

6. To promote more self employment projects,

7. To revive sick units,

8. To improve the management of large industries by providing training,

9. To remove regional disparities or regional imbalance,

10. To promote science and technology in new areas by providing risk capital,

11. To improve capital market in the country.

The Industrial Finance Corporation of India (IFCI)

Industrial Finance Corporation of India was the first All India Development Bank to be set up in
the country. It was set up in 1948 with the object of providing medium and long-term credit to
industry. Its role was that of a gap filler as it was not expected to compete with the prevailing
channels of industrial finance. It was only meant to supplement their efforts. With effect from
July 1, 1993, IFCI has been converted into a public limited company and is now known as
Industrial Finance Corporation of India Ltd. IFCI became a Government controlled company
subsequent to enhancement of equity shareholding to 55.53% by Government of India on
December 21, 2012. In April, 2015, Government of India has acquired six crore Preference
Shares of IFCI Ltd. of Rs.10/- each from six public sector banks. With this, the shareholding of
the Government of India in paid-up share capital of IFCI has been increased to 51.04% and IFCI
has become a Government Company under Section 2(45) of the Companies Act, 2013. IFCI is
also a Systemically Important Non-Deposit taking Non-Banking Finance Company (NBFC-ND-
SI), registered with the Reserve Bank of India.

Functions of the IFCI : The Industrial Finance Corporation of India grants financial assistance
in the following forms:
(1) Granting loans or advances both in rupees and foreign currencies repayable within 25 years,
(2) Guaranteeing rupee loans floated in the open market by industrial concerns
(3) Underwriting of shares and debentures of the industrial concerns
(4) Guaranteeing (a) deferred payments in respect of imports of machinery. (b) foreign currency
loans raised from foreign institutions, and (c) rupee loans raised from scheduled banks or state
cooperative banks by industrial concerns.
In the beginning, the IFCI was expected to extend financial assistance only to industrial concerns
in the private and cooperative sectors. Now both public sector and joint sector projects are also
eligible for financial assistance from the IFCI. Financial assistance is available from the IFCI for
new industrial projects as well as for expansion, renovation modernisation or diversification of
the existing ones. This may include the purchase of plant and machinery, construction of factory
building and purchase of land for the factory. Normally the IFCI does not provide finance for the
repayment of existing liabilities. Its funds are also not available for raising working capital which
includes the purchase of raw material.

Financial Resources of IFCI Financial resources of the IFCI are constituted of the following
three components: (i) share capital (ii) bonds and debentures, and (iii) other borrowings. The
paid-up capital of the IFCI was initially Rs. 5 crores. Since then it has been increased several
times, Rs1662.04CR as on 31/03/2015. Industrial Development Bank of India, commercial
banks, the LIC and the cooperative banks account for the share capital of the IFCI. The IFCI has
also built-up sizeable reserves. Apart from the paid-up capital and reserves, the major financial
resources of the IFCI are issue of bonds and debentures, borrowing from the government, the
Reserve Bank of India and the Industrial Development Bank of India, and foreign loans. The
bonds and debentures are guaranteed by the Government of India in respect of repayment of
principal and the payment of interest.

Lending Operations of IFCI

The IFCI had started its lending operations on a modest scale in 1948, but over the years with
greater accent on industrialization, they have grown both in scope and size. In recent years there
has been spectacular rise in the amount of assistance provided to industrial establishments. While
in 1970-71, assistance sanctioned was of Rs. 32.2 crores, in 1999- 2000, it touched the level of
Rs. 2,376 crores. The cumulative assistance sanctioned and disbursed by IFCI as at the end of
March 2000 stood at Rs. 49,621 crores. Although IFCI provides assistance to all the private
sector, the cooperative sector and the public sector – it is the private sector that is the main
recipient of its assistance. For instance, in 1997-98, the private sector accounted for as much as
97.5 per cent of assistance sanctioned followed by joint sector as 2.2 per cent. Public and co-
operative sectors accounted for a very negligible amount. However, it is necessary to point out
here that IFCI has participated actively in the financing of industrial cooperatives. In fact, it is
the financial assistance from the IFCI that has made the experiment of industrial cooperatives
successful in this country. The IFCI has set up Merchant Banking and Allied Services
Department (MBAD) with head office in Delhi and a bureau in Mumbai. MBAD has taken up
assignments for capital restructuring, merger and amalgamation, loan syndication with other
financial institutions, and trusteeship assignments. It guides entrepreneurs in project formulation
and raising resources for meeting project cost, etc.
State Financial Corporations (SFC)

Industrial Finance Corporation of India was set up in 1948 to cater to the needs of large
industrial concerns. It can render financial assistance only to limited companies and cooperative
societies. After independence the Government of India realised the need for financial institutions
at the state level to assist the promotion and expansion of medium and small-scale industries.
The State Financial Corporations Act was born out of this need in 1951. The Act was amended in
1956 and 1962. The State Governments were empowered by the Act to establish financial
corporation in their respective regions to foster and stimulate the development of medium and
small scale industries.

Functions: The State Financial Corporations are empowered to render financial help in the
following forms:
(a) Granting loans and advances to or subscribing to the debentures of industrial concerns
repayable within 20 years.
(b) Guaranteeing loans raised by industrial concerns repayable within 20 years.
(c) Underwriting the stocks, shares, debentures, subject to their being disposed off in the market
within 7 years.
(d) Guaranteeing deferred payments due from industrial concerns on their purchases of capital
goods in India.
(e) Granting soft loans to or participating in the equity of the weaker segments of the medium
and small-scale sector. The State Financial Corporations can grant assistance to public limited
companies, partnerships and proprietory concerns. The assistance given to a single concern
should not exceed 10% of the paid up capital of the corporation or 15 lakhs whichever is less.
The limit is raised to 30 lakhs in the case of limited companies and co-operative societies.
Management: The State Finance Corporation is managed by a Board of Directors. The board
consists of 10 members of which three are nominated by the State Government concerned, one
by the Reserve Bank of India, one by the I.F.C. and the remaining four are elected by bank, and
insurance companies. One member of the board is appointed as the Managing Director.

Resources: State Financial Corporations can raise finance by the following methods:
(a) Share Capital: The capital structure of a State Finance Corporation is fixed by the State
Government concerned. It is subject to a minimum of Rs. 50 lakhs and a maximum of Rs. 5
crores. Initially the share capital is to be contributed by the State Government concerned,
Reserve Bank of India, Co-operative banks and Insurance companies in a predetermined ratio.
Not more than 25% of the share capital may be allotted to the public. The shares are to be
guaranteed by the State Government with regard to both principal and interest. With effect from
February 1976 the holding of the RBI in SFCs were transferred to IDBI. The rate of dividend
should not exceed 5 per cent per annum.
(b) Bonds and Debentures:The corporations are empowered to issue bonds and debentures to
supplement their resources. The amount raise through this source should not exceed ten times the
amount of their paid-up capital and reserve fund.
(c) Public Deposits: The corporations are also empowered to accept public deposits for a period
of not less than five years. However, the amount of deposits should not exceed the paid up
capital of the corporation. (d) Borrowings: The corporations can also borrow from the Reserve
Bank, the IDBI and the State Government concerned. Borrowings from IDBI account for nearly
one third of the total resources.

Recently some measures have been taken to streamline these corporations and coordinate their
activities with other financial institutions engaged in industrial finance. The corporations are
acting as agents of their respective State Governments for routing funds under the liberalised
scheme of assistance to small-scale industries.

The SFCs are the prime sources of finance to small and medium scale industries. They should
adopt a number of measures, as the commercial banks did to increase their volume of assistance
to small scale units. Setting up of separate cell to look after the needs of the small scale units,
adoption of some selected districts for intensive operations, conducting surveys to identify
industrial potential are some of the measures suggested to make the corporations play a more
effective and constructive role in the process of industrial growth.

The State Industrial Development Corporations (SIDCs) and the State Industrial
Investment Corporations (SIICs)

State Industrial Development Corporations : The State Industrial Development Corporations

were set up under the Companies Act, 1956, as wholly owned state government undertakings for
promotion and development of medium and large industries. In addition to provision of financial
assistance, they are also involved in developing industrial infrastructure like industrial estates,
industrial parks and setting up industrial projects either on their own or in the joint sector in
collaboration with private entrepreneurs or as wholly owned subsidiaries. SIDCs exist in all the
States and have developed industrial infrastructure facilities to enable prospective entrepreneurs
to set up their industries in the states. These corporations render technical assistance to the
entrepreneurs in the formulation of the project reports and also provide common facilities in the
industrial estates. These corporations provide loans and advances to the industrial units in the
medium and large sectors to the maximum of Rs. 400 lakhs. The interest rate ranges between
13.5% to 17% depending upon the size of the loan. 

State Industrial Infrastructure and Investment Corporations : The State Industrial

Infrastructure and Investment Corporations have also been set up under the Companies Act
under the overall control of the State Governments to develop industrial infrastructure in the
States. As on date, only 10 such corporations have been set up in the States of Andhra Pradesh,
Gujarat, Maharashtra, Orissa, Tamil Nadu, Uttar Pradesh, Delhi and Goa. These corporations are
primarily engaged in developing infrastructure, which has been identified as the major thrust area
for taking the country on the path of the economic growth. The infrastructure projects undertaken
by these corporations include developing industrial growth centres, export promotion zones,
software parks, industrial townships, industrial parks, as also industrial estates. To a large extent,
these corporations are supplementing the efforts of State Industrial Development Corporations in
so far as development of industrial infrastructure in the states is concerned. 

The Industrial Credit and Investment Corporation of India (ICICI)

The Industrial Credit and Investment Corporation of India (ICICI) was the second all India
development bank to be established in the country. It was set up in January 1955 as a joint-
venture of the World Bank, India's public-sector banks and public-sector insurance companies to
provide project financing to Indian industry and it commenced business in March of the same
year. The principal objective was to create a development financial institution for providing
medium-term and long-term project financing to Indian businesses.
The ICICI differs from two other all-India development banks, viz., the IFCI and IDBI in respect
of ownership, management and lending operations. Unlike the IFCI and the IDBI which are
public sector development banks, the ICICI is a private sector development bank. Its
distinguishing feature is that it provides underwriting facilities which are generally neglected by
the other institutions.
ICICI Bank was established by the Industrial Credit and Investment Corporation of India
(ICICI), an Indian financial institution, as a wholly owned subsidiary in 1994 in Vadodara.

In the 1990s, ICICI transformed its business from a development financial institution offering
only project finance to a diversified financial services group offering a wide variety of products
and services, both directly and through a number of subsidiaries and affiliates like ICICI Bank.
In 1999, ICICI become the first Indian company and the first bank or financial institution from
non-Japan Asia to be listed on the NYSE.
After consideration of various corporate structuring alternatives in the context of the emerging
competitive scenario in the Indian banking industry, and the move towards universal banking,
the managements of ICICI and ICICI Bank formed the view of merging ICICI with ICICI Bank.
In October 2001, the Boards of Directors of ICICI and ICICI Bank approved the merger of ICICI
and two of its wholly-owned retail finance subsidiaries, ICICI Personal Financial Services
Limited and ICICI Capital Services Limited, with ICICI Bank.
The ICICI provides assistance in various forms, the important ones being: (1) long or medium-
term loans or equity participation; (2) guaranteeing loans from other private investment sources;
(3) subscription to ordinary or preference capital and underwriting of new issues or securities;
and (4) rendering consultancy service to Indian industry in the form of managerial and technical
advice.

Financial Resources of ICICI Initially the resources of the ICICI were rather moderate
compared with its present massive resources. Total liabilities and assets of ICICI were Rs. 149
crores in 1971 which rose substantially. Additional loans from the government and the Industrial
Development Bank of India have helped the ICICI in augmenting its resources. The most
important source of rupee funds of the ICICI is the issue of bonds and debentures to the public.

Lending Operations of ICICI In terms of sheer amount of financial assistance provided by the
ICICI, its performance has been quite impressive. From Rs. 14.8 crores in 1961-62 and Rs. 43.0
crores in 1970-71, the assistance sanctioned by the ICICI rose to Rs. 44,479 crores in 1999-2000.
The ICICI has provided financial assistance in the form of (i) rupee loans including guarantees;
(ii) foreign currency loans; (iii) underwriting of shares and debentures; (iv) direct subscription to
shares and debentures; and (v) financial services (in the form of deferred credit, leasing,
installment sale and asset credit). Of the total assistance of Rs. 44,479 crores sanctioned by ICICI
in 1999-2000, the beneficiaries includes corporate finance, oil, gas and petrochemicals and other
projects. The ICICI was originally set up to provide finance to industrial concerns in the private
sector, and even now they account for the bulk of the loans sanctioned by this institution. The
scope of its operations has been enlarged in recent years by including the projects in the joint,
public and cooperative sectors. As far as industry wise assistance is concerned, the major
recipients of the financial assistance from the ICICI are non-traditional growth-oriented
industries such as chemicals, petrochemicals, heavy engineering and metal products.

The ICICI has joined the consortium of the IDBI, the IFCI and other financial institutions
for providing loans on soft terms to a number of industries for modernisation. In this country,
quite a large number of enterprises in some traditional industries, particularly cotton textiles,
jute, sugar, and cement have been facing serious problems for a long time due to obsolescence.
Among the new industries some engineering units urgently need modernisation. They all require
financial assistance on soft terms to carry out their plans in respect of replacing the outdated
plant and machinery. The consortium of all-India development banks now extends assistance to
such industrial units for the purpose of modernisation. The ICICI has been assigned the lead
responsibility for industrial enterprises in the engineering group. In 1983, ICICI commenced
leasing operations. It provides leasing assistance for computerisation, modernisation/replacement
schemes, equipment for energy conservation, export orientation, pollution control, balancing and
expansion.

The Industrial Development Bank of India (IDBI)

Prior to the establishment of the Industrial Development Bank of India (IDBI), the country had a
number of special industrial financing institutions. They had done commendable work in the
field of industrial finance, though in terms of range and magnitude they could not adequately
meet the demands of the industry. There was no apex organisation to coordinate the functions of
various industrial financing institutions. V.V. Bhatt rightly stated that the country needed a
central development banking institution for providing “dynamic leadership in the task of
promoting a widely diffused and diversified and yet viable process of industrialization.” It was
under these circumstances that IDBI was set up in July 1964 under Industrial Development Bank
of India Act, 1964 as a Development Financial Institution (DFI) and came into being as on July
01, 1964. The IDBI was initially set up as a wholly owned subsidiary of the Reserve Bank of
India. In February 1976 the IDBI was made an autonomous institution and its ownership passed
on from the Reserve Bank of India to the Government of India.  It was regarded as a Public
Financial Institution and continued to serve as a DFI for 40 years till the year 2004 when it was
transformed into a Bank.

The IDBI has rightly been designated as the apex organisation in the field of development
banking. It not only has organisational links with other development banks but it also renders
some such services to them which only an apex organisation is expected to perform. In the first
place, it provides refinance against loans granted to industrial concerns by other development
banks like the IFCI, the SFCs and so on and rediscounts their machinery bills. Secondly, it
subscribes to the share capital and bond issues of the IFCI, the ICICI, the SFCs and the IIBI.
Apart from these linkages, the IDBI plays the role of a coordinator at all-India level. For this
purpose, a meeting has been evolved and regular meetings of the Heads of various financial
institutions are held under its leadership. Thus, the IDBI enjoys a unique position in India’s
development banking system. It occupies the same place in the field of development banking as
is occupied by the RBI in the field of commercial banking.

Financial Resources of IDBI The operations of the IDBI have grown over the years and so have
its resources. The main sources of its funds are share capital, reserves, bonds and debentures
issues, deposits from companies and Certificates of Deposits, and borrowings from the Reserve
Bank of India and Government of India.
Cumulative Assistance by IDBI The IDBI is the leading development bank in India. Its
progress has been spectacular in whole of the period of its existence but particularly so in recent
years. Considering the underdeveloped nature of the capital market and the difficulties which a
large number of industrial firms encounter in raising funds from the market, the quantum of
assistance is not small. In fact, it is almost equal to the amount of financial assistance provided
by all other special industrial financing institutions taken together.
Composition of Financial Assistance The state pertaining to the IDBI enables it to have
considerable flexibility in its operations. It, therefore, can provide financial assistance to all kinds
of big, medium and small enterprises. In respect of the size of loans, there are virtually no
restrictions on it. Moreover, it is completely free to use its own discretion in respect of the
security to be obtained against the loan sanctioned. Its assistance can be broadly classified into
the following categories:
1. Direct Financial Assistance to Industrial Enterprises: The IDBI provides direct financial
assistance to industrial concerns in the form of loans, underwriting and direct subscription to
shares and debentures and guarantees. The policy framework of the IDBI in respect of direct
financing has been decided by its apex position. It, therefore, generally avoids competing with
other special industrial financing institutions. It, in fact, acts as the lender of the last resort. The
IDBI’s direct assistance to industrial enterprises in the entire period of its existence has
accounted for about one-third of its total assistance. Loans as a form of direct finance constitute
the major part of the IDBI’s financial assistance to the industry.
2. Indirect Financial Assistance to Industries: A major part of the IDBI’s assistance is routed
through some other financial institutions including the State Financial Corporations, State
Industrial Development Corporations and Commercial Banks. This form of assistance is
generally characterised as indirect financial assistance. The IDBI’s indirect assistance can be
broadly classified into four categories: (a) refinance of industrial loans, (b) rediscounting of bills,
(c) subscription to shares and bonds of financial institutions, and (d) seed capital assistance.
3. Assistance to Backward Areas: The IDBI has initiated certain financial and nonfinancial
measures to encourage industries in backward areas. Financial measures are mainly of three
types: (a) direct financial assistance in the form of loans at concessional rates, longer initial grace
period, etc., (b) concessional refinance assistance to projects in backward areas; and (c) special
concessions to projects in North-Eastern area under the bill rediscounting scheme. Non-financial
measures aim at helping potential entrepreneurs in identifying and formulating viable projects,
technical assistance etc.
Industry-wise analysis of IDBI’s financial assistance reveals that core and other manufacturing
sectors accounted for bulk of the assistance sanctioned and disbursed. Core sector includes
industries such as iron and steel, oil exploration and refining, cement and fertilizer. Other major
industries that received large sanctions are: chemicals and chemical products, textiles, electronic
and electrical products, food manufacturing and artificial fibres.

Promotional Functions of the IDBI

Apart from providing financial assistance to industry, the IDBI performs certain promotional
functions as well. These include provision of training in project evaluation and development of
entrepreneurship. A special scheme has been initiated for “no industries districts.” Under this
scheme, IDBI has done surveys to study the industrial potential of no industry districts. The
programme is to arrange training for potential entrepreneurs in these districts besides giving
financial, technical and administrative assistance to selected projects. It also runs a Technical
Consultancy Organisation (TCO). Besides doing feasibility studies, project appraisals, industrial
and market potential surveys, etc., TCO has also made considerable progress in training new
entrepreneurs. The IDBI is also supporting a number of interinstitutional groups which provide a
forum for discussions on industrial development programmes.

National Bank for Agriculture and Rural Development (NABARD)

Established on 12th July, 1982 as an apex bank for agriculture and rural development in
accordance with the recommendations of the Committee to Review Arrangements for
Institutional Credit for Agriculture and Rural Development (CRAFICARD), NABARD is
accredited with all matters concerning policy, planning and operations in the field of credit for
agriculture and other economic activities in rural areas. NABARD functions to promote
sustainable rural development for attaining prosperity of rural areas in India.
It is basically concerned with “matters concerning policy, as well as planning and operations in
the field of credit for agriculture and other economic activities in rural areas in India”. It is worth
noting with refernce to NABARD that RBI has sold its own stake to the Government of India.
Therefore, Government of India holds 99% stake in NABARD.

Functions of NABARD
Credit Functions:

 Framing policy and guidelines for rural financial institutions.

 Providing credit facilities to issuing organizations
 Monitoring the flow of ground level rural credit.
 Preparation of credit plans annually for all districts for identification of credit potential.
 NABARD gives high priority to projects formed under IRDP. It provides refinance for
IRDP accounts in order to give highest share for the support for poverty alleviation
programs run by IRDP.

Development Functions:

 Help cooperative banks and Regional Rural Banks to prepare development actions plans
for themselves.
 Help Regional Rural Banks and the sponsor banks to enter into MoUs with state
governments and cooperative banks to improve the affairs of the Regional Rural Banks.
 Monitor implementation of development action plans of banks.
 Provide financial support for the training institutes of cooperative banks, commercial
banks and Regional Rural Banks.
 Provide financial assistance to cooperative banks for building improved management
information system, computerization of operations and development of human resources.
 NABARD also prepares guidelines for promotion of group activities under its programs
and provides 100% refinance support for them.
 It is making efforts to establish linkages between Self-help Group(SHG) that are
organized by voluntary agencies for poor and needy in rural areas and other official credit
agencies.
 It refinances to the complete extent for those projects that are taken under the ‘National
Watershed Development Programme‘ and the ‘National Mission of Wasteland
Development‘.
 It also has a system of District Oriented Monitoring Studies, under which, study is
conducted for a cross section of schemes that are sanctioned in a district to various banks,
to ascertain their performance and to identify the constraints in their implementation, It
also initiates appropriate action to remedy them.
  It also supports Vikas volunteer Vahini programs which offer credit and development
activities to poor farmers.
 It also runs programs for agriculture and rural development.
 NABARD also provides assistance and support for the training and development of the
staff of various other credit institutions, that are engaged in credit distributions.

Supervisory Functions:

 Undertakes inspection of Regional Rural Banks (RRBs) and Cooperative Banks (other
than urban/primary cooperative banks) under the provisions of Banking Regulation Act,
1949.
 NABARAD also recommends about licensing for RRBs and Cooperative banks to RBI.
 Undertakes inspection of State Cooperative Agriculture and Rural Development Banks
(SCARDBs) and apex non- credit cooperative societies on a voluntary basis.
 Provides recommendations to Reserve Bank of India on issue of licenses to Cooperative
Banks, opening of new branches by State Cooperative Banks and Regional Rural Banks
(RRBs).
 Undertakes portfolio inspections besides off-site surveillance of Cooperative Banks and
Regional Rural Banks (RRBs).
 It also inspects and supervises the cooperative banks and RRBs to periodically ensure the
development of the rural financing and farmers’ welfare.

Types of Banking system

UNIT BANKING VS BRANCH BANKING The banking system in different countries vary
substantially from one another. Broadly speaking, however, there are two important types of
banking systems, viz., unit banking and branch banking.

A. Unit Banking ‘Unit banking’ means a system of banking under which banking services
are provided by a single banking organisation. Such a bank has a single office or place of
work. It has its own governing body or board of directors. It functions independently and
is not controlled by any other individual, firm or body corporate. It also does not control
any other bank. Such banks can become member of the clearing house and also of the
Banker’s Association. Unit banking system originated and grew in the U.S.A. Different
unit banks in the U.S.A. are linked with each other and with other financial centres in the
country through “correspondent banks.”
Advantages of Unit Banking Following are the main advantages of unit banking:
1. Efficient Management: One of the most important advantages of unit banking system
is that it can be managed efficiently because of its size and work. Co-ordination and
control becomes effective. There is no communication gap between the persons making
decisions and those executing such decisions.
2. Better Service: Unit banks can render efficient service to their customers. Their area of
operation being limited, they can concentrate well on that limited area and provide best
possible service. Moreover, they can take care of all banking requirements of a particular
area.
3. Close Customer-banker Relations: Since the area of operation is limited the customers
can have direct contact. Their grievances can be redressed then and there.
4. No Evil Effects Due to Strikes or Closure: In case there is a strike or closure of a unit,
it does not have much impact on the trade and industry because of its small size. It does
not affect the entire banking system.
5. No Monopolistic Practices: Since the size of the bank and area of its operation are
limited, it is difficult for the bank to adopt monopolistic practices. Moreover, there is free
competition. It will not be possible for the bank to indulge in monopolistic practices
6. No Risks of Fraud: Due to small size of the bank, there is stricter and closer control of
management. Therefore, the employees will not be able to commit fraud.
7. Closure of Inefficient Banks: Inefficient banks will be automatically closed as they
would not be able to satisfy their customers by providing efficient service.
8. Local Development: Unit banking is localised banking. The unit bank has the
specialised knowledge of the local problems and serves the requirement of the local
people in a better manner than branch banking. The funds of the locality are utilised for
the local development and are not transferred to other areas.
9. Promotes Regional Balance: Under unit banking system, there is no transfer of
resources from rural and backward areas to the big industrial and commercial centres.
This tends to reduce regional imbalance.
Disadvantages of Unit Banking
1. No Economies of Large Scale: Since the size of a unit bank is small, it cannot reap the
advantages of large scale viz., division of labour and specialisation.
2. Lack of Uniformity in Interest Rates: In unit banking system there will be large
number of banks in operation. There will be lack of control and therefore their rates of
interest would differ widely from place to place. Moreover, transfer of funds will be
difficult and costly.
3. Lack of Control: Since the number of unit banks is very large, their co-ordination and
control would become very difficult.
4. Risks of Bank’s Failure: Unit banks are more exposed to closure risks. Bigger unit can
compensate their losses at some branches against profits at the others. This is not possible
in case of smaller banks. Hence, they have to face closure sooner or later.
5. Limited Resources: Under unit banking system the size of bank is small. Consequently
its resources are also limited. Hence, they cannot meet the requirements of large scale
industries.
6. Unhealthy Competition: A number of unit banks come into existence at an important
business centre. In order to attract customers they indulge in unhealthy competition.
7. Wastage of National Resources: Unit banks concentrate in big metropolitan cities
 whereas they do not have their places of work in rural areas. Consequently there is
uneven and unbalanced growth of banking facilities.
8. No Banking Development in Backward Areas: Unit banks, because of their limited
resources, cannot afford to open uneconomic branches in smaller towns and rural areas.
As such, these areas remain unbanked.
9. Local Pressure: Since unit banks are highly localised in their business, local pressures
and interferences generally disrupt their normal functioning.

B. Branch Banking System

It means a system of banking in which a banking organisation works at more than one
place. The main place of business is called head office and the other places of business
are called branches. The head office controls and co-ordinates the work at branches. The
day-to-day operations are performed by the branch manager as per the policies and
directions issued from time to time by the head office. This system of banking is
prevalent throughout the world. In India also, all the major banks have been operating
under branch banking system.

Advantages of Branch Banking

1. Better Banking Services: Such banks, because of their large size can enjoy the
economies of large scale viz., division of work and specialisation. These banks can also
afford to have the specialised services of bank personnel which the unit banks can hardly
afford.
2. Extensive Service: Branch banking can provide extensive service to cover large area.
They can open their branches throughout the country and even in foreign countries.
3. Decentralisation of Risks:In branch banking system branches are not concentrated at
one place or in one industry. These are decentralised at different places and in different
industries. Hence the risks are also distributed.
4. Uniform Rates of Interest: In branch banking, there is better control and coordination
of the central bank. Consequently interest rates can be uniform.
5. Better Cash Management: In branch banking there can be better cash management as
cash easily be transferred from one branch to another. Therefore, there will be lesser need
to keep the cash idle for meeting contingencies.
6. Better Training Facilities to Employees: Under branch banking the size of the bank is
quite large. Therefore, such banks can afford to provide better training facilities to their
employees. Almost every nationalised bank in India has its separate training college.
7. Easy and Economical Transfer of Funds: Under branch banking, a bank has a
widespread of branches. Therefore, it is easier and economical to transfer funds from one
branch to the other.
8. Better Investment of Funds: Such bank can afford the services of specialised and
expert staff. Therefore they invest their funds in such industries where they get the
highest return and appreciation without sacrificing the safety and liquidity of funds.
9. Effective Central Bank Control: Under branch banking, the central bank has to deal
only with a few big banks controlling a large number of branches. It is always easier and
more convenient to the central bank to regulate and control the credit policies of a few
big banks, than to regulate and control the activities of a large number of small unit
banks. This ensures better implementation of monetary policy.
10. Contacts with the Whole Country: Under branch banking, the bank maintains
continual contacts with all parts of the country. This helps it to acquire correct and
reliable knowledge about economic conditions in various parts of the country. This
knowledge enables the bank to make a proper and profitable investment of its surplus
funds.
11. Greater Public Confidence: A bank, with huge financial resources and number of
branches spread throughout the country, can command greater public confidence than a
small unit bank with limited resources and one or a few branches.

Disadvantages of Branch Banking

Following are the disadvantages of branch banking:

1. Difficulties of Management, Supervision and Control: Since there are hundreds of

branches of a bank under this system, management, supervision and control
became more inconvenient and difficult. There are possibilities of
mismanagement in branches. Branch managers may misuse their position and
misappropriate funds. There is great scope for fraud. Thus there are possibilities
of fraud and irregularities in the financial management of the bank.
2. Lack of Initiative: The branches of the bank under this system suffer from a
complete lack of initiative on important banking problems confronting them. No
branch of the bank can take decision on important problems without consulting
the head office. Consequently, the branches of the bank find themselves unable to
carry on banking activities in accordance with the requirements of the local
situation. This makes the banking system rigid and inelastic in its functioning.
This also leads to “red-tapism” which means “official delay.”
3. Monopolistic Tendencies: Branch banking encourages monopolistic tendencies in
the banking system. A few big banks dominate and control the whole banking
system of the country through their branches. This can lead to the concentration of
resources in the hands of a small number of men. Such a monopoly power is a
source of danger to the community, whose goal is a socialistic pattern of society.
4. Regional Imbalances: Under the branch banking system, the financial resources
collected in the smaller and backward regions are transferred to the bigger
industrial centres. This encourages regional imbalances in the country.
5. Continuance of Non-profitable Branches: Under branch banking, the weak and
unprofitable branches continue to operate under the protection cover of the
stronger and profitable branches.
 6. Unnecessary Competition: Branch banking is delocalised banking, under branch
banking system, the branches of different banks get concentrated at certain places,
particularly in big towns and cities. This gives rise to unnecessary and unhealthy
competition among them. The branches of the competing banks try to tempt
customers by offering extra inducements and facilities to them. This naturally
increases the banking expenditure.
7. Expensiveness: Branch banking system is much more expensive than the unit
banking system. When a bank opens a number of branches at different places,
then there arises the problem of co-ordinating their activities with others. This
necessitates the employment of expensive staff by the bank.
8. Losses by Some Branches Affect Others: When some branches suffer losses due
to certain reasons, this has its repercussions on other branches of the bank. Thus
branch banking system as well as unit banking system suffer from defects and
drawbacks. But the branch banking system is, on the whole, better than the unit
banking system. In fact, the branch banking system has proved more suitable for
backward and developing countries like India. Branch banking is very popular
and successful in India. A comparison between unit banking and branch banking
is essentially a comparison between small-scale and large-scale operations.

Investment Banking (Development): are those banks which provide long term loans to
industries for the purpose of expansion and modernization. They raise capital by issue of
shares and debentures and provide long term loans to industries. These banks are also
responsible for the development of backward areas for which they promote industries in
those places. In India, examples for industrial banks include Industrial Finance Corporation
of India (IFCI), State Industrial Investment Corporations etc
This refers to banks whose main function is to provide finance for investment to industrial
concerns. They provide this by purchasing shares and debentures of newly floated
companies.
Investment bank is a financial and banking organization, which provides both financial as
well as advisory banking services to their clients. Besides this, they also deal with research,
marketing and sales of a range of financial products like commodities, currency, credit,
equities etc. As investment banks, they contribute to share capital and/or take part in capital
issue management for promoting the companies by underwriting their issues and facilitate
public to buy those shares. The industrial activities are promoted by these banks and they
also mobilize long term deposits.

Universal Mixed Banking: Most banks in India play both roles. Deposit Banking and
Investment Banking. Such type of banking is called mixed banking. Example .ICICI
The functions of these bank includes the functions given under retail as well as investment
banking.
 Retail bank

It refers to banking in which banks undergo transactions directly with consumers rather than
with corporates or other banks. Consumer credit is the heart of retail banking. In retail
banking the banks provide services to individuals and small business concerns and the
dealings are in large volumes and low values. The retail banking portfolio encompasses
deposits and assets linked products as well as other financial services offered to individuals
for personal consumption. Retail banking is increasingly viewed by banks as an attractive
market segment with opportunities for growth and profit. Retail banking is a system of
providing soft loans to the general public like family loans, house loans, personal loans, loans
against property, car loans, auto loans etc. The products are backed by world-class service
standards and delivered to the customers through the growing branch network, as well as
through alternative delivery channels like ATMs, Phone Banking, Net Banking and Mobile
Banking.
Today’s retail banking sector is characterized by the following features:
• Retail banking aims at doing banking business in large volume of transactions involving
low value.
• The retail banking portfolio includes deposits and assets linked products as well as other
financial services provided to individuals for personal consumption.
• Retail banking business is an attractive market segment with opportunities for growth and
profits.
• It provides an opportunity to banks to diversify their asset portfolio. Since loans are given
to a large number of consumers and transactions have very low value, the risk of NPA is
reduced because all the consumers do not make default in making loan repayment at a time.
• Retail banking is based on the maxim “do not keep all the eggs in one basket”
Retail banking industry is diverse and competitive. There is a large number of retail banking
products that are extremely customer-friendly and are offered by many banks.
• Banks adopt multiple channels of distribution of retail banking products. The channels
include call centre, branch, internet, mobile phones, ATMs etc.

Retail banking refers to the efforts of the bankers to reach up to the customers on both fronts of
the balance sheet i.e., Liabilities side( deposits/) as well as Assets side (loans).

The main three important functions of retail banking is

1. Give Credit
2. Accept deposit
3. Money management
1) Give Credit
Banks offer credit to their clients for purchasing it also includes mortgages and loans. By doing
this banks will increase liquidity in the economy. this will lead to increase employment and
create more opportunities.

2) Accept Deposit
Banks are a secure place for those who want to deposit their savings. Banks will give a higher
rate of interest to savings accounts, certificates of deposits, and other financial products.

3) Money Management
The retail bank will help to manage money through accounts and cards. It will help to do
transactions online at any place.

The following channels are effectively utilized by the bankers to mobilize business from the
potential clients:
 Premises banking or banking at doorsteps
 Automated Teller Machines
 Debit Cards and Credit Cards
 Telephone banking
 Internet Banking
 Mobile Banking
 Electronic Funds
 Transfer/Electronic Clearing System debit

Investment banking (Securities /trading)

A financial intermediary that performs a variety of services. Investment banks specialize in

large and complex financial transactions such as underwriting, acting as an intermediary
between a securities issuer and the investing public, facilitating mergers and other corporate
reorganizations, and acting as a broker and/or financial adviser for institutional clients. Major
investment banks include Barclays, BofA Merrill Lynch, Warburg's, Goldman Sachs, Deutsche
Bank, JP Morgan, Morgan Stanley, Salomon Brothers, UBS, Credit Suisse, Citibank and
Lazard. Some investment banks specialize in particular industry sectors. Many investment
banks also have retail operations that serve small, individual customers

Functions of investment banks

IPOs: initial public offering. Investment banking helps in raising the capital for both public as
well as private company by providing underwriting securities.
 Investment management: Investment bankers also provide advice to investors on buying
selling and managing securities(bonds,shares,) like other facilities like real estate,hedge fund,
mutual fund etc.the investment management division has been divided into separate division
called private wealth management and private client services

Boutiques: Small investment banking firms providing financial services are called boutiques.
They are mainly specialised in trading bonds, advising for mergers and acquisition , and
providing technical analysis.

Structuring of derivates: Investment banks also help in structuring derivatives such as futures,
options, swaps etc

Mergers and acquisitions: The bank offers mergers and acquisition services.

Merchant Banking Investment banks help companies and governments and their agencies to
raise money by issuing and selling securities in the primary market. They assist public and
private corporations in raising funds in the capital markets (both equity and debt),
Investment banks also act as intermediaries in trading for clients. Investment banks differ from
commercial banks, which take deposits and make commercial and retail loans. In recent years,
however, the lines between the two types of structures have blurred, especially as commercial
banks have offered more investment banking services.
Investment banks may also differ from brokerages, which in general assist in the purchase and
sale of stocks, bonds, and mutual funds. 

The professional management of various securities (shares, bonds etc) and other assets (e.g.
real estate), to meet specified investment goals for the benefit of the investors. Investors may be
institutions (insurance companies, pension funds, corporations etc.) 

 Role as an advisor: Deciding how to raise capital is a major decision for any company or
government. In most cases, they lean on an investment bank. Taking into account the current
investing climate, the bank will recommend the best way to raise funds. This could entail selling
an ownership stake in the company through a stock offer or borrowing from the public through a
bond issue. The investment firm can also help determine how to price these instruments by
utilizing sophisticated financial models.  In the case of a stock offering, its financial analysts
will look at a variety of different factors – such as earnings potential and the strength of the
management team – to estimate how much a share of the company is worth. If the client is
offering bonds, the bank will look at prevailing interest rates for similarly rated businesses to
figure out how much it will have to compensate borrowers.
Investment banks also offer advice in a merger or acquisition scenario. For example, if a
business is looking to purchase a competitor, the bank can advise its management team on how
much the company is worth and how to structure the deal in a way that’s favourable to the
buyer 
Underwriting stocks and bonds: If an entity decides to raise funds through an equity or debt
offering, one or more investment banks will also underwrite the securities. This means the
institution buys a certain number of shares – or bonds – at a predetermined price and re-sells
them through an exchange.

Research – Larger investment banks have large teams that gather information about companies
and offer recommendations on whether to buy or sell their stock. They may use these reports
internally but can also generate revenue by selling them to hedge funds and mutual fund
managers.

Trading and Sales – Most major firms have a trading department that can execute stock and
bond transactions on behalf of their clients.

Wealth Management – Some of the same banks that perform investment banking functions for
Fortune 500 businesses also cater to everyday investors. Through a team of financial advisors,
they help individuals and families save for retirement and other long-term needs 

Securitized Products – These days, companies often pool financial assets – from mortgages to
credit card receivables – and sell them off to investors as a fixed-income products. An
investment bank will recommend opportunities to “securitize” income streams, assemble the
assets and market them to institutional investors.

Corporate banking

Corporate banking represents a wide range of banking and financial services provided to
domestic and international operations of large local Corporates and local operations of
multinational corporations.
Services include the following:
Access to commercial banking products, including working capital facilities such as domestic
and international trade operations and funding
 Channel financing, and overdrafts
 Letters of guarantee, etc.
 Structured solutions both onshore and offshore
 Term loans (including external commercial borrowings in foreign currency).
 Domestic and international payments
 Support to clients' worldwide operations, ensuring a full understanding of the company’s
business and financial needs.
Banks may classify their corporate customers into three segments on the basis of capital
employed and sales volume: Large corporations, Mid-size companies, and Small and Medium
business Enterprises (SMEs). Corporate customers can be further segmented into industry
verticals, such as automobiles, aviation, tourism, etc. Banks develop long-term relationships with
their corporate clients as a part of their marketing efforts. In a competitive market, building
strong relationships with the customers help to retain customers and improve profitability. The
communications and relationships between the banks and their corporate clients are affected by
three factor groups – the external environment, the atmosphere of the interactions, and the
interaction process.

Private Banks

Private Banks are banks where the majority of share capital is held by private individuals. They
elect board of directors which manages the affairs of the banks. Some examples of private banks
in India include The Lakshmi Vilas Bank Ltd., The Karur Vysya Bank Ltd., The City Union
Bank Ltd., HDFC Bank, Axis Bank etc

Co-operative banks

Cooperative bank is an institution established on the cooperative basis and dealing in ordinary
banking business. Like other banks, the cooperative banks are founded by collecting funds
through shares, accept deposits and grant loans.
Cooperative banks are generally concerned with the rural credit and provide financial assistance
for agricultural and rural activities.
Cooperative banking in India is federal in structure. Primary credit societies are at the lowest
rung. Then, there are central cooperative banks at the district level and state cooperative banks at
the state level. Joint stock banks do not have such a federal structure.

These institutions can be classified into two broad categories- agricultural and non agricultural.
Agricultural credit institutions dominate the entire cooperative credit structure. Agricultural
credit institutions are further divided into short-term agricultural credit institutions and long-term
agricultural credit institutions.
The short-term agricultural credit institutions which cater to the short-term financial needs of
agriculturists have three-tier federal structure

Short-Term Rural Cooperative Credit Structure:

In rural India, there exists a 3-tier short-term rural cooperative structure. Tier-I includes state
cooperative banks (SCBs) at the state level; Tier-II includes central cooperative banks (CCBs) at
the district level; and Tier- III includes primary agricultural credit societies (PACSs).
1. State Cooperative Banks (SCBs):
State cooperative banks are the apex institutions in the three-tier cooperative credit structure,
operating at the state level. Every state has a state cooperative bank. State cooperative banks
occupy a unique position in the cooperative credit structure because of their three
important functions:
(a) They provide a link through which the Reserve Bank of India provides credit to the
cooperatives and thus participates in the rural finance,
(b) They function as balancing centers for the central cooperative banks by making available the
surplus funds of some central cooperative banks. The central cooperative banks are not permitted
to borrow or lend among themselves,
(c) They finance, control and supervise the central cooperative banks, and, through them, the
primary credit societies.
Capital:
State cooperative banks obtain their working capital from own funds, deposits,
borrowings and other sources:
(i) Own funds include share capital and various types of reserves. Major portion of the share
capital is raised from member cooperative societies and the central cooperative banks, and the
rest is contributed by the state government. Individual contribution to the share capital is very
small;
(ii) The main source of deposits is also the cooperative societies and central cooperative banks.
The remaining deposits come from individuals, local bodies and others.
(iii) Borrowings of the state cooperative banks are mainly from the Reserve Bank and the
remaining from state governments and others.
Loans and Advances:
State cooperative banks are mainly interested in providing loans and advances to the cooperative
societies. More than 98 per cent loans are granted to these societies of which about 75 per cent
are for the short-period. Mostly the loans are given for agricultural purposes.

2. Central Cooperative Banks (CCBs):

Functions and Organisation:
Central cooperative banks are in the middle of the three-tier cooperative credit structure.
Central cooperative banks are of two types:
(a) There can be cooperative banking unions whose membership is open only to cooperative
societies. Such cooperative banking unions exist in Haryana, Punjab, Rajasthan, Orissa and
Kerala.
(b) There can be mixed central cooperative banks whose membership is open to both individuals
and cooperative societies. The central cooperative banks in the remaining states are of this type.
The main function of the central cooperative banks is to provide loans to the primary cooperative
societies. However, some loans are also given to individuals and others.
Capital:
The central cooperative banks raise their working capital from own funds, deposits, borrowings
and other sources. In the own funds, the major portion consists of share capital contributed by
cooperative societies and the state government, and the rest is made up of reserves.
Deposits largely come from individuals and cooperative societies. Some deposits are received
from local bodies and others. Deposit mobilisation by the central cooperative banks varies from
state to state.
For example, it is much higher in Gujarat, Punjab, Maharashtra, and Himachal Pradesh, but very
low in Assam, Bihar, West Bengal and Orissa. Borrowings are mostly from the Reserve Bank
and apex banks.
Loans and Advances:
About 98 per cent loans are received by the cooperative societies and about 75 per cent loans are
short-term. Mostly the loans are given for agricultural purpose.
About 80 per cent loans given to the cooperative societies are unsecure and the remaining loans
are given against the securities such as merchandise, agricultural produce, immovable property,
government and other securities etc.

3. Primary Agricultural Credit Societies (PACSs):

Functions and Organisation:
Primary agricultural credit society forms the base in the three-tier cooperative credit structure. It
is a village-level institution which directly deals with the rural people. It encourages savings
among the agriculturists, accepts deposits from them, gives loans to the needy borrowers and
collects repayments.
It serves as the last link between the ultimate borrowers, i.e., the rural people, on the one hand,
and the higher agencies, i.e., Central cooperative bank, state cooperative bank, and the Reserve
Bank of India, on the other hand.
A primary agricultural credit society may be started with 10 or more persons of a village. The
membership fee is nominal so that even the poorest agriculturist can become a member.
The members of the society have unlimited liability which means that each member undertakes
full responsibility of the entire loss of the society in case of its failure. The management of the
society is under the control of an elected body.
Capital:
The working capital of the primary credit societies comes from their own funds, deposits,
borrowings and other sources. Own funds comprise of share capital, membership fee and reserve
funds. Deposits are received from both members and non- members. Borrowings are mainly
from central cooperative banks.
In fact, the borrowings form the chief source of working capital of the societies. Normally,
people do not deposit their savings with the cooperative societies because of poverty, low saving
habits, and non-availability of better assets to the savers in term of rate of return and riskiness
from these societies.
Loans Advanced:
Only the members of the societies are entitled to get loans from PACS. Most of the loans are
short-term loans and are for agricultural purposes. Low interest rates are charged on the loans.
The societies are expected to increase amounts of loans to the weaker sections of the rural
community, particularly the small and marginal farmers.

Long-Term Rural Cooperative / Land Development Banks (LDBs) or Cooperative

Agricultural and Rural Development Banks (CARDBs) :
Besides short-term credit, the agriculturists also need long-term credit for making permanent
improvements in land, for repaying old debts, for purchasing agricultural machinery and other
implements. Traditionally, the long-term requirements of agriculturists were mainly met by
money lenders and some other agencies. But this source of credit was found defective and has
been responsible for the exploitation of farmers.
Cooperative banks and commercial banks by their very nature are not in a position to provide
long-term loans because their deposits are mainly demand (short-term) deposits. Thus, there was
a great need for a specialised institution for supplying long-term credit to agriculturists. The
establishment of land development banks now known as cooperative and rural development
banks (CARDBs) is an effort in this direction.
Structure:
The land development banks are registered as cooperative societies, but with limited liability.
These banks have two-tier structure:
(a) At the state level, there are state or central land development banks, now known as state
cooperative agricultural and rural development banks (SCARDBs) generally one for each state.
They were previously known as central land mortgage banks,
(b) At the local level, there are branches of the state land development banks or SCARDBs and
primary land development banks now known as primary cooperative agricultural and rural
development banks (PCARDBs).
In some states, there are no primary land development banks, but the branches of the state land
development bank. In Madhya Pradesh, the state cooperative bank itself functions as the state
land development bank. In other states like Andhra Pradesh, Kerala and Maharashtra, there are
more than one state land development banks.
Similarly, the primary land development banks also vary organisationally in different states. At
the national level, the land development banks have also formed a union, called All-India Land
Development Banks’ Union.
Capital:
Land development banks raise their funds from share capital, reserves, deposits, loans and
advances, and debentures. Debentures form the biggest source of finance. The debentures are
issued by the state land development banks.
They carry fixed interest, have maturity varying from 20 to 25 years, and are guaranteed by the
state government. These debentures are subscribed by the co-operative banks, commercial banks,
the State Bank of India and the Reserve Bank of India.
Besides the ordinary debentures, the land development banks also float rural debentures for the
period upto 7 years. These debentures are subscribed by farmers, panchayats, and the Reserve
Bank. The Reserve Bank substantially contributes to the finance of land development banks by
extending funds to the state governments for contributing to the share capital of these banks and
by subscribing to ordinary and rural debentures.
Growth:
In India, the first cooperative land mortgage bank was organised in Jhang in Punjab in 1920.But
the effective beginning was made in Madras with the establishment of a central land
development bank in 1929. Later on other states also established such institutions.
The number of state cooperative agricultural and rural development banks (SCARDBs) which
was 5 in 1950-51, rose to 20 in 2013. The number of primary cooperative agricultural and rural
development banks (PCARDBs) was 697 in 2013.
Loans and Advances:
The land development banks or SCARDBs provide long-term loans to the agriculturists- (a) for
redemption of old debt, (b) for improvement of land and methods of cultivation, (c) purchasing
costly machinery, and (d) in special cases, for purchasing land. These banks grant loans against
the mortgage of land and the period of loan varies from 15 to 30 years.

Micro Credit: Meaning and importance

What is Micro Credit?

Micro Credit is defined as provision of thrift, credit and other financial services and products of
very small amount to the poor in rural, semi-urban and urban areas for enabling them to raise
their income levels and improve living standards. Micro Credit Institutions are those which
provide these facilities.

The reform of the interest rate regime has constituted an integral part of the financial sector
reforms initiated in our country in 1991. In consonance with this reform process, interest rates
applicable to loans given by banks to micro credit organizations or by the micro credit
organizations to Self-Help Groups/member-beneficiaries has been left to their discretion. The
interest rate ceiling applicable to direct small loans given by banks to individual borrowers,
however, continues to remain in force.

Banks have been given freedom to formulate their own lending norms keeping in view ground
realities. They have been asked to devise appropriate loan and savings products and the related
terms and conditions including size of the loan, unit cost, unit size, maturity period, grace period,
margins, etc. Such credit covers not only consumption and production loans for various farm and
non-farm activities of the poor but also include their other credit needs such as housing and
shelter improvements

A Self-Help Group (SHG) is a registered or unregistered group of micro entrepreneurs having

homogenous social and economic background voluntarily, coming together to save small
amounts regularly, to mutually agree to contribute to a common fund and to meet their
emergency needs on mutual help basis. The group members use collective wisdom and peer
pressure to ensure proper end-use of credit and timely repayment thereof. In fact, peer pressure
has been recognized as an effective substitute for collaterals.

Advantages of Micro financing through SHGs :

An economically poor individual gain strength as part of a group. Besides, financing through
SHGs reduces transaction costs for both lenders and borrowers. While lenders have to handle
only a single SHG account instead of a large number of small-sized individual accounts,
borrowers as part of a SHG cut down expenses on travel (to and from the branch and other
places) for completing paper work and on the loss of workdays in canvassing for loans.

Pursuant to the announcement of Union Finance Minister in his budget speech for the year 2000-
01, this Rs. 100 crore fund has been created in NABARD to support broadly the following
activities:
(a) giving training and exposure to self-help group (SHG) members, partner NGOs, banks and
govt. agencies;
(b) providing start-up funds to micro finance institutions and meeting their initial operational
deficits;
(c) meeting the cost of formation and nurturing of SHGs;
(d) designing new delivery mechanisms; and
(e) promoting research, action research, management information systems and dissemination of
best practices in micro finance.
(f) This fund is thus expected to address institutional and delivery issues like institutional
growth and transformation, governance, accessing new sources of funding, building institutional
capacity and increasing volumes.

RBI and NABARD have contributed Rs. 40 crore each to this fund. The balance of Rs. 20 crore
was contributed by 11 public sector banks.

Islamic Financing – Meaning and Five Basic Principles

Definition:
“An Islamic bank is a financial institution whose statutes, rules and procedures expressly
state its commitment to the principle of Shariah and to the banning of the receipt and payment of
interest on any of its operation”
Moreover, the Malaysian Islamic Banking Act 1983, defines an Islamic bank as
“a company which carries on Islamic business. Islamic business means banking business
whose aims and operations do not involve any element which is not approved by the religion of
Islam…”
Thus, Islamic banking is banking that complies with Shariah or Islamic law.
 One objective of Islamic finance and banking is to assist in the spread of economic
prosperity. The other objective is to do this in accordance with Shariah principles.
 Among the norms concerning Islamic finance are a free market, where prices are
determined by demand and supply, freedom from manipulation, prevention of hoarding,
profit and loss sharing in partnerships, information efficiency etc

Principles of Islamic Finance :Islamic finance strictly complies with Sharia law.
Contemporary Islamic finance is based on a number of prohibitions that are not always
illegal in the countries where Islamic financial institutions are operating:

1. ban on ribà(charging of interest);

2. ban on speculating (maysìr) and introducing elements of uncertainty in contracts
(ghàrar);
3. ban on the use of trade and investment in prohibited assets or activities (haram);
4. Profit and Loss Sharing—PLS principle;
5. the obligation to have real assets underlying all financial transactions

1. Ban on Ribà
Islam prohibits interest, in Arabic ‘ribà’ .The explicit basis of this prohibition is to be found
in The Koran and gives form to the substantial objective that characterizes the Islamic economic
system, meaning, that there can be no earnings without the assumption of the related risks and
earnings must always result from the active work of man. Hence the absolute prohibition of any
positive, fixed and predetermined return rate that is guaranteed regardless of the typology and the
results of the investment.
This conception implies that Islamic Finance requires to operate without resorting to interest,
which however, is a key factor in the functioning of traditional finance. To replace interest, Islam
indicates profit (intended economically as the rate of profit or the mark up) as a lawful alternative
to earnings, i.e., the profit that results from trade/investment transactions and therefore represents
the actual measure of the actual growth obtained of the capital through its use. Lawful earnings
are based mainly on Profit and Loss Sharing, which in Islamic Finance is an essential principle
and requires the holder of the capital and he who uses it to share both the responsibility and the
risks of the investment made.
2. The Ban on Ghàrar and Maysìr
The Koran explicitly prohibits profit based on uncertainty (ghàrar) The ban on ghàrar
principally concerns the characteristics and purposes of contracts of the Islamic financial
instruments.
In order to be valid, contracts must not contain elements of uncertainty in relation to the essential
elements of the contract, such as the uncertainty of the purpose or the nature of the contract and
the price of the goods that are the subject of the trade. Consequently, Islamic Finance does not
admit so-called speculatory contracts characterized by the uncertainty of their effects. Thus,
transactions are banned that determine enrichment due to chance (such as the case of gambling
and placing bets) and which have speculative elements (so-called derivative financial instruments
and hedging transactions such as swaps).
This principle involves the Islamic Finance’s preference to operate through immediate
performance exchange contracts. The aim is in preventing that the deferral of the performance
of the contract by one of the parties generates a benefit for said party, or for the other one that is
not proportionate to the activity put in place and results solely from variations in the quality or
price of the asset being the subject matter of the contract in the period between the conclusion
and the performance of the contract.

An equally fundamental prohibition for the validity of the contracts is maysìr (speculation),
a term that derives from the Arabic word ‘yousr’, which means easiness or easy and effortless
earnings.
This implies the prohibition on assuming excessive risks characterized by extreme results, or the
attempt to obtain richness by chance by betting on the future result of an event. The value of this
prohibition, compared with gharàr, is more centered on the behaviour of the individual and the
relative repercussions on society.

3. The Concept of Haram

According to Islam, the behaviour of the individual has social, political and economic
ramifications such as relations with others (based on respect, honesty, good faith, solidarity and
cooperation), clothing (respectful clothing in public spaces) and food (prohibition of many items
such as wine and pork meat). Such a regulation implies the definition and classification of the
actions and activities considered admissible and those prohibited. Prohibitions are based on the
concept of haram which means ‘unlawful’ from the point of view of the sharia.
Thus, the use, consumption and trading in or (direct or indirect) investment in certain goods or
activities such as (a) alcoholic drinks (production and sale); (b) pork (the breeding of pigs,
processing, sale and production of pork-based foodstuffs); (c) weapons; (d) tobacco; (e)
pornography; (f) gambling and placing bets, are prohibited.
Another important deduction from this principle is the prohibition of investments in shares of
companies, whether listed or non-listed, that are directly or indirectly involved in the trading or
production of the above mentioned goods
4.The Sharing of Risks and Earnings:
Due to the ban on ribà, the Islamic economic system provides for Profit and Loss Sharing (PLS).
The aim of this principle is to safeguard the parties of a transaction (the holder of the capital and
the user of the capital) to assume their responsibilities in the case of successes as well as in the
case of risks.
The individuals that provide capital will have a return proportionate to the effective goodness of
the investment and not a pre-fixed amount. As a result, this is the main difference between
Western and Islamic banks, consisting in replacing interest with profit sharing principle.

5. Real Economic Activities

In addition to the ban on ribà, gharar and maysir and the adoption of the principle of Profit
and Loss Sharing (PLS), which are mandatory in the Islamic financial and economic system,
Islam defines the intrinsic characteristics of the activities that can be the subject of financial
investments and transactions. Consequently, all the financial transactions must have real
activities underpinning them and not be a mere exchange of sums of money or the buying and
selling of financial debts (as it is in the case of swaps and derivatives in general). The obligation
to have real assets underlying all financial transactions is important in this case.

The analysis of the principles outlined above allows that the ban on ribà closely connected with
the monetary and financial activity, whilst the other four prohibitions concern the real economy,
the socially responsible behaviour of companies in their business and investments.

RESERVE BANK OF INDIA

A central bank, reserve bank, or monetary authority, is an entity responsible for the monetary
policy of its country. 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 “bailout” lender of last resort to the banking sector during times of financial
crisis. It may also have supervisory powers, to ensure that banks and other financial institutions
do not behave recklessly or fraudulently.
The central bank of our country is the Reserve Bank of India (RBI). The Reserve Bank of India
was set up on the recommendations of the Hilton Young Commission. The commission
submitted its report in the year 1926, though the bank was not set up for another nine years. It
was established in April 1935 in accordance with the provisions of the Reserve Bank of India
Act, 1934. The Central Office of the Reserve Bank was originally established in erstwhile
Calcutta but was permanently moved to Mumbai in the year 1937.

Objectives of RBI
The main objectives of the Reserve Bank of India are:
1. Promotion of monetisation and monetary integration of the economy.
2. Amendment and modification of currency and regulation of foreign exchange.
3. Promotion of specialised financial institutions at national and regional levels to enhance
facilities for term finance to industry.
4. Provide support to planning authorities and governments to bring economic development
with stability and social justice.
5. Institutionalization of savings through promotion of banking habit.
6. Building up a sound and adequate banking and credit structure.
7. Evolving a well-differentiated structure of institutions for providing credit for Agriculture
and Allied (related) activities.
The main objectives of the Reserve Bank of India are:
1. Promotion of monetisation and monetary integration of the economy.
2. Amendment and modification of currency and regulation of foreign exchange.
3. Promotion of specialised financial institutions at national and regional levels to enhance
facilities for term finance to industry.
4. Provide support to planning authorities and governments to bring economic development
with stability and social justice.
5. Institutionalization of savings through promotion of banking habit.
6. Building up a sound and adequate banking and credit structure.
7. Evolving a well-differentiated structure of institutions for providing credit for Agriculture
and Allied (related) activities.

Regulatory Authority – RBI Qualitative and Quantitative credit control measure (in
detail).

CREDIT CONTROL: It means the regulation of the creation and contraction of credit in the
economy. It is an important function of central bank of any country. The importance of credit
control has increased because of the growth of bank credit and other forms of credit. Commercial
banks increase the total amount of money in circulation in the country through the mechanism of
credit creation. In addition, businessmen buy and sell goods and services on credit basis.
Because of these developments, most countries of the world are based on credit economy
rather than money economy. Fluctuations in the volume of credit cause fluctuations in the
purchasing power of money. This fact has far reaching economic and social consequences. That
is why, credit control has become an important function of any central bank. For
instance, the preamble to the Bank of Canada Act states that the Bank of Canada will
regulate credit in Canada. In India, the Reserve Bank has been given wide powers
to control credit creation and contraction by commercial banks. Before we discuss
the techniques of credit control, it is desirable to understand the objectives of credit
control.

Objectives of Credit Control

The central bank is usually given many weapons to control the volume of credit in the
country. The use of these weapons is guided by the following objectives:
(a) Stability of Internal Price-level: The commercial bank can create credit because their
main task is borrowing and lending. They create credit without any increase in cash
with them. This leads to increase in the purchasing power of many people which may
lead to an increase in the prices. The central bank applies its credit control to bring
about a proper adjustment between the supply of credit and measures requirements
of credit in the country. This will help in keeping the prices stable.
(b) Checking Booms and Depressions: The operation of trade cycles causes instability in
the country. So the objective of the credit control should be to reduce the uncertainties
caused by these cycles. The central bank adjusts the operation of the trade cycles by
increasing and decreasing the volume of credit.
(c) Promotion of Economic Development: The objective of credit control should be to promote
economic development and employment in the country. When there is lack of money,
its supply should be increased so that there are more and more economic activities and
more and more people may get employment. While resorting to credit squeeze, the
central bank should see that these objectives are not affected adversely.
(d) Stability of the Money Market: The central bank should operate its weapons of credit
control so as to neutralise the seasonal variations in the demand for funds in the
country. It should liberalise credit in terms of financial stringencies to bring about
stability in the money market.
(e) Stability in Exchange Rates: This is also an important objective of credit control.
Credit control measures certainly influence the price level in the country. The
internal price level affects the volume of exports and imports of the country which
may bring fluctuations in the foreign exchange rates. While using any measure of
credit control, it should be ensured that there will be no violent fluctuation in the
exchange rates.

Methods of Credit Control

The various methods employed by the central bank to control credit creation power of the
commercial banks can be classified in two groups viz., quantitative controls, and qualitative
controls. Quantitative controls are designed to regulate the volume of credit created by the
banking system. These measures work through influencing the demand and supply of credit.
Quantitative measures, on the other hand, are designed to regulate the flow of credit in
specific uses.
 Methods of Credit Control

Quantitative/ Qualitative/
General Methods Selective Methods
QUANTITATIVE / GENERAL METHODS

1. Quantitative Methods: Quantitative methods aim at controlling the total volume of credit in
the country. They relate to the volume and cost of bank credit in general, without regard to the
particular field of enterprise or economic activity in which the credit is used.
The important quantitative or general methods of credit control are as follows:

A. Bank Rate Policy or the Discount Rate Policy

B. Open Market Operations (OMO)
C. Variable Cash Reserve Ratio (CRR)
D. Statutory Liquidity Ratio (SLR)
E. Liquidity Adjustment Facility (LAF) : Repo rate and Reverse Repo rate
F. Marginal Standing facility (MSF)

A. Bank Rate or Discount Rate Policy

Bank Rate Policy or the Discount Rate Policy has been the earliest instrument of quantitative
credit control. It was the Bank of England which experimented with the bank rate policy for the
first time as a technique of monetary management. Now every central bank has been endowed
with this instrument of credit control.
Meaning
Bank rate refers to the official minimum lending rate of interest of the central bank. It is the rate
at which the central bank advances loans to the commercial banks by rediscounting the approved
first class bills of exchange of the banks. Hence, bank rate is also called as the discount rate.
Theory of Bank Rate
The theory underlying the operation of bank rate is that by manipulating the bank rate, the
central bank is in a position to exercise influence upon the supply of credit in the economy.
According to the theory of bank rate an increase or a decrease in the bank rate leads to a
reduction or an increase in the supply of credit in the economy. This is possible because changes
in the bank rate bring about changes in the other rates of interest in the economy.
Working of Bank Rate
As mentioned above, by manipulating the bank rate it is possible to effect changes in the supply
of credit in the economy. During a period of inflation, to arrest the rise in the price level, the
central bank raises the bank rate. When the bank rate is raised, all other interest rates in the
economy also go up. As a result, the commercial bank also raise their lending rates. The
consequence is an increase in the cost of credit. This discourages borrowing and hence
investment activity is curbed in the economy. This will bring about a reduction in the supply of
credit and money in the economy and therefore in the level of prices. On the other hand, during a
period of deflation, the central bank will lower the bank rate in order to encourage business
activity in the economy. When the bank rate is lowered, all other interest rates in the economy
also come down. The banks increase the supply of credit by reducing their lending rates. A
reduction in the bank rate stimulates investment and the fall in the price level is arrested.
The Process of Bank Rate Influence
Regarding the process through which changes in the bank rate influence the supply of credit, the
level of business activity and the price level, we can distinguish two approaches. One put
forth by R.G. Hawtrey and the other one associated with J.M. Keynes. In the opinion of Hawtrey,
changes in the bank rate operate through changes in the short term rates of interest. These
changes in the short term interest rates, in their turn, influence the cost of borrowing by
businessmen and industrialists. But, according to Lord Keynes, changes in bank rate become
effective through changes in the long term interest rates as reflected by changes in the capital
value of long term securities.
But, it should be noted that there is not much difference between the two approaches
and hence they are complementary to each other.
Conditions for the Success of the Bank Rate Policy
The efficacy of bank rate as an instrument of monetary management calls for the fulfillment
of the following conditions:
(a) Close relationship between bank rate and other interest rates: It is necessary that the
relationship between bank rate and the other interest in the economy should be close and direct.
Changes in the rate should bring about similar and appropriate changes in the other interest rates
in the economy. Otherwise the efficacy of bank rate will be limited. There is, therefore, the need
for the existence of an integrated interest rate structure.
(b) Existence of an elastic economic system: The success of bank rate requires the existence of an
elastic economic structure. That is, the entire economic system should be perfectly flexible to
accommodate itself to changes in the bank rate. Changes in the bank rate should bring about
similar and desirable changes in prices, costs, wages, output, profits, etc. The existence of a rigid
economic structure will reduce the efficacy of bank rate.
(c) Existence of short term funds market: Another condition required for the success of bank rate
policy is the existence of market for short term funds in the country. This will help to handle
foreign as well as domestic funds that come up on account of changes in the interest rates,
following changes in the bank rate. Before the First World War, bank rate policy was very
effective as an instrument of quantitative credit control because, the conditions necessary for the
success of bank rate were there. But, after the war, the significance of bank rate began to wane
because the post-war atmosphere was not conducive for the smooth and effective operation of
the bank rate policy.
Limitations
The Bank Rate Policy suffers from the following limitations:
(a) It has been argued that bank rate proves ineffective to combat boom and depression. During a
period of boom, investment is interest inelastic. Even if the bank rate is raised to any extent,
investment activity will not be curbed, because during a period of boom, the marginal efficiency
of capital will be very high and the entire business community will be caught in a sweep of
optimism. During depression, bank rate becomes ineffective following the general psychology of
diffidence and pessimism among the business circles.
(b) The growth of non-banking financial intermediaries has proved an effective threat to the
effectiveness of bank rate policy. It has been adequately established by the study of the Redcliffe
Report and Gurley-Shaw, that the mushroom growth of non-banking financial intermediaries has
belittled the significance of bank rate. This is because changes in the bank rate immediately
affect the rates of interest of the commercial banks only and the non-banking financial
institutions are not subject to the direct control of the central bank. Hence, it is said that “the
good boy is punished for the actions of a bad boy.”
(c) The decline in the use of bills of exchange as credit instruments also has been responsible for
the decline in the importance of bank rate.
(d) Further, of late, businessmen have found out alternative methods of business financing, self-
financing, ploughing back the profits, public deposits, etc. Indeed, the role of commercial banks
as suppliers of loanable funds has been decreasing in importance.
(e) Moreover, the economic structure has not been adequately responding itself to changes in the
bank rate. After the war, all kinds of rigidities have crept into the economic system.
(f) The invention of alternative instruments of credit control also has accounted for the decline in
the popularity of bank rate.
(g) Further, the dependence of the commercial bank on the central bank for loans also has
decreased leading to the decline in getting the bills of exchange rediscounted by the central bank.
In addition, there has been an increased liquidity in the assets of banks.
(h) Finally, the increase in the importance of fiscal policy following the Great Depression of
1930’s has also reduced the importance of bank take policy as a technique of credit control.
However, in spite of the above limitations that the bank rate policy is subject to, it would be
wrong to undermine the significance of bank rate as a tool monetary management. Though, by
itself, it may not yield the desirable results, but will certainly prove effective when used with
other instruments of credit control. The scope for the use of bank rate by the central bank,
therefore, cannot be completely ruled out. The bank rate has undergone a significant revival. Its
significance in controlling inflation cannot be undermined.
B. Open Market Operations
After the First World War, bank rate policy as a tool of monetary management began to loose
its significance following the invention of alternative techniques of credit control. Among the
alternative instruments of quantitative credit control invented in the post-war period, open
market operations assumed significance.
Meaning
Open market operations refer to the purchase and sale of securities by the central bank. In its
broader sense, the term includes the purchase and sale of both government and private securities.
But, in its narrow connotation, open market operations embrace the purchase and sale of
government securities only. It was in Germany that open market operations took its birth as an
instrument of quantitative credit control.
Theory of Open Market Operations
The theory underlying the operation of open market operations is that by the purchase and sale of
securities, the central bank is in a position to increase or decrease the cash reserves of the
commercial banks and therefore increase or decrease the supply of credit in the economy.
The modus operandi of open market operations can now be explained.
During a period of inflation, the central bank seeks to reduce the supply of credit in the economy.
Hence, it sells the securities to the banks, public and others. As a result of the sale of securities
by the central bank, there will be a transfer of cash from the buyers to the central bank. This will
reduce the cash reserves of the commercial banks. The public has to withdraw money from their
accounts in the banks to pay for the securities purchased from the central bank. And the
commercial banks themselves will have to transfer some amount to the central bank for having
purchased the securities. All this shrinks the volume of cash in the vaults of the banks. As a
result the banks will be unable to expand the supply of credit. When the supply of credit is
reduced by the banking system, the consequences on the economy will be obvious. Investment
activity is discouraged ultimately leading to a fall in the price level. On the other hand, during a
period of deflation, in order to inject more and more credit in to the economy, the central bank
purchases the securities. This will have an encouraging effect on investment because the banks
supply more credit following an increase in their cash reserves. Thus, the central bank seeks to
combat deflation in the economy.
Objectives of Open Market Operations
The main objectives of open market operations are:
(a) To eliminate the effects of exports and imports to gold under the gold standard.
(b) To impose a check on the export of capital.
(c) To remove the shortage of money in the money market.
(d) To make bank rate more effective.
(e) To prevent a ‘run on the bank’.
Conditions for the Success of Open Market Operations
The efficacy of open market operations as a tool of quantitative credit control requires the
fulfillment of certain conditions discussed below.
1. Institutional Framework: The success of open market operations requires the existence of an
institutional framework, that is, the existence of a well-knit and well developed securities market.
The absence of a matured money market constitutes a serious impediment to the development of
open market operations as an effective instrument of monetary control. In fact, in the under
developed countries, the scope for open market operations is limited because of the absence of
the institutional framework referred to above.
2. Legal Framework: The effective and meaningful functioning of open market operations calls
for a suitable legal setting. The legal setting is that there should be no legal restrictions on the
holding of securities by the central bank. It has been found that in some countries the
governments have imposed ceilings on the holdings of government securities by central banks.
Such legal restrictions obviously circumscribe the efficacy of open market operations.
3. Maintenance of a Definite Cash Reserve Ratio: Another condition that should be fulfilled
for the success of open market operations is that the cash reserves of the banks should change in
accordance with the purchase and sale of securities by the central bank. When the central bank
purchases the securities, the cash reserves of the banks should increase and when the central
bank sells the securities, the cash reserves of the banks should fall. This means that the banks
should maintain a definite cash reserve ratio. But, if the banks keep the cash reserves in excess of
the fixed ratio or have other secret reserves, the very purpose of open market operations will be
defeated.
4. Non-operation of Extraneous Factors: Due to the operation of certain extraneous factors the
cash reserves of the banks may not change in accordance with the requirement of open market
operations. For example, when the central bank purchases the securities in order to inject more
credit into the economy, this objective may be defeated by an outflow of money due to
unfavourable balance of payments or the public may hoard a part of the additional cash put into
circulation.
5. Non-existence of Direct Access of Commercial Banks to the Central Bank: Another
important condition for the smooth working of the open market operations is that the commercial
banks should not have direct access to the central bank for financial accommodation. In case the
banks have direct accommodation to the central bank, then the reduction in their cash reserves
through open market sale of securities by the central bank may be neutralised by these banks by
borrowing from the central bank. It should be noted here that the above conditions necessary for
the success of open market operations constitute by themselves the limitations of the open
market operations. In fact, in many countries, particularly in the less developed countries, the
success of open market operations is limited because the above conditions are not fulfilled.
Popularity of Open Market Operations
Despite the limitations of open market operations, it has been argued that this technique of credit
control is superior to the bank rate policy. The superiority of open market operations stem from
the following points:
(a) The discount rate policy seeks to regulate credit in an indirect way, whereas open market
operations have a more direct and effective influence on the regulation of credit by the central
bank.
(b) The influence of bank rate is on short term interest rates only. The long term interest rates are
influenced only indirectly by changes in bank rate. But, the policy of open market operations has
a direct bearing on the prices of long term securities and hence on the long term interest rates. It
has a direct and immediate effect on the quantity of money and credit and hence on the market
interest rates. It is on this score that the policy of open market operations is now increasingly
used to influence the interest rates as well as the prices of government securities in the money
market. But, the above two points of the superiority of the policy of open market operations
should not make us blind to the fact that the policy of open market operations will itself help
to achieve the desired results. It is necessary to combine both bank rate and open market
operations judiciously to achieve the desired results. Wherever possible, open market operations
will have to be supplemented by the bank rate policy. This will go a long way in producing
effective results in regulating the volume of credit in the economy.

G. Variable Cash Reserve Ratio (CRR) and

H. Statutory Liquidity Ratio (SLR)

Cash Reserve Ratio (CRR) is the amount of funds that all Scheduled Commercial Banks (SCB)
must maintain with RBI. aintenance of CRR is stipulated for ensuring the liquidity and solvency
of Banks. Section 42 (1) of RBI Act 1934 empowers RBI to announce the CRR to be maintained
from time to time. CRR is to be maintained in relation to the net Demand and Time Liabilities
(DTL) of the Bank.

Statutory Liquidity Ratio (SLR) is the percentage of the Net Demand and Time Liabilities, a
Scheduled Commercial bank (SCB) is required to maintain in liquid assets.

The traditional instruments of quantitative credit control, bank rate policy and open market
operations, suffer from certain inherent defects and have been found unsuitable to serve the
interests of underdeveloped countries. Hence, an entirely new and unorthodox instrument of
quantitative credit control, in the form of variable reserve ratio, came into vogue, thanks to the
Federal Reserve System of the United States. It was, however, Lord Keynes who was responsible
for popularising the use of this novel technique of monetary management. The Federal Reserve
System became the trendsetter by pressing into service variable reserve ratio for the first time in
1933 as a weapon of quantitative credit control.
Meaning
Variable Reserve Ratio refers to the percentage of the deposits of the commercial banks to be
maintained with the central bank, being subject to variations by the central bank. In other words,
altering the reserve requirements of the commercial banks is called variable reserve ratio. It is a
well known fact that all the commercial banks have to maintain a certain percentage of their
deposits as cash reserves with the central bank. The central bank, therefore, acts as the custodian
of the cash reserve of the commercial banks. By doing so, the central bank imparts liquidity and
confidence into the system. This reserve requirement is subject to changes by the central bank
depending upon the monetary needs and conditions of the economy.
In certain countries, like United States and India, there are clear written laws stipulating the
banks to maintain the reserve requirements with the central bank. Such a reserve ratio is called
the Statutory Reserve Ratio. But, in England, the banks maintain the reserve ratio as a matter of
custom. Hence this kind of reserve ratio is called the Customary Reserve Ratio. Anyhow, the
central bank has the authority to vary the reserve requirements of the banks.
Theory of Variable Reserve Ratio
The theory underlying the mechanism of variable reserve ratio is that by varying the reserve
requirements of the banks, the central bank is in a position to influence the size of credit
multiplier of the banks and therefore the supply of credit in the economy. An increase or
decrease in the reserve requirements will have a contractionist or expansionary influence
respectively on the supply of credit by the banking system.
Working of Variable Reserve Ratio
It is interesting to examine the working of variable reserve ratio as a technique of quantitative
credit control. During a period of inflation, the central bank raises the reserve ratio in order
to reduce the supply of credit in the economy and therefore to reduce the price level. When
the reserve requirements of the banks are raised, the excess reserves of the banks shrink and
hence the size of their credit multiplier decreases. It should be noted that the size of credit
multiplier is inversely related to the reserve ratio prescribed by the central bank. An increase
in the reserve ratio, therefore, discourages the commercial banks from expanding the supply
of credit.
On the contrary during a period of deflation, the central bank lowers the reserve requirements of
the banks in order to inject more purchasing power into the economy. When the reserve ratio is
lowered, the excess reserves with the banks increase and hence the size of credit multiplier
increases. This will have an encouraging effect on the ability of the banks to create credit. Thus,
the central bank seeks to combat deflation in the economy.
Another variant of Variable Reserve Ratio is the method of Statutory Liquidity Ratio (S.L.R.)
which is being used by the Reserve Bank of India. In this case, every scheduled bank in India is
required under law to maintain certain liquid assets to meet its liabilities. These liquid assets
comprise cash reserves with the central bank, balances with other banks in current account and
investment in government securities. By varying the S.L.R., the central bank seeks to influence
the credit creating capacity of the commercial banks. This method is known as the method of
Secondary Reserve Requirements, and is being extensively used in western countries, like
France, the U.S., Sweden, etc. Other variants of Variable Reserve Ratio include the
supplementary Reserve Requirements, Special Accounts System, Special Deposits System, etc.
There is a substantial measure of agreement that variable reserve ratio can be appropriately
pressed into service when a country is experiencing large and sudden movements in its gold and
foreign exchange assets, especially as a result of speculative international capital movements.
The effects of large inflows and outflows of foreign capital can be counteracted smoothly and
effectively by changes in the reserve requirements. Again, by varying the reserve ratio, it is
possible to meet the minor fluctuations and shifts in the balance of payments position.
Though variable reserve ratio also has been a tool of quantitative credit control. It should be
sharply distinguished from the traditional instruments of the bank rate and open market
operations which belong to the same group. While the bank rate policy and open market
operations alter the volume of free reserves of the banks indirectly by influencing the total
amount of reserves, the variable reserve ratio does so directly. “Whereas the other two methods
are designed to bring about an actual quantitative change in reserve holdings and thereby in free
reserves a change in reserve requirements serves to create or destroy free reserves by a stroke of
pen.”
Limitations
The following constitute the limitations of variable reserve ratio:
(a) In the first place, variable reserve ratio has been considered to be a blunt and harsh instrument
of credit control.
(b) As compared with the open market operations, it is inexact and uncertain as regards changes
not only in the amount of reserves, but also the place where these changes can be made effective.
(c) Variable reserve ratio is accused of being discriminatory in its effect. It affects different
banks differently. Banks with a large margin of excess reserves would be hardly affected
whereas banks with small excess reserves would be hard pressed.
(d) Variable Reserve Ratio is considered to be inflexible. It lacks flexibility in that changes in
reserve requirements would not be well adjusted to meet small or localized situations of reserve
stringency or superfluity.
(e) This method of credit control is likely to create a panic among the banks and the investors.
(f) Maintaining the reserve ratio with the central bank imposes a burden on the banks because no
interest is allowed on these cash reserves by the central bank.
(g) In the event of the commercial banks having huge foreign funds, the method of variable
reserve ratio proves ineffective.
In view of the above limitations, according to De Kock, variable reserve ratio should be used
“with moderation and discretion and only under abnormal conditions.” Yet, the case for variable
reserve ratio is stronger than for bank rate policy and open market operations. Variable reserve
ratio has the merit of being applied universally. It is considered to be the battery of the most
improved type that the central bank has added to its armoury of the instruments of credit control.
The technique of variable reserve ratio has been found extremely popular among the central
banks of the less developed and the developing countries. As mentioned earlier, while the
success of bank rate and open market operations calls for the fulfillment of certain conditions, in
the case of variable reserve ratio, the desired results can be achieved just ‘by a stroke of pen’.
From the above, we should not draw the conclusion that any of the three methods is preferable to
the others. The right attitude should be not to accept this method or that method but to combine
all the three methods in right proportions in order to secure effective results in the field of credit
creation. The three methods, as we have seen above, have their own merits and demerits, and
hence, no method, taken alone, can be successful in producing the desired results. Therefore, a
judicious and skilful combination of all the three methods is essential in order to realize the
objectives of credit control. These three methods may be combined in varying proportions to
achieve effective results in the field of credit.
E. Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity
and money supply. The following types of LAF are:

Repo rate
Repo rate, also known as the benchmark interest rate is the rate at which the RBI lends money to
the banks for a short term. When the repo rate increases, borrowing from RBI becomes more
expensive. This in turn, raises the interest rate in the economy and therefore reduces the total
money supply.

If RBI wants to make it more expensive for the banks to borrow money, it increases the repo
rate. Similarly, if it wants to make it cheaper for banks to borrow money it reduces the repo rate.

Reverse Repo rate 

Reverse Repo rate is the short term borrowing rate at which RBI borrows money from banks.
The central bank uses this tool to change the money supply in the economy.

An increase in the reverse repo rate means that the banks will get a higher rate of interest from
RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending
it to others (people, companies etc) which is considered risky.

F. Marginal Standing facility (MSF) 

It is a special window for the commercial banks to borrow from the RBI against approved
government securities, in case of an emergency such as an acute cash shortage. MSF rate is
generally higher than Repo rate.

An increase in the MSF rate leads to higher borrowing cost for the banks and thus, reduces
money supply in the economy.

SELECTIVE OR QUALITATIVE METHODS

The central bank may assume that the inflationary pressure in the country is due to artificial
scarcities created by speculators and hoarders who may hoard and black market essential goods
through the use of bank credit. Accordingly, the central bank may not regulate and control the
volume of credit but control the use of credit or the person’s security, etc. Such controls are
known as selective or direct controls. The special features of selective or qualitative controls are:
(a) They distinguish between essential and non-essential uses of bank credit.
(b) Only non-essential uses are brought under the scope of central bank controls.
(c) They affect not only the lenders but also the borrowers.
Selective controls attempt to cut down the credit extended for non-essential purposes or uses.
Loans extended to speculators to hoard goods or bank credit to consumers to raise their demand
for such durable goods as refrigerators, cars, etc., will prove to be inflationary when there is
already excessive demand as compared to the limited supply. Essentially, therefore, selective
controls are meant to control inflationary pressure in a country.
Objectives
The following are the broad objectives of selective instruments of credit control:
(a) To divert the flow of credit from undesirable and speculative uses to more desirable and
economically more productive and urgent uses.
(b) To regulate a particular sector of the economy without affecting the economy as a whole.
(c) To regulate the supply of consumer credit.
(d) To stabilise the prices of those goods very much sensitive to inflation.
(e) To stabilise the value of securities.
(f) To correct an unfavourable balance of payments of the country.
(g) To bring under the control of the central bank credit created by non-banking financial
intermediaries.
(h) To exercise control upon the lending operations of the commercial banks.
Measures of Selective Credit Control
For the purpose of selective credit control, the central bank generally uses the following
forms of control, from time to time:

1. Margin Requirements
2. Regulation of Consumer Credit
3. Rationing of Credit
4. Control through Directives
5. Moral Suasion
6. Direct Action
7. Publicity

1. Margin Requirements: Banks are required by law to keep a safety margin against securities
on which they lend. The central bank may direct banks to raise or reduce the margin. In the
U.S.A. before World War II, the Federal Reserve Board fixed a margin of 40 per cent (i.e., a
bank could lend up to 60 per cent of the value of security). But during the war and later, the
margin requirements were raised from 40 per cent to 50 per cent, then to 75 per cent and in 1946
to 100 per cent in some cases. When the margin was raised to 75 per cent one could borrow only
25 per cent of the value of the security and when the margin requirement was fixed at 100 per
cent one could borrow nothing. Thus by raising the margin requirement, the central bank could
reduce the volume of bank credit which a commercial bank can grant and a party can borrow.
Margin requirement is a good tool to reduce the degree and extent of speculation in commodity
market and stock exchanges.
2. Regulation of Consumer Credit: During the Second World War an acute scarcity of goods
was felt in the U.S.A., and the position was worsened by the system of bank credit to consumers
to enable them to buy durable and semi-durable consumer goods through instalment buying. The
Federal Reserve Banks of the U.S.A., were authorised to regulate the terms and conditions under
which consumer credit was extended by commercial banks. The restraints under these
regulations were two-fold: (a) They limited the amount of credit that might be granted for the
purchase of any article listed in the regulations; and
(b) they limited the time that might be agreed upon for repaying the obligation. Suppose a buyer
was required to make a down-payment of one-third of the purchase price of a car and the balance
to be paid in 15 monthly instalments. Under the regulations restraining consumer credit, the
down-payment was made larger and the time allowed was made shorter. The result was a
reduction in the amount of credit extended for the purchase of cars and the time it was allowed to
run; and the ultimate result was the restriction, in the demand for consumer goods at a time when
there was a shortage in supply and when there was a necessity for restriction on consumer
spending. This measure was a success in America in controlling inflationary pressures there. In
the post-war period, it has been extensively adopted in all those countries where the system of
consumer credit is common.
3. Rationing of Credit: Rationing of credit, as a tool of selective credit control, originated in
England in the closing years of the 18th century. Rationing of credit implies two things. First, it
means that the central bank fixes a limit upon its rediscounting facilities for any particular bank.
Second, it means that the central bank fixes the quota of every affiliated bank for financial
accommodation from the central bank.
Rationing of credit occupies an important place in Russian Economic Planning. The central bank
of the Russian Federation allocates the available funds among different banks in accordance with
a definite credit plan formulated by the Planning Commission.
But the criticism of rationing of credit is that it comes into conflict with the function of the
central bank as a lender of the last resort. When the central bank acts as a lender of the last resort
it cannot deny accommodation to any bank through it has borrowed in excess of its quota.
Moreover, this method proves effective only when the demand for credit exceeds the supply of
it.
4. Control through Directives: In the post-war period, most central banks have been vested
with the direct power of controlling bank advances either by statute or by mutual consent
between the central bank and commercial banks. For instance, the Banking Regulation Act of
India in 1949 specifically empowered the Reserve Bank of India to give directions to commercial
banks in respect of their lending policies, the purposes for which advances may or may not be
made and the margins to be maintained in respect of secured loans. In England, the commercial
banks have been asked to submit to the Capital Issue Committee all loan applications in excess
of £ 50,000. There is no uniformity in the use of directives to control bank advances. On the one
extreme, the central bank may express concern over credit developments; the concern may be
combined with mild threat to avoid increase or decrease in the existing level of bank loans. On
the extreme, there can be a clear and open threat to the commercial banks financing certain types
of activities.
5. Moral Suasion: This is a form of control through directive. In a period of depression, the
central bank may persuade commercial banks to expand their loans and advances, to accept
inferior types of securities which they may not normally accept, fix lower margins and in general
provide favourable conditions to stimulate bank credit and investment. In a period of inflationary
pressure, the central bank may persuade commercial banks not to apply for further
accommodation or not to use the accommodation already obtained for financing speculative or
non-essential activities lest inflationary pressure should be further worsened. The Bank of
England has used this method with a fair measure of success. But this has been mainly because
of a high degree of co-operation which it always gets from the commercial banks.
6. Direct Action: Direct action or control is one of the extensively used methods of selective
control, by almost all banks at sometime or the other. In a broad sense, it includes the other
methods of selective credit controls. But more specifically, direct action refers to controls and
directions which the central bank may enforce on all banks or any bank in particular concerning
lending and investment. The Reserve Bank of India issued a directive in 1958 to the entire
banking system to refrain from excessive lending against commodities in general and forbidding
commercial banks granting loans in excess of Rs. 50,000 to individual parties against paddy and
wheat. There is no doubt about the effectiveness of such direct action but then the element of
force associated with direct action is resented by the commercial banks.
7. Publicity: Under this method, the central bank gives wide publicity regarding the probable
credit control policy it may resort to by publishing facts and figures about the various economic
and monetary condition of the economy. The central bank brings out this publicity in its
bulletins, periodicals, reports etc.
Limitations of Selective Credit Controls
(a) The selective controls embrace the commercial banks only and hence the nonbanking
financial institutions are not covered by these controls.
(b) It is very difficult to control the ultimate use of credit by the borrowers.
(c) It is rather difficult to draw a line of distinction between the productive and
unproductive uses of credit.
(d) It is quite possible that the banks themselves through manipulations advance loans
for unproductive purposes.
(e) Selective controls do not have much scope under a system of unit banking.
(f) Development of alternative methods of business financing has reduced the
importance of selective controls.
From the above discussion, we arrive at the conclusion that the two types of credit control
measures, quantitative as well as qualitative, are not rivals, but, on the contrary, they supplement
each other. For successful monetary management, the central bank should combine the two
methods of credit control in appropriate proportions. In fact, a judicious and a skilful
combination of general and selective credit control measures is the right policy to follow for the
central bank of a country. It must, however, be pointed out that the various methods, whether
quantitative or qualitative, cannot ensure perfect credit control in an economy in view of the
several limitations from which they suffer, and other complexities involved in the situation.
Conclusion
To conclude, the central bank of a country acts as the leader of the money market, supervising,
controlling and regulating the activities of commercial banks and other financial institutions. It
acts as a bank of issue and is in close touch with the government, as banker, agent and adviser to
the latter.