Introduction

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

What is a Bank?
A bank is a financial institution where an individual can deposit money. Banks provide a system for easily transferring money from one person or business to another. Using banks and the many services they offer saves an incredible amount of time, and ensures that the funds of micro as well as macroeconomic agents "pass hands" in a legal and structured manner. There are also other types of financial institutions that operate just like banks.

Functions of a Bank
Functioning of a Bank is among the more complicated of corporate operations. Since Banking involves dealing directly with money, governments in most countries regulate this sector rather stringently. In India, the regulation traditionally has been very strict and in the opinion of certain quarters, responsible for the present condition of banks, where NPAs are of a very high order. The process of financial reforms, which started in 1991 has cleared the cobwebs somewhat but a lot remains to be done. The multiplicity of policy and regulations that a Bank has to work with makes its operations even more complicated, sometimes bordering on illogical. This section attempts to give an overview of the functions in as simple manner as possible.

-1-

Banking Regulation Act of India, 1949 defines Banking as "accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheques, draft, order or otherwise". Deriving from this definition and viewed solely from the point of view of the customers, Banks essentially perform the following functions: 1. 2. Accepting Deposits from public/others (Deposits) Lending money to public (Loans) 3. Transferring money from one place to another (Remittances) 4. Credit Creation 5. Acting as trustees 6. Keeping valuables in safe custody 7. Investment Decisions and analysis 8. Government business 9. Other types of lending and transactions. In addition to providing a safe custodian of money, banks also loan money to businesses and consumers. A large portion of a bank's business is lending. How do banks get the money they loan? The money comes from depositors who intend to save a portion of their wealth. Banks acting as intermediaries use these deposits as loans to prospective borrowers. The objective of commercial banks like any other organization is profit maximization. This profit generally originates from the interest differential between borrowers and lenders. In the present day, however, the banking operation has extended much beyond simple lending exercise. So there are other different channels of profit ensuing from other investment programmes as well. However, it should be mentioned in this context that the entire deposit held by a bank cannot be given as loans as the Central Bank retains a portion of this money in the form of cash-reserve for unforeseen circumstances.

-2-

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

In this way, money grows and flows throughout the community in a much greater amount than physically exists. That $100 makes a much larger ripple in the economy than you may realize. Other Services Offered by Banks: Credit Cards Personal Loans
-3-

Home and Car Loans Mutual Funds Business Loans Safe Deposit Boxes Debit Cards Trust Services Signature Guarantees And many other investment services.

Types of Banks
1. Central Bank: A central bank, reserve bank, or monetary authority is the entity responsible for the

monetary policy of a country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidizedloan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently. 2. Commercial Banks: A commercial Bank performs all kinds of banking functions such as

accepting deposits, advancing loans, credit creation & agency functions. They generally advance short term loans to their customers, in some cases they may give medium term loans also. 3. Industrial Banks: Ordinarily, the industrial banks perform three main functions: Firstly,

Acceptance of Long term deposits: Since the industrial bank give long term loans, they cannot accept short term deposits from the public. Secondly, Meeting the credit requirements of companies: Firstly the industries require purchasing land to erect buildings and purchase heavy machinery. Secondly the industries require short term loans to buy raw materials & to make payment of wages to workers. Thirdly it does some Other Functions - The industrial banks tender advice to big industrial firms regarding the sale & purchase of shares & debentures.

-4-

4.

Agricultural Banks: As the commercial & the industrial Banks are not in a position to meet the

credit requirements of agriculture, there arises the need for setting up special types of banks to finance agriculture. Firstly, the farmers require short term loans to buy seeds, fertilizers, ploughs and other inputs. Secondly, the farmers require long term loans to purchase land, to effect permanent improvements on the land to buy equipment & to provide for irrigation works. 5. Foreign Exchange Banks: Their main function is to make international payments through the

purchase and sale of exchange bills. As is well known, the exporters of a country prefer to receive the payment for their exports in their own currency . Hence their arises the problem of converting the currency of one country into the currency of another. The foreign exchange banks try to solve this problem . These banks specialize in financing foreign trade. 6. Indigenous Banks: According to the Indian Enquiry Committee, Indigenous banker is a Person

or a firm which accepts deposits, transacts business in hundies and advances loans etc

Financial and Banking Sector Reform

-5-

Role of Banks
A proper financial sector is of special importance for the economic growth of developing and underdeveloped countries. The commercial banking sector which forms one of the backbones of the financial sector should be well organized and efficient for the growth dynamics of a growing economy. No underdeveloped country can progress without first setting up a sound system of commercial banking. The importance of a sound system of commercial banking for a developing country may be depicted as follows: Capital Formation: The rate of saving is generally low in an underdeveloped economy due to the

existence of deep-rooted poverty among the people. Even the potential savings of the country cannot be realized due to lack of adequate banking facilities in the country. To mobilize dormant savings and to
-6-

make them available to the entrepreneurs for productive purposes, the development of a sound system of commercial banking is essential for a developing economy. Monetization: An underdeveloped economy is characterized by the existence of a large non

monetized sector, particularly, in the backward and inaccessible areas of the country. The existence of this non monetized sector is a hindrance in the economic development of the country. The banks by opening branches in rural and backward areas, can promote the process of monetization in the economy . Innovations: Innovations are an essential prerequisite for economic progress. These innovations

are mostly financed by bank credit in the developed countries. But the entrepreneurs in underdeveloped countries cannot bring about these innovations for lack of bank credit in an adequate measure. The banks should, therefore, pay special attention to the financing of business innovations by providing adequate and cheap credit to entrepreneurs. Finance for Priority Sectors: The commercial banks in underdeveloped countries generally

hesitate in extending financial accommodation to such sectors as agriculture and small scale industries, on account of the risks involved there in . They mostly extend credit to trade and commerce where the risk involved is far less .But for the development of these countries it is essential that the banks take risk in extending credit facilities to the priority sectors, such as agriculture and small scale industries. Provision for Medium and Long term Finance: The commercial banks in underdeveloped

countries invariably give loans and advances for a short period of time. They generally hesitate to extend medium and long term loans to businessmen. As is well known, the new business need medium and long term loans for their proper establishment. The commercial banks should, therefore, change their policies in favor of granting medium and long term accommodation to business and industry. Cheap Money Policy: The commercial banks in an underdeveloped economy should follow cheap

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

prerequisite for the economic development of a backward country.

Banking Sector in India

-7-

Central Bank: The Reserve Bank of India is the central Bank that is fully owned by the Government. It is governed by a central board (headed by a Governor) appointed by the Central Government. It issues guidelines for the functioning of all banks operating within the country.

Public Sector Banks a. b. c. State Bank of India and its associate banks called the State Bank Group. 20 nationalized banks. Regional rural banks mainly sponsored by public sector banks. Private Sector Banks a. Old generation private banks
-8-

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

Vision of Banks in India

The banking scenario in India has already gained all the momentum, with the domestic and international banks gathering pace. The focus of all banks in India has shifted their approach to 'cost', determined by revenue minus profit. This means that all the resources should be use deficiently to better the productivity and ensure a win-win situation. To
-9-

survive in the long run, it is essential to focus on cost saving. Previously, banks focused on the 'revenue' model which is equal to cost plus profit. Post the banking reforms, banks shifted their approach to the 'profit' model, which meant that banks aimed at higher profit maximization.

Consolidation of Banks in India

Would the banking industry in India get opened up for more international competition? India would see a large number of global banks controlling huge stakes of the banking entities in the country. The overseas banking units would bring along with it capital, technology, and management skills. This would lead to higher competition in the banking frontier and ensure greater efficiency. The FDI norms in the banking sector would give more leverage to the Indian banks. Thus, a consolidation phase in the banking industry in India is expected in the near future with mergers and acquisitions gathering more pace. One might also see mergers between public sector banks or public sector banks and private banks. Credit cards, insurance are the next best strategic places where alliances can be formed.

Role of Banks in Indian Economy

In India, as in many developing countries, the commercial banking sector has been the dominant element in the countrys financial system. The sector has performed the key functions of providing liquidity and payment services to the real sector and has accounted for the Bulk of the financial intermediation process. Besides institutionalizing savings, the banking sector has contributed to the process of economic development by serving as a major source of credit to household, government , business and to weaker sectors of the economy like village and small scale industries and agriculture. Over the years, over 3040% of gross household savings, have been in the form of bank deposits and around 60% of the assets of all financial institutions accounted for by commercial banks. An important landmark in the development of banking sector in recent years has been the initiation if reforms following the recommendations of the first Narasimham Committee on Financial System. In reviewing the strengths and weaknesses of these banks , the Committee suggested several measures to transform the Indian banking sector from a highly regulated to more market oriented system and to enable it to compete effectively in an increasingly globalize environment . Many of the recommendations of the Committee
- 10 -

especially those pertaining to Interest rate, an institution of prudential regulation and transparent accounting norms were in line with banking policy reforms implemented by a host of developing countries since 1970s.

Capital Formation

The significance of DFIs lies in their making available the means to utilize savings generated in the economy, thus helping in capital formation. Capital formation implies the diversion of the productive capacity of the economy to the making of capital goods which increases future productive capacity. The process of Capital Formation involves three distinct but interdependent activities, viz., saving financial intermediation and investment. However, poor country/economy may be, there will be a need for institutions which allow such savings, as are currently forthcoming, to be invested conveniently and safely and which ensure that they are channeled into the most useful purposes. A well-developed financial structure will therefore aid in the collections and disbursements of investible funds and thereby contribute to the capital formation of the economy. Indian capital market although still considered to be underdeveloped has been recording impressive progress during the post-interdependence period.

Support to the Capital Market

The basic purpose of DFIs particularly in the context of a developing economy, is to accelerate the pace of economic development by increasing capital formation, inducing investors and entrepreneurs, sealing the leakages of material and human resources by careful allocation thereof, undertaking development activities, including promotion of industrial units to fill the gaps in the industrial structure and by ensuring that no healthy projects suffer for want of finance and/or technical services. Hence, the DFIs have to perform financial and development functions on finance functions, there is a provision of adequate term finance and in development functions there include providing of foreign currency loans, underwriting of shares and debentures of industrial concerns, direct subscription to equity and preference share capital, guaranteeing of deferred payments, conducting techno-economic surveys, market and investment research and rendering of technical and administrative guidance to the entrepreneurs.

- 11 -

Rupee Loans

Rupee loans constitute more than 90 per cent of the total assistance sanctioned and disbursed. This speaks eloquently on DFIs obsession with term loans to the neglect of other forms of assistance which are equally important. Term loans unsupplemented by other forms of assistance had naturally put the borrowers, most of whom are small entrepreneurs, on to a heavy burden of debt-servicing. Since term finance is just one of the inputs but not everything for the entrepreneurs, they had to search for other sources and their abortive efforts to secure other forms of assistance led to sickness in industrial units in many cases.

Foreign Currency Loans

Foreign currency loans are meant for setting up of new industrial projects as also for expansion, diversification, modernization or renovation of existing units in cases where a portion of the loan was for financing import of equipment from abroad and/or technical know-how, in special cases.

Subscription to Debentures and Guarantees

Regarding guarantees, it is well-known that when an entrepreneur purchases some machinery or fixed assets or capital goods on credit, the supplier usually asks him to furnish some guarantee to ensure payment of installments by the purchaser at regular intervals. In such a case, DFIs can act as guarantors for prompt of installments to the supplier of such machinery or capital under a scheme called Deferred Payments Guarantee.

Assistance to Backward Areas

Operations of DFIs in India have been primarily guided by priorities as spelt out in the Five- Year Plans. This is reflected in the lending portfolio and pattern of financial assistance of development financial institutions under different schemes of financing. Institutional finance to projects in backward areas is extended on concessional terms such as lower interest rate, longer moratorium period, extended repayment schedule and relaxed norms in respect of promoters contribution and debt-equity ratio. Such concessions are extended on a graded scale to units in industrially backward districts, classified into the
- 12 -

three categories of A, B and c depending upon the degree of their backwardness. Besides, institutions have introduced schemes for extending term loans for project/area-specific infrastructure development. Moreover, in recent years, development banks in India have launched special programmes for intensive development of industrially least developed areas, commonly referred to as the No-industry Districts (NIDs) which do not have any large-scale or medium-scale industrial project. Institutions have initiated industrial potential surveys in these areas.

Promotion of New Entrepreneurs

Development banks in India have also achieved a remarkable success in creating a new class of entrepreneurs and spreading the industrial culture to newer areas and weaker sections of the society. Special capital and seed Capital schemes have been introduced to provide equity type of assistance to new and technically skilled entrepreneurs who lack financial resources of their own even to provide promoters contribution in view of longterm benefits to the society from the emergence of a new class of entrepreneurs. Development banks have been actively involved in the entrepreneurship development programmes and in establishing a set of institutions which identify and train potential entrepreneurs. Again, to make available a package of services encompassing preparation of feasibility of reports, project reports, technical and management consultancy etc. at a reasonable cost, institutions have sponsored a chain of 16 Technical Consultancy organizations covering practically the entire country. Promotional and development functions are as important to institutions as the financing role. The promotional activities like carrying out industrial potential surveys, identification of potential entrepreneurs, conducting entrepreneurship development programmes and providing technical consultancy services have contributed in a significant manner to the process of industrialization and effective utilization of industrial finance by industry. IDBI has created a special technical assistance fund to support its various promotional activities. Over the years, the scope of promotional activities has expanded to include programmes for up gradation of skill of State level development banks and other industrial promotion agencies, conducting special studies on important issues concerning industrial development, encouraging voluntary agencies in implementing their programmes for the uplift of rural areas, village an cottage industries, artisans and other weaker sections of the society.
- 13 -

Objectives of Central Bank (RBI)

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

Evolution of Indian Banking

Prior to 1969, all banks, except State Bank of India and its seven associate banks were privately owned /. However there was a perception among policy makers that under private ownership, too many rural and semi urban-areas remained un-served by banks , whereas the banking industry has to be developed to touch the lives of millions. Further as India became an increasing planned economy, policy makers felt that It would be difficult to undertake credit planning unless the link control of industry and banks in the same
- 14 -

(private) banks is snapped by the nationalization of banks (Hazari Report , 1967) . These considerations led to the Nationalization Act of 1969 which caused 14 largest privately owned domestic banks to be nationalized. In 1980 under the same Act, the Government of India acquired ownership of 6 more private banks, bringing the total number of nationalized banks to 20. Notwithstanding the positive role played by the banking sector since nationalization in institutionalizing savings and becoming a source of credit to the small borrower, the cumulative effect of excessive focus on quantitative achievement and social obligations took a toll on profitability and efficiency. Rates of return became low by international standards, the capital base was eroded, NPSs were on the rise, and customer service was below expectation. These conditions led to gradual liberalization of banking sector operations since the mid 1980s and culminated in the initiation of fundamental banking sector reforms of 1992 with the acceptance of key recommendations of the Narasimham Committee.

The Challenges Ahead

The major challenges facing the banking system in the country, particularly in The wake of the global financial crisis. The First Challenge: Maintaining the Credit Flow There was a noticeable decline in the credit demand in the month of November 2008 but it is not yet clear if it was a one off episode or it reflects a trend. If it is indicative of slowing economic activity, it would be a major challenge for the banks to ensure healthy flow of credit to the productive sectors of the economy. As you know, economic growth, even in normal times, requires efficient financial intermediation. An economic downturn, therefore, requires even more efficient financial intermediation and this is a major challenge that the banking community has to address. The Second Challenge: How to Reform Financial Sector Regulation? Several Issues have come to the fore. I will mention just a few. How can complex Derivative products, which transmitted risks across the system, be made more transparent? What are the financial stability implications of structured products like credit derivatives?
- 15 -

Are exchange traded derivatives better than over-the-counter (OTC) derivatives? How do we eliminate the drawbacks of the 'originate-to- distribute' model? Is universal banking, the model that the United States has now turned to, appropriate? Can we apply the same regulatory regime for both wholesale and retail banks?

SWOT Analysis
Strengths
Indian banks have compared favorably on growth, asset quality and profitability

with other regional banks over the last few years. The banking index has grown at a compounded annual rate of over 51 per cent since April 2001 as compared to a 27 per cent growth in the market index for the same period.

- 16 -

Policy makers have made some notable changes in policy and regulation to help

strengthen the sector. These changes include strengthening prudential norms, enhancing the payments system and integrating regulations between commercial and co-operative banks. Bank lending has been a significant driver of GDP growth and employment. Extensive reach: the vast networking & growing number of branches & ATMs.

Indian banking system has reached even to the remote corners of the country. The government's regular policy for Indian bank since 1969 has paid rich dividends

with the nationalization of 14 major private banks of India. In terms of quality of assets and capital adequacy, Indian banks are considered to

have clean, strong and transparent balance sheets relative to other banks in comparable economies in its region. India has 88 scheduled commercial banks (SCBs) - 27 public sector banks (that is

with the Government of India holding a stake)after merger of New Bank of India in Punjab National Bank in 1993, 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively.

Weaknesses
PSBs need to fundamentally strengthen institutional skill levels especially in sales

and marketing, service operations, risk management and the overall organizational performance ethic & strengthen human capital. Old private sector banks also have the need to fundamentally strengthen skill levels
- 17 -

The cost of intermediation remains high and bank penetration is limited to only a

few customer segments and geographies. Structural weaknesses such as a fragmented industry structure, restrictions on

capital availability and deployment, lack of institutional support infrastructure, restrictive labour laws, weak corporate governance and ineffective regulations beyond Scheduled Commercial Banks (SCBs), unless industry utilities and service bureaus. Refusal to dilute stake in PSU banks: The government has refused to dilute its

stake in PSU banks below 51% thus choking the headroom available to these banks for raining equity capital. Impediments in sectoral reforms: Opposition from Left and resultant cautious

approach from the North Block in terms of approving merger of PSU banks may hamper their growth prospects in the medium term.

Opportunity
The market is seeing discontinuous growth driven by new products and services

that include opportunities in credit cards, consumer finance and wealth management on the retail side, and in fee-based income and investment banking on the wholesale banking side. These require new skills in sales & marketing, credit and operations. Banks will no longer enjoy windfall treasury gains that the decade-long secular

decline in interest rates provided. This will expose the weaker banks. With increased interest in India, competition from foreign banks will only intensify.

Given the demographic shifts resulting from changes in age profile and household

income, consumers will increasingly demand enhanced institutional capabilities and service levels from banks. New private banks could reach the next level of their growth in the Indian banking

sector by continuing to innovate and develop differentiated business models to profitably serve segments like the rural/low income and affluent/HNI segments; actively adopting
- 18 -

acquisitions as a means to grow and reaching the next level of performance in their service platforms. Attracting, developing and retaining more leadership capacity. Foreign banks committed to making a play in India will need to adopt alternative

approaches to win the race for the customer and build a value-creating customer franchise in advance of regulations potentially opening up post 2009. At the same time, they should stay in the game for potential acquisition opportunities as and when they appear in the near term. Maintaining a fundamentally long-term value-creation mindset. reach in rural India for the private sector and foreign bank With the growth in the Indian economy expected to be strong for quite some time-

especially in its services sector-the demand for banking services, especially retail banking, mortgages and investment services are expected to be strong. The Reserve Bank of India (RBI) has approved a proposal from the government to

amend the Banking Regulation Act to permit banks to trade in commodities and commodity derivatives.

Threats
Threat of stability of the system: failure of some weak banks has often threatened

the stability of the system. Rise in inflation figures which would lead to increase in interest rates. Increase in the number of foreign players would pose a threat to the PSB as well as

the Private players.

- 19 -

Conclusion
The banking system in India has undergone significant changes during last 16 years. There have been new banks, new instruments, new windows, new opportunities and, along with all this, new challenges. While deregulation has opened up new vistas for banks to augment incomes, it has also entailed greater competition and consequently greater risks. India adopted prudential measures aimed at imparting strength to the banking system and ensuring its safety and soundness, through greater transparency, accountability and public credibility. Banking sector reform has been unique in the world in that it combines a comprehensive reorientation of competition, regulation and ownership in a non-disruptive and costeffective manner. Indeed banking reform is a good illustration of the dynamism of the public sector in managing the overhang problems and the pragmatism of public policy in enabling the domestic and foreign private sectors to compete and expand. There has been no banking crisis in India. The Government took steps to reduce its ownership in nationalized banks and inducted private ownership but without altering their public sector character. The underlying rationale of this approach is to assure that the salutary features of public sector banking were not lost in the transformation process. On account of healthy market value of the
- 20 -

banks shares, the capital infusion into the banks by the Government has turned out to be profitable for the Government.

- 21 -