Banking Business and Functions-1

Contents

Functions of Banks

The core functions commercial banks can be segregated into three main segments viz. Financial Intermediation, Payment System and Financial Services. Apart from these, various other functions of banks are as follows:

  • Banks work as trustees for certain requirements of the businesses, governments and public.
  • They issue Letter of credit for the purpose of facilitating trade.
  • They help in the disbursement of the pension to pensioners.
  • Enable Government to Government (G2G), Government to Corporate (G2C) transactions.
  • Banks liaison with local government departments and government treasury.

Financial Intermediation

The key business of the banks is to accept different types of deposits from the public and then lend these funds to the borrowers. This is called Financial intermediation. In terms of the banks, the deposits represent the “liabilities” of the banks while loans advanced and investments made by banks represent their “assets”.

Acceptance of Deposits

Banks are called custodians of public money and mobilization of the deposits from the public is the most important function of the commercial banks.  There are mainly two types of deposits viz. Time deposits (Term Deposits) and Demand Deposits. As custodians of public money, the banks provide security to the money and valuables of the general public.  In India, the bank deposits are covered under the deposit insurance scheme provided by DICGC. For security of valuables banks provide locker facilities.

Loans and Advances

There are various types of loans or advances, which can be divided on the basis of different sets of criteria. More information about various types of lending operations in India, click here.

Payment System

Payment refers to the transfer of an item of value from one party to another in exchange for goods or services or both; or to fulfill a legal obligation. In any economy, the banks are core to the payment systems. Banks not only enable transfer of money but also its mobilization. The basic method of financial transactions is by negotiable instruments such as cheques and drafts. In modern times, the electronic banking, wire transfers, real time settlements, internet banking etc. are various modes of financial transactions. Banks also enable the internal remittances, foreign exchange transactions, telegraphic transfers of money.

Financial Services provided by Banks

Apart from the above, Banks impart various financial services such as investment banking, insurance-related services, government-related business, foreign exchange businesses, wealth management services, etc. Banks also provide agency services to their customers which includes:

  • Collection and payment of cheques and bills on behalf of customers.
  • Collection of dividends, interest, rent etc. on behalf of customers, if so instructed by them.
  • Purchase and sale of shares and securities on behalf of customers.
  • Payment of rent, interest, insurance premium, subscriptions, on behalf of customers, if so instructed.
  • Acting as a trustee or executor.

Deposits and Accounts

Time deposits and demand deposits

Banks are called custodians of public money and mobilization of the deposits from the public is the most important function of the commercial banks.  Mainly, there are two types of deposits viz. Time Deposits and Demand Deposits. When money is deposited for a fixed period, before which it cannot be withdrawn; such deposits are called “Time deposits” or “Term deposits”. The most common example of Time deposits is “Fixed Deposit“. On the other hand, if money deposited can be withdrawn by the customer (depositor / account holder) at any time without any advanced notice to banks; it is called demand deposit. Most common example of demand deposit is our Saving Banks Account, Current Bank Accounts etc. We can withdraw the funds in these accounts on demand.

Different types of time deposits

On the basis of their nature, time deposits may be of three types as follows:

  • Fixed deposits: A fixed rate of interest is paid at fixed, regular intervals
  • Re-investment deposits: Interest is compounded quarterly and paid on maturity, along with the principal amount of the deposit. In the Flexi Deposits amount in savings deposit accounts beyond a fixed limit is automatically converted into term-deposits.
  • Recurring deposits: Fixed amount is deposited at regular intervals for a fixed term and the repayment of principal and accumulated interest is made at the end of the term. These deposits are usually targeted at persons who are salaried or receive other regular income. A Recurring Deposit can usually be opened for any period from 6 months to 120 months.

Key Features of Time Deposits

  • All time deposits are eligible for interest payments. Interest rate depends upon the tenure and amount of deposit. This rate varies from bank to bank.
  • The interest rate is generally higher for time deposits of longer tenure.

Key features of demand deposits

  • The money as demand deposit is liquid and can be encashed at any time. The ownership of demand deposits can be transferred from one person to another via cheques or electronic transfers. There is no fixed term to maturity for Demand Deposits.
  • The demand deposits may or may not pay interest to the depositor. For example, while we get an interest on savings accounts; no interest is paid on current accounts.

Different types of Demand deposits

The demand deposits are those from which one can withdraw the funds any time by issuing cheque, using ATM or withdrawal forms at the bank branches. Thus, demand deposits can be of two types viz. savings accounts and current accounts.

Main features of current account

  • A current account is always a Demand Deposit and the bank is obliged to pay the money on demand.
  • The Current accounts bear no interest and they account for the smallest fraction among the current, saving and term deposits.
  • They provide the convenient operation facility to the individual / firm.
  • The cost to maintain the accounts is high and banks ask the customers to keep a minimum balance.

Main features of savings account

  • Saving account is also a demand deposit but they are subject to some restrictions on the number of withdrawals as well as on the amounts of withdrawals during any specified period.
  • Further, minimum balances may be prescribed in order to offset the cost of maintaining and servicing such deposits.
  • Savings deposits are deposits that accrue interest at a fixed rate set by the commercial banks.

Key differences between current accounts and savings accounts

The basic objective of a Savings Bank Account is to enable the customer save his / her liquid assets and also earn money on that saving. The Savings banks Accounts are preferred by individuals and provide liquidity for private and small businesses sometimes. On the other hand the current account is basically a transactional account which is preferred by business people. The basic objective of the current accounts is to provide flexible payment methods to the business people and entities. These payment methods include special arrangements such a overdraft facility, accommodation of standing orders, direct debits, offset mortgage facility. The Key differences are thus listed below:

DifferenceSaving AccountCurrent Account
Basic ObjectiveEnable the customer to save liquid assets and also earn interest on thatProvide flexible payment method for individuals, businesses and entities.
PreferencePreferred by individuals saversPreferred by businesses.
Transaction scaleUsually low scale transactionsUsually high scale transactions
InterestEarns interestEarns no interest
Overdraft FacilityNo overdraft facilityThere is overdraft facility
Minimum Balance RequirementMay or May not needNot need

CASA Deposits

CASA Deposits refers to Current Account Saving Account Deposits. As an aggregate the CASA deposits are low interest deposits for the Banks compared to other types of the deposits. So banks tend to increase the CASA deposits and for this they offer various services such as salary accounts to companies, and encouraging merchants to open current accounts, and use their cash-management facilities. The Bank is High CASA ratio (CASA deposits as % of total deposits) are in a more comfortable position than the Banks with low CASA ratios , which are more dependent on term deposits for their funding, and are vulnerable to interest rate shocks in the economy, plus lower spread they earn.

Deposits which have features of both time and demand deposits

Banks also provide a combination of demand and time deposits in the form of various products. Examples of such products include Recurring Deposits, Flexible RDs, Multiplier FDs, Special Term deposit accounts etc.

Account Operations

Opening of Deposit Account & KYC

The Banks have to follow the KYC (Know Your Customer) norms to open new bank accounts. Currently, the RBI has directed the banks to accept a single document, like a driving license, which contains the applicant’s photograph and address to open an account.

The officially valid documents for KYC include

  • passport
  • driving license
  • voter ID card
  • PAN card
  • Aadhaar letter issued by UIDAI and
  • job card issued by MNREGA and signed by a state government official

Nomination

Nomination is a procedure wherein a depositor declares the name of the person to whom the money can be disbursed on account of former’s death. The name of the nominee has to be declared while opening the account. The Banking Companies (Nomination) Rules, 1985 allows the banks to pay all dues to the nominee without any succession certificate or any claims of the legal heir. The features of nomination are:

  • Nomination can be made in case of safe lockers, bank deposits, safe custody articles.
  • One deposit account can only have one nominee irrespective of the account being held singly or jointly.
  • In case of safe lockers, there can be 2 nominees for jointly held lockers.
  • In case of a minor account, a person who is legally entitled to use his account can also file nomination on behalf of the minor.

Procedures followed to operate a deposit account

  • Deposits are usually by filling a deposit or pay-in slip. The depositor or the account holder has to fill in all the particulars and undersign it. In case of transaction of above a certain denomination the depositor has to furnish the PAN (Permanent Account Number) too. Also, the deposits can be made by submitting a cheque and filling in the same deposit slip.

Withdrawals from deposit accounts

Deposits can be withdrawn from one’s account in three ways:

  • Withdrawal Form: The customer is supposed to fill various particulars in the deposit form. The latter is presented with the passbook. After a few checks like balance, signature match etc. the banker clears the form for cash to be collected at the counter.
  • Cheque: These unlike withdrawal forms can be used to make payments to other parties. The payment can be taken from the same bank or any other bank by the other person.
  • ATM (Automated Teller Machine): It can be used both for savings and current accounts. It can be operated by a magnetic card with a secret access PIN (Personal Identification Number) number. They work 24X7.

Passbook

A passbook is a vital document to all banking transactions.

  • It carries a final and unquestionable record of all transactions between the banker and the customer.
  • It is usually a true copy of the entries in the ledger of the bank.
  • It also contains all the rules and regulations to operate a savings bank account.
  • It is given at the time of opening the account and carries the name of the depositor, account number, customer ID, etc.
  • Some banks only issue periodic bank statements to customers and not issue a proper passbook.
  • Banks issue duplicate passbooks in case of loss, mutilation or any kind of spoilage, the passbook is reissued at a nominal charge.

Closure of account of the customers

Banks have the right to close any bank account without any prior intimation if the account has not been operated for a stipulated amount of time. There can be many reasons under which bank can initiate such proceedings. They are:

  • If many cheques are repeatedly issued and there are insufficient funds.
  • Cheques are not honoured.
  • Failing to remit funds which cover bills domiciled at the bank

Banks should however serve timely notice to the customers before initiating such proceedings.

The customers can however withdraw the balance to his credit and not give any prior notice.

In case of pre-mature closures of recurring or fixed accounts a small penalty is charged.

Procedure to Issue of a cheque book.

  • Cheque-book is issued at the time of opening of the account. It is given to the depositor or any person so authorized by the former after proper acknowledgement.
  • If the cheques are frequently returned or dishonored, the bank reserves the right to proceed with closure of the account.
  • A person may sign for an option to not to use a cheque book at the time of opening the account.
  • Person receiving the cheque book should verify the number of leaves and report any damage to the bank officer.
  • It should be kept in secured possession and any loss or theft should be immediately reported to the bank.
  • Banks like SBI give 40 cheque leaves free in a year. Any additional cheque leaves are issued at a service charge. This varied with banks.

Procedure for Issue of fixed deposit receipt

  • A fixed deposit receipt represents the funds which a customer deposits in a bank for fixed or long-term deposits.
  • The term of the deposit and the rate of interest are fixed in advance.
  • A person having any type of dealing or account can open a fixed deposit account.
  • In case of minors, the fixed deposit account can be opened under the guardianship of parents or other designated adults.
  • If the fixed deposit receipt is lost or damaged, a duplicate slip can also be issued after an indemnity bond is furnished in a prescribed format accompanied by the bank guarantee.

Procedure for Closure of fixed and recurring deposits.

Banks have the right to close any bank account without any prior intimation if the account has not been operated for a stipulated amount of time. There can be many reasons under which bank can initiate such proceedings. They are:

  • If many cheques are repeatedly issued and there are insufficient funds.
  • Cheques are not honoured.
  • Failing to remit funds which cover bills domiciled at the bank

Banks should however serve timely notice to the customers before initiating such proceedings.

The customers can however withdraw the balance to his credit and not give any prior notice.

In case of pre-mature closures of recurring or fixed accounts a small penalty is charged.

Different types of account holders

A bank account is a monetary account of a customer with a banking institution. It is a record of balance of money. A bank allows many different types of account holders. They are:

  • Individual: It is an account held by an individual for use by his own needs. The banks usually differentiate their services like minimum balance requirements, ATM usage, fees etc. for different types of holders.
  • Joint account: It is an account opened in name of two or more people. The account can be operated by either of the account holders. These can also be opened in names of associations, cooperative societies etc.
  • Illiterate account: These accounts are opened on discretion of the banks if the person personally goes to the bank along with a witness already known to the bank and the depositor. No cheque books are issued for such accounts. Any withdrawal is done by a thumb impression of the depositor in presence of the bank officer who is able to verify the identity.
  • Minor account: Savings account in name of a minor can be opened in a bank. It can be operated either by the natural guardian or a guardian appointed by the court. The minor can operate the account after an age of 21 years.
  • Married women account: A married woman can have a bank account to which her husband has no access. Such accounts are generally provided by private banks and come with facilities like internet banking, ATM, debit cards, online bill payment.
  • Non-Resident Accounts: NRIs can open accounts based on either repatriation facility or currency of account. These are- Non-Resident Ordinary account; Non-Resident External Rupee; Foreign Currency Non-Resident account and Resident Foreign Currency Account.

Difference between individual account and joint account.

Individual AccountJoint Account
Held by an individual for his own needsHeld by two or more individuals
It can be operated only by the individualIt can be operated by either of two or more individuals operating the account.
In case of death, the balance can be withdrawn by the nomineeIn case of death of any of the account holders, the others can operate the account.
It is not requiredA mandate of operation can be furnished in the account opening form.
It is not applicable in this case.A cheque drawn by one of the account holders can be stopped by another, even if the latter is not authorised to operate the account. Such cheques can only be paid with the consent of all account holders.

Precautions the bankers should take while opening an account in the name of a married woman

A married woman can enter into a valid banking contract and can have her own bank account without giving any rights to her husband to operate it. In case of debt, only she will be responsible and her husband cannot be held liable unless under special circumstances.

  • A banker should take specific precautions to open account for a pardanashin woman as her identity cannot be ascertained. The banker should get her signature attested by any responsible person.
  • An overdraft facility is provided to her if she has sufficient property to her name and is prompt in her dealings.
  • The banker should thus secure sufficient property which can be easily converted into liquid assets.
  • As an agent of her husband banker should ensure she does not overdraw.
  • Banker should include a “Free Will” clause in loans or overdraft agreements
  • In case of joint accounts banks should be sure of who should operate the account and to whom the payment will be made in case of death of any one holder.

Peculiarities of non-resident accounts

A NRI account should have the following peculiarities different from basic bank accounts:

  • Funds are held in Indian currency.
  • One has to pay tax on interests earned.
  • A person can have a resident of India as a joint account holder.
  • It can be converted to a normal resident account if the NRI shifts back to India.
  • Funds can be easily deposited or withdrawn from such an account
  • In case of a NRE account, one can have an option of “No Questions Asked” policy to send funds to India.
  • In case of FCNR account, funds can be held in foreign currency.

Procedures to open account in the name of a Joint Hindu family

A Joint Hindu Family stands for persons who have the same ancestry. A joint Hindu family is governed by the Mitakshara or Dayabhaga laws.

  • Banker should be cautious that any debt on the family head is binding on the estate of the family if the loan was sought for purposes of family benefit.
  • Banker has to be careful and should have awareness about the ownership and inheritance rights as they can pose serious challenges to the banks.
  • The Banker generally takes declaration signed by all members of the family giving rights of operation and decision to the senior-most male member of the house.
  • The head or Karta will govern all transactions done in the account.

The banker takes residential proof, ID and also PAN Card of the Karta when starting the account.

Accounts for Non-Residents

There are several kinds of accounts available for non resident Indians , Persons of Indian Origin and Overseas Citizens of India. These mainly include NRO, NR(E)RA and FCNR account.

NRO Account

NRO refers to Non Resident Ordinary Account. Such account can be opened by any person outside India. Normally, when a resident becomes a non resident, his domestic rupee account gets converted into the NRO account. This helps the NRI to get his credits which accrue in India, for example rent or interest from investments.

NR(E)RA Account

NR(E)RA refers to Non-Resident (External) Rupee Account. This account was introduced as NRE scheme in 1970. It’s a Rupee account and the NRI can remit money to India from the funds abroad.

FCNR Account Scheme

Foreign Currency Non-Resident Account Bank or FCNR (B) was first introduced in 1993. While  NRERA Account is a rupee account and the depositor is exposed to the Currency rates risk; FCNR is opened in foreign currency only. Currently, FCNR Account can be opened in six designated currencies viz. US Dollar (USD), Great Britain Pound (GBP), Euro (EUR), Japanese Yen (JPY), Canadian Dollar (CAD) and Australian Dollar (AUD).

  • However, it’s worth note that the FCNR account is opened ONLY in the form of Term Deposits and NOT in the form of Demand Deposits.  The term is from 1 year to 5 years.
  • The person who opens FCNR account is allowed to repatriate the principal and interest after maturity. Interest on such accounts is paid only on maturity.

Deposit Insurance

In India, the bank deposits are covered under the insurance scheme provided by Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly owned subsidiary of the Reserve Bank of India. DICGC is a statutory body, created by an act of parliament in 1961. The idea behind the Deposit Insurance is to boost the faith of the public in the banking system, and provide protection against the loss of deposits to a significant extent.

Banks which are covered under Deposit Insurance Scheme

All commercial & cooperative Banks (state, district and Urban cooperative banks) are insured by DICGC; however there are a few exceptions. The following are not covered under deposit insurance scheme:

  1. Primary Agricultural Credit Societies (PACS)
  2. Cooperative banks from Meghalaya
  3. Cooperative Banks from Union Territories of Chandigarh, Lakshadweep and Dadra and Nagar Haveli.

This implies that:

  1. All commercial banks including branches of foreign banks functioning in India, local area banks and regional rural banks are insured by the DICGC.
  2. All State, Central and Primary cooperative banks, also called urban cooperative banks, functioning in States / Union Territories are covered under the Deposit Insurance System.
  3. At present all co-operative banks other than those from Meghalaya, Chandigarh, Lakshadweep and Dadra and Nagar Haveli are covered under the deposit insurance system of DICGC.

Primary cooperative societies (PACS) , which are village level cooperatives and disburse short term credits in the country are NOT insured by the DICGC. So around 95000 PACS in the country are out of coverage of the DICGC.

Kinds of deposits that are insured under Deposit Insurance

The DICGC insures all deposit accounts including savings, fixed, current, recurring, except:

  1. Deposits of the Foreign Governments
  2. Deposits of the Central and State Governments.

How Deposit Insurance works?

When a bank covered by Deposit insurance scheme of DICGC fails, or undergoes liquidation or is merged with another bank; the DICGC pays the amount due to depositors via the officially appointed liquidator in a time bound manner. All claims are settled by DICGC within two months from the receipt of the claim from the liquidator.

Maximum amount insured under deposit insurance

The maximum amount per depositor insured is Rs. 1 Lakh including Principal and Interest. This means that

  1. If a person has principal amount of Rs. 91000 and interest Rs. 7,000 then the amount insured by DICGC is Rs. 98,000.
  2. However, if the same person has deposits Rs. 98000 and interest  is Rs. 8000 then , the amount insured by the DICGC would be Rs. 1 Lakh.

The insurance cost is borne by the bank which is insured. The DGCIC charges 10 paise per Rs. 100 as insurance premium.

If a person has different accounts in different branches of the same bank, then the deposits in different branches are totaled and the maximum cover of ₹1-lakh is applied. In case of the joint accounts and other accounts one had, all deposit accounts one holds in his / her name in the same bank are clubbed together to apply the maximum cover. This implies that if someone has savings, fixed, current and recurring deposit accounts in different branches of the bank, he / she will get only Rs. 1 Lakh if the bank fails. However, if one maintains deposits in different capacities in different banks; the Rs. 1 Lakh limit is applied separately for each bank.

Bancassurance

Bancassurance or Bank Insurance Model refers to the distribution of the insurance and related financial products by the Banks whose main business is NOT insurance. So, simply Bancassurance, i.e., banc + assurance, refers to banks selling the insurance products. Bancassurance term first appeared in France in 1980, to define the sale of insurance products through banks’ distribution channels.

Benefits of Bancassurance

Bancassurance helps both the banks and Insurance Companies as follows:

  • This is a referral business in which the banks tend to leverage the existing clientele.
  • Insurance companies get the benefit because they can have distribution relationships with multiple insurers.

Business Model in Bancassurance

For Bancassurance, the Banks need to obtain a prior license from the IrDA or Insurance Regulatory and Development Authority, so that they can work as “Composite Corporate Agent” or may have “Referral Arrangement” with the Insurance Companies.

Major problem of Bancassurance

Banks have to follow RBI as well as IrDA regulations for Bancassurance Business. The present regulations do not allow banks to sell insurance products of more than one insurance company.

Lending policy of the commercial banks

Lending is an indispensible function of banks. Commercial banks consider have to consider many factors while deciding lending policy. These are:

  • Liquidity: A bank has to ensure sufficient liquidity under all conditions.  Any bank indulging in lending finances generally makes its investments in non-liquid assets and manages funding of loans with short-term liabilities. A bank has to thus forecast its liquidity requirements and have emergency standby credit lines at other banks.
  • Profitability: Profits in banking are derived from the difference on the interests paid on deposits and the interests it charges on loans (lending). This is also known as “spread” between the costs of funds and interest rates of loans.
  • Safety Issues: The failure of many banks across the world has brought the issue of safe lending to the fore.
  • Diversification of risk: It has great effect on the performance of the bank. The most important advantage of diversification is lower cost of capital.

Major safety issues banks need to consider in lending policy

Banks across the world have faced failures due to lack of lending precautions and adopting safety valves. Banks have to tread carefully and consider the following points for successful lending:

  • Leverage: It is a dangerous option for any bank irrespective of the quality of credit analysis behind any loan. Banks should adhere to minimum leverage and check for capital adequacy requirements, risk measurement, restrict lending against real estate, shares etc.
  • Fully Collateralized loans: Riskless loans are completely collateralized with actively traded assets. Collateral has to be valued at its liquidation value. It thus requires liquidity and transparency of assets accepted as collateral. The level of transparency thus warranted is supported by the Open electronic limit order book market.

Diversification of Risks

Diversification of risks have a tremendous effect on bank’s performance. A well-diversified bank can effectively channelize its cash flow from less efficient operations to the ones where diversification is most beneficial. Banks can thus mainly diversify on two broad parameters:

  • Geographically: Geographically diversified banks have high annual stock returns than geographically focused banks. Also , this leads to an access to more capital markets which can stem a lower cost of funds due to a large deposit base. Banks may also achieve economies of scale via this route.
  • Activity: Some banks diversify in terms of activities they undertake and diversify to include newer roles and peripherals.

Policy of risk-return trade-off

Risk-return trade-off means the amount of risk a bank can take while not getting uneasy with other investments. Risk as per the dictionary is the possibility of actual returns on investment being different than the expected returns. Risks are associated with low and high levels of uncertainty. A risk-return trade-off is successful if there is proper balance between the lowest possible risk and maximum possible return.  Banks often resort to diversification to manage the trade-off between portfolio risk and return. They generally have diversified portfolios. Larger banks have multiple specialized business lines and small banks have a higher ratio of marketable securities.

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