Mobilization of Resources 3: Government Finances

GoI retains a big role in economy. In aftermath of LPG reforms, it has pulled back substantially from
private sector, yet its presence is unquestionable and desirable in social sector, defense and security,
provision of public goods and services etc. It has huge bureaucracy which consumes enormous national
resources. Further, in line with modern concept of Market Socialism government intervenes in case of
market failures for which it needs to provide services or goods significantly below cost. In effect,
governments expenditure generally surpasses its revenue which results into Revenue or Fiscal deficit.
In the first place, major source of government revenue is from taxation, but there are non-tax sources
too. At last, government resorts to deficit financing to fulfill its commitments. All this happens under
aegis of Finance Ministry.
Finance Ministry
This ministry is biggest subdivision of GoI and has under it, largest number of departments (5). It also
has one Minister of State. Departments under it are
1.
2.
3.
4.
5.

Economic Affairs
Expenditure
Revenue
Financial Services
Disinvestment

(Please explore sites and have a glance at subdivisions)

This ministry eclipses whole economic and financial system. All regulatory bodies and attached offices
relating to economics and finance come under it.

Expenditure: Plan and non-Plan

a) Plan Expenditure: As the name suggests, plan expenditure is directed toward building productive
social and physical assets or we can say achieving the goals of development. Expenditure on all
Centrally Sponsored Schemes like, NREGA, ICDS etc. are part Plan Expenditure. This till now
remained in hands of planning commission. Now with abolition of PC future development are to be
seen.
Gross budgetary outlay for plan Central plan plus central assistance to state and UTs
b) Non Plan Expenditure Non-plan revenue expenditure is incurred on interest payments, subsidies
(mainly on food and fertilizers), wage and salary payments to government employees, grants to States
and Union Territories governments, pensions, police, economic services in various sectors, other
general services such as tax collection, social services, and grants to foreign governments. It also
includes defense, loans to public enterprises, loans to States, Union Territories and foreign
governments.
Rangarajan Committee in 2010 recommended that this distinction should be done away with. Reason
was that this distinction resulted in over focus on Plan expenditure and neglect of Non plan
expenditure. It projected Non Plan expenditure as a waste expenditure, and various welfare lobbies kept
pressurizing government to increase proportion of plan expenditure at cost of non-plan. This resulted in
substandard quality and underfinancing of basic responsibilities of government which rely on Non-plan
expenditure.
It is felt that in absence of this distinction, Non-plan expenditure can outpace Plan expenditure and
major Safety net schemes will suffer a set back.
Apart from this expenditure is also classified into, Capital and Revenue Expenditure. Former
involves creation of durable capital assets and latter is consumption expenditure with no durable assets
created.
Revenue: Tax and non-tax Revenue
As already said, expenditure of the government is dominantly financed by tax revenue.
1. Tax revenue
Direct Taxes
These involve taxes such as income tax, wealth tax, corporate tax etc. Peculiar feature of direct tax is
that person who is charged to tax himself is liable to pay tax.
Indirect Taxes
In this case, tax is generally on transactions, commodities etc. In this case person who pays tax can
claim tax so paid from customer. This way whole burden is shifted on ultimate consumer.
Value added Tax
Lets take a typical value chain of Manufacturer- wholesaler-retailer- Consumer. Here value addition
(in sale price) is at three stages viz. when goods move from manufacturer, wholesaler and retailer to
finally consumer. Let respective sale prices be 100, 120 and 150.
If Indirect tax (say Sales tax) is 10%, it will be collected at three stages on same product. So new prices
will be Manuf. = 100+10% = 110; Wholesaler = 110 + 10% (tax) = 121 + Rs 20 (profit) = 141;
Retailer= 141+ 10% (tax) = 155 + 30 (profit) = Rs 185. This way, with simple flat sales tax rate,
consumer end up paying substantially higher prices. He also paid tax on tax, which is called cascading

effect (note that Rs 141 at which 10% tax was claimed by retailer already includes Rs 21 of tax).
Government got tax of 10+11+14.1 = Rs 35.1, for sale of Rs 185 which is significantly higher that
10%.
To remove this distortion and cascading effect, Value added tax was introduced. In this case tax was
charged only on value addition at every stage. At first stage 10% tax will be paid by manufacturer and
goods will be invoiced at 110, now wholesaler will sell at Rs 100 (actual cost) + Rs 20 Profit @ Rs 120
+ 10% (VAT).
He will collect Rs 12 from retailer and while paying this 12 to government hell deduct Rs 10 he
already paid to manufacturer as VAT. This is called input credit.
This was that product will reach customer as 100+20+30=150 + 10% = Rs 165 and customers pays Rs.
150 to retailer and Rs 15 (10%) to government, through retailer. VAT though removed cascading effects
of sales tax, yet there is plethora of other indirect taxes (such as Service tax, excise duty, custom duty,
luxury tax etc.) which add up to the costs because of their cascading effect.
Further, VAT is chargeable in different states at different rates. In case of goods sold from one state to
another CST is charged for which input credit is not allowed. All this create impediments in intercourse
of national markets and trades, which is much desirable for competitive markets, industry and low
prices.
Taxation subjects are divided between center and states as per lists in schedule seven under article
246. For e.g. its gives Excise, customs, service tax to center and sales tax/vat to state.
This multiplicity of taxes has unfavorable impact on GDP as to avoid complexities; people prefer to
conceal their transactions. It is estimated that GST will push growth rate up by 1-1.5%.
Further, it obviously makes India performing poorly at indexes like ease of doing business. This is
because all these taxes have separate compliance provisions and reporting mechanisms. This increases
compliance costs and time significantly.
More requirements for compliance naturally create more avenues for corruption and rent seeking.
Goods and Service Tax
One of the biggest taxation reforms in India the Goods and Service Tax (GST) is all set to
integrate State economies and boost overall growth. GST will create a single, unified Indian market to
make the economy stronger. Finance Minister Pranab Mukherjee while presenting the Budget on July
6, 2009, said that GST would come into effect from April 2010.
The basic principal governing behind GST is to have single Taxation System for Goods and Services
across the country. As already said, currently Indian economy has various taxes on Goods and
services such as VAT, Service Tax, Excise, Entertainment Tax, Luxury Tax Etc. now in the new
Proposal of GST; we will be having only two taxes on all goods and Services as follows:
1. State Level GST (SGST)
2. Central Level GST (CGST)
A unified rate will be arrived at for e.g. (10+6), which will comprise of both Central and state GST and
collection will go to respective authority, center or state.
The Union Finance Minister introduced the said Bill in the Lok Sabha in December, 2014. The
proposed amendments in the Constitution will confer powers both to the Parliament and State
legislatures to make laws for levying GST on the supply of goods and services in the same transaction.

GST will
1. Simplify and harmonize the indirect tax regime in the country.
2. GST will broaden the tax base
It is feature of a good taxation regime that while keeping tax rates low they should attempt to include as
much people as possible under tax net.
3. Result in better tax compliance due to a robust IT infrastructure.
Due to the seamless transfer of input tax credit from one state to another in the chain of value addition,
there is an in-built mechanism in the design of GST that would incentivize tax compliance by traders. It
is thus, expected that introduction of GST will foster a common and seamless Indian market and
contribute significantly to the growth of the economy.
4. Reduce cost of collection for government: Currently government has huge bureaucracy
collecting different taxes. Integration will naturally result into downsizing of bureaucracy and
hence reduction of collection costs. Amusingly, in case of wealth tax (direct tax charged over
wealth over Rs. 30 lakhs) collection is so low that, cost of collection is more than tax collected.
5. Impact on Inflation: In long term, GST will undoubtedly result in easing of inflation. However
as initially rates of integrated GST are expected to be kept as high as 16% or more, it is well
above current service tax, excise or VAT rates. In case of services, it will increase prices
directly. In case of other goods inflation depends upon their present component of taxation viz.
excise, VAT, Custom etc. For e.g. some goods which are currently exempted from excise (but
are chargeable to VAT) will bear new burden of excise in form of increased rate (approx. 16%)
of GST.
Following are the salient features of this amendment Bill:
A new Article 246A is proposed which will confer simultaneous power to Union and State
legislatures to legislate on GST.
A new Article 279A is proposed for the creation of a Goods & Services Tax Council which
will be a joint forum of the Centre and the States. This Council would function under the
Chairmanship of the Union Finance Minister and will have Ministers in charge of
Finance/Taxation or Minister nominated by each of the States & UTs with Legislatures, as
members. The Council will make recommendations to the Union and the States on important
issues like tax rates, exemptions, threshold limits, dispute resolution modalities etc.
The proposed GST has been designed keeping in mind the federal structure enshrined in the
Constitution and will have the following important features:
1. Central taxes like Central Excise Duty, Additional Excise Duties, Service Tax, Additional
Customs Duty (CVD) and Special Additional Duty of Customs (SAD), etc. will be subsumed in
GST. (Note that basic custom duty in not included)
2. At the State level, taxes like VAT/Sales Tax, Central Sales Tax, Entertainment Tax, Octroi and
Entry Tax, Purchase Tax and Luxury Tax, etc. would be subsumed in GST.
3. All goods and services, except alcoholic liquor for human consumption and Petroleum and
petroleum products will be brought under the purview of GST.
4. Both Centre and States will simultaneously levy GST across the value chain. Centre would
levy and collect Central Goods and Services Tax (CGST), and States would levy and collect the
State Goods and Services Tax (SGST) on all transactions within a State.

5. In case of interstate trade The Centre would levy and collect the Integrated Goods and
Services Tax (IGST) on all inter-State supply of goods and services. There will be seamless
flow of input tax credit from one State to another. Proceeds of IGST will be apportioned
among the States.
6. GST is a destination-based tax. All SGST on the final product will ordinarily accrue to the
consuming State. It means that as goods will move in value chain from producer to consumer,
whole GST burden/price will be recovered from consumer. (As explained in example for VAT
above)
7. GST rates will be uniform across the country. However, to give some fiscal autonomy to the
States and Centre, there will a provision of a narrow tax band over and above the floor
rates of CGST and SGST.
8. It is proposed to levy a non-vatable additional tax of not more than 1% on supply of goods in
the course of inter-State trade or commerce. This tax will be for a period not exceeding 2 years,
or further such period as recommended by the GST Council. This additional tax on supply of
goods shall be assigned to the States from where such supplies originate. Because GST is a
destination based tax, tax will accrue to states in which goods are ultimately sold. So, to
compensate states from which goods originated this (non-vatable tax) is proposed.
Finance Minister expects that if they are able to push GST through state legislature smoothly, then they
can roll out GST in 2016. As this tinkers with federal fiscalism of the nation and require amendment in
Schedule 7 and so many other federal articles (246A-279A), it is supposed to be passed by atleast half
of state legislatures along with in both houses of parliament by special majority. So, it is to be seen that,
whether current government able to do so.
Tax reforms have been in news for some time. GST is one of the major reform for which government
is working. Some other topics and issues are
1. Minimum Alternate Tax- Government has, in order to attract investments in various backward
geographic locations, or in exports or in certain crucial industry like Food processing or in
SEZ/EOU, keep rolling out tax holiday schemes. Under these schemes investment as per some
conditions, attracts a certain tax exemption for a certain period.
Overtime, businesses started exploiting these schemes to fullest by aggressive tax planning. Under
these planning companies often used some or other loophole to secure more tax exemption than was
reasonably due under spirit of the scheme. Reliance Industries was particularly notorious for this about
a decade back. Eventually, these companies declared significant profits and dividends year after year,
but taxable profit as per income tax rule remained nil. Note that book profits and Taxable Profits
are different. Adjustments are made into former to arrive at latter. So say with aggressive tax panning
book profits are Rs 100 Crore, but after adjustments taxable profits comes out to be NIL.
To remedy this Minimum alternate Tax was introduced under which Minimum Floor rates were
introduced on which companies will, notwithstanding any exemptions it enjoy, was liable to taxes. This
rate was kept high.
By this move situation moved to opposite extreme. Now bonafied investor, who invested only because
of concessions were forced to pay taxes. This kept investment away from Indian Special economic
zones and other incentivized destinations.
2. Retrospective Taxation few years back Hutchison (Telecom Company based in Hong Kong)
sold its stake in Hutch Essar to Vodafone PLC, and reaped huge profits. But all this profit which
accrued in India, escaped from income tax by exploiting loopholes in the law. This was

enormous loss to exchequer. Since this event, income Tax department had been desperately
trying to recover tax from Vodafone. For this government in 2012 budget gave itself power for
retrospective amendment in Income Tax and finance acts. Through this government can make
new laws or change current laws or cancel amendment, all with force from backdate. Note that
Article 20 prohibits retrospective legislation in case of criminal law only and it allows same for
civil laws.
3. General Anti Avoidance Rules It was to be introduced wef. 1stApril, 2014 to check
aggressive tax planning and flouting of income tax laws. It gives more power to Income Tax
officials on how treat a suspicious entry in books of accounts. Onus to prove that entry is
bonafied is on assesse. But, budget 2014 didnt mention anything about GAAR, after budget,
MoS for finance replied in parliament, GAAR will be applicable from 1st April 2015.
All this (MAT, retrospective taxation and GAAR) gave Indian Government and Income Tax department
much bad name in eyes of all types of investors and business community. State was accused of
unleashing tax terrorism on businesses to make good its own weaknesses and messed up fiscal
situation.
The government tried to revive investor sentiment by constituting an expert committee chaired by
Parthasarathi Shome to re-examine the provisions on GAAR and retrospective amendments. The
committee recommended a significant curtailment of GAAR and cautioned against retrospective
amendments, except in the rarest of rare cases.
4. Tax Administration Reforms Commission (TARC) Also under Mr. Parthasarathi Shome
(This is different from above mentioned expert panel). Its terms of reference, as name suggests
included overall reforms in tax organization structure, processes, practices so as to reduce cost
of tax collection and increase tax base. This involved capacity building of Tax departments in
order to minimize tax evasion etc. Major recommendations were
Merge Central Board of Direct Taxes and Central Board of Excise and Customs (these are
currently under department of revenue and oversees direct and indirect taxes, respectively)
Abolish post of revenue secretary and instead council of chairmen of boards should be
appointed for job.
Work of Dept. Of Revenue be allocated to above two boards, it will result in better efficiency in
collection.
At least 10 % of tax administration budget should be spent on tax-payer services
Income Tax return should include wealth tax return, Pre filled returns could be considered.
PAN number should be made common business identification number, to be used by other
government departments also such as customs, central excise, service tax, DGFT and EPFO
Avoid retrospective amendments in TAX LAWS , results in Protracted disputes
Tax council headed by the chief economic advisor in the finance ministry be set up to develop
a common tax policy, analysis and legislation for both direct and indirect taxes
Efficient and speedy payments of tax refunds and Passbook scheme for TDS
Tax being main source of government finance is central for resource mobilization in economy. But in
India Tax to GDP ratio is quite low. Combined (state center) tax to GDP ratio is only 15%. In other
developing countries it is as high as 35%. For center alone in India it is (11-12%). Main reason is
narrow taxation base and huge Tax Expenditure (or Tax foregone) by GoI.
Tax Expenditure/Tax Foregone/ Tax Subsidies

The statutory rates of taxes as notified by respective laws are divergent from the actual or effective
rates of taxes, which is attributable to tax provisions that allow
deductions or exemptions from the taxpayers taxable expenditure, income, or investment,
deferral of tax liability,
preferential tax rates
These provisions allow people to pay lower taxes by claiming deductions under various rules.
Consequently, significant amount of tax is legally not received by government. This point remains most
potent weapon in hands of left leaning parties to attack government.
A tax expenditure statement was laid before the Parliament for the first time in 2006-07 and it seeks to
list the revenue impact of tax incentives or tax subsidies that are a part of the tax system of the central
government.
Introduction of MAT significantly reduced tax foregone.
While the magnitude of tax expenditures or revenue forgone from central taxes is showing an upward
trend for both direct and indirect taxes, it is imperative to introduce sunset clause with every provision
which facilitates tax expenditure.
Revenue foregone forms significant part of GDP at 4-5%
Read these articles 1 and 2
Non Tax Revenue
Non-tax revenues of the centre mainly consist of interest and dividend receipts of the government,
receipts from the services provided by central government like supply of central police force, issue of
passport and visa, registration of companies, patents and licence fees, royalty from offshore oil fields,
Coal mines and various receipts from the telecom and other sectors.
Further, there are sometimes handsome proceeds in from of non-debt capital receipts, which arise from
disinvestments. Disinvestments targets last year were failed at miserably and this year government is
quite optimistic about reaping benefits from good stock valuations at stock markets. Disinvestment was
discussed at length here.
Budgetary Deficits
So far we saw government finances in following form

High spending in social and physical infrastructure which is often as per plan expenditure, even higher
non-plan commitments, low tax to GDP ratio and high tax foregone, all this boil downs to Deficits i.e.
spending more than earning. There are different forms of budget deficit viz. primary Deficit, Revenue
Deficit, Fiscal Deficit.
Whenever we are told that government expenditure has exceeded its receipts, in short that we have
incurred budget deficit, before arriving at any conclusion we need to ask some further questions
before arriving at any conclusions.

These questions may be like was capital receipts or borrowings used to finance revenue
expenditure? If so this is undesirable and correction in this should be prime focus of government.
If revenue expenditure is less than Revenue income than Revenue deficit takes place. (RE-RI =
RD) In this situation deficit will be financed by capital receipts. Capital receipts come from productive
investments. Under resource mobilization we are attempting to tilt national income, away from
consumption, towards savings and then eventually towards productive investment. But, note here
whats happening? Here Investment resources are sold off to fund consumption.
Our 2nd question will be was capital (or even revenue) expenditure financed through borrowings? If
so we have incurred fiscal deficit. It is arrived at as (Total Expenditure Total Income) borrowings
= fiscal deficit
There may be situation where Revenue deficit was nil, but Fiscal Deficit was positive, this indicates

that borrowing, were used to finance capital asset creation. Now policymakers and observers are keen
to see that assets which are created on back of borrowings are productive enough to serve the interest
rates.
Case 1 (dont get disturbed by small figures)
Hypothetically, say when under MSP regime, wheat is procured from farmer by FCI at Rs 15/ kg and
then through state PDS, this is sold at discounted prices of Rs. 1. Deficit of Rs. 14 has been incurred.
Now at the yearend government has to pay farmer its due. It got just 1 rupee from consumer, it will
give balance money from tax it collected. Now again tax it collected comes out to Rs. 10.
Now we can say revenue deficit of Rs 3 has been Incurred (Rs. 14-11)
Now government sold some PSU and is able arrange Rs 2 from that, now fiscal deficit will be Rs. 1,
which will be borrowed by the government. (So Fiscal Deficit = Borrowing)
Case 2
Note that if earning from PSU was Rs 3 than there was no Fiscal Deficit.
Case 3
Wheat procured is for Rs. 15 and some Dam is created by Govt. for Rs 5. Wheat sold for PDS @ 1, tax
collected is Rs 14. Now revenue deficit is Nil. And government sold some PSU for 2. Fiscal deficit is
Rs 3 which will be financed by borrowing.
This is much tenable situation. In fact Fiscal Deficit is used to create demand in economy and it is
method of Redistribution of resources. Note in this example that Tax collected of Rs. 14 has moved
from taxpayers to farmers and Targeted beneficiaries of PDS. Also note that, Spending of Rs. 15 + 5 is
more than income of government i.e. Rs. 17. Now there is Rs 3 more in circulation and this on one
hand will revive demand and on other, it will create inflationary conditions.
It was John Keynes which in aftermath of Great Depression propagated that governments should incur
fiscal deficits to revive demand.
Third question that can be asked is How much flexibility do we have to curtail our expenditure?
Interest on borrowings is non flexible and non-negotiable expenditure. So it is excluded from fiscal
deficit to arrive at Primary deficit. So primary deficit = Fiscal Deficit interest on borrowings
Fiscal Discipline and FRBM act
Government is welfare state and strives to promote welfare. But as explained above it has financial
constraints. By intervention government should attempt to build capacity of people to survive and grow
themselves in market. But at same time government has to set minimum standards and provide safety
nets to disadvantaged and vulnerable people of the society.
For this to happen successfully in long term, require governments to observe strict fiscal discipline.
There is always immense pressure on government for spend its resources for competing interests. In
turn government is always vulnerable for giving in blindly to such demands, due to political
compulsions. Going too much beyond its resources may be beneficial in short term but for long term it
results in to piling up of debt and ever increasing interest payments and as a result high inflation.
Deficit results in Inter-Generational inequity Deficit simply means today government is living
beyond its means, and to finance its expenditure it borrows money, which is to be paid backing future.
This borrowing will accumulate interest overtime and after some time Principle along with interest will

be paid by government by charging future tax payers, who are forced to pay for expenditure not being
incurred over them.
Deficit ruins monetary policy of RBI RBI makes monetary policy by monitoring supply of money
in the economy. Main target behind this is inflation. As we have seen in foregoing discussion, that
fiscal (and other) deficits increases money supply in the market, an inflationary trend is created.
Fiscal Responsibility and Budget Management act
The main purpose was to eliminate revenue deficit of the country (building revenue surplus thereafter)
and bring down the fiscal deficit to a manageable 3% of the GDP by March 2008. However, due to
the 2007 international financial crisis, the deadlines for the implementation of the targets in the act was
initially postponed and subsequently suspended in 2009. In 2011, given the process of ongoing
recovery, Economic Advisory Council publicly advised the GoI to reconsider reinstating the provisions
of the FRBMA.
Further, the Act prohibits borrowing by the government from the Reserve Bank of India, thereby,
making monetary policy independent of fiscal policy. The Act bans the purchase of primary issues of
the Central Government securities by the RBI after 2006, preventing monetization of government
deficit.
After reinstatement of FRBM act new targets were agreed at. Accordingly current year target is 4.1%
last year was 4.6%.
It should be noted that, government used undesirable means to contain deficit last year. Government
PSUs were forced to shell out huge dividends, some expenses were differed on next years and worst
was that there was huge cut on plan expenditure. This crumbled centrally Sponsored schemes such as
NREGA.
Government Borrowings
Fiscal deficit is nothing but borrowings of the government. Government has three sources viz. Borrow
from RBI, Borrow from Open Market or Borrow from abroad.
In case it borrows from abroad it has to see that long term borrowings dont are not financing revenue
consumption and productive assets are created against them. This is also true for domestic borrowings.
Government keeps issuing bonds and Banks subscribes to these as they are required to invest in these
bonds to comply with Statutory Lending Ratio (22% of net time and demand deposits).
There is well built primary and secondary debt market in which bond securities are subscribed to.
If fiscal deficit is high, it will result in increased inflation and money demanded by government from
any of the source will be high. Here as demand for money becomes high, bond yields will shoot up and
bond prices will fall. Say 6% Bond already trading at 98 will fall to 96, this will increase yield which is
now Rs. 6 @ Rs 96 bond. This increased yield will become new rate at which money can be raised by
government.
If money becomes too expensive government will have to resort to monetization of deficit which is
most undesirable. It means government will sell new bonds to RBI, which will pay Government newly
printed currency. This will increase money supply in economy without any corresponding increase in
real economy.

Debt to GDP ratio

This ratio measures government debt to percentage of GDP. Factors influencing it are

Fresh Fiscal Deficit increases the ratio

Retirement of old debt decreases the ratio
Interest rate of debt
GDP growth rate

Last two factors are most interesting, if GDP growth rate is above interest rate on debt, then ratio tends
to decline overtime, this happened in India upto few years back, when growth rate was high. But with
slowing down of economy, and growth rate falling below rate of return has resulted in rise in this
ration.
This is serious concern, because GDP is directly proportional to tax collection. If ratio rises, more tax
will go to serving interests and fiscal deficit will be higher.
Indias debt to GDP ratio is much comfortable and is hovering around 50%. Further, Indias debt
majorly consists of long term and domestic debt. In contrast countries like China have majorly
external debt and their Debt is more than their GDP. This is case with most of the developed countries.
Japans ratio is whopping 250% of its GDP, because of very low tax collections there.

Resource Mobilization 2: Capital Markets

Resources can be mobilized either for short term or for long term. Economy consists of huge number of
enterprises and individuals, requirements of all of them differ. Some have surplus cash to save, while
some other needs cash. Some firms/individuals wants to make good there short term liquidity
requirements, some wants money for long term capital investment. So distinction can be made as to
period for which one intends to lend or borrow. In this sense financial market is categorized into money
market and capital markets. In Money market, period involved (for funds movement) is 1 year or
less, while in capital markets period is generally more than 1 year. Banks basically caters to money
market and mobilizes resources from savers to borrowers (this is because distinguishing feature of a
bank is to accept deposits and open current accounts). But, it plays significant role in capital markets
too, as it lends for capital investment purposes. As economy of the country grows, highly specialized
institutions comes up which caters exclusively to capital needs and banks continues its money market

business. These institutions are known as Capital Market intermediaries.

These are intermediaries like insurance companies, housing finance companies, pension funds, and
investment funds etc. which mobilize savings and fund long term investments.
Now again, person having surplus money for long term may be willing to lend or to invest. This
forms distinction between debt and equity. In former, lender will get fixed return and in latter investor
will get share of his profit. These are invested through different type of intermediaries as per interest of
lender, may be mutual fund, debt fund, stock market etc.
In financial market, financial assets are created such as debenture, shares, bonds etc. Financial Assets
represent claim of their holder over certain asset with certain quantity. This claim arises because of a
contract between two parties e.g. lender and borrower or buyer and seller. In the first place, these are
created when fresh money is raised in the market (either through debt or equity). These instruments,
after being issued could be traded like anything else and they have their market. Now there are again
distinctions between primary and secondary markets. Markets in which fresh funds are raised are
primary and in which financial assets are traded are called Secondary markets.
What are Financial Markets?
Financial market is a market where financial instruments are exchanged or traded and helps in
determining the prices of the assets that are traded (also called the price discovery process). These
facilitate trade in financial assets by providing platform for coming together of buyers and sellers or
Borrowers or Lenders.
Financial markets may be classified on the basis of 1. debt and equity markets
2. money market and capital market
3. primary market and secondary market
Indian Financial Market consists of the following markets:
Capital Markets
Primary capital market
Whenever a company raises fresh capital or debt, it does so by initial public offer (IPO). Already
listed company can again raise capital by follow on public offer (FPO).
Secondary capital market
Shares which were issued in primary market remains listed on stock exchanges and are traded. Share
prices move in accordance with Market Sentiment, Economic and Political stability, and fundamentals
of particular company.

Stock Exchanges

Both these activities are facilitated by Stock exchanges. In layman terms stock exchanges are markets
(or mandis) where prospective buyer and seller meets and item traded is Shares, debentures, bonds etc.
In early days, there was physical interface between two parties; there were mediators in stock
exchanges, which for a commission used to negotiate the deal. Lot of buyers would come and make
bids for purchase and on other hand there would be sellers with financial assets, attempting to sell at
highest possible price. When difference between selling and buying bid is eliminated, deal is done.

Mediators used to shout bids for their clients. This was known as open outcry system.
The Bombay Stock Exchange (BSE), the oldest and the largest stock exchange in India. Historically, it
traded for two hours in a day with an open outcry system. The exchange was managed in the interests
of individual members, a majority of whom had inherited their seats. A large proportion of stocks listed
on the exchange were not actively traded. There was minimum supervision from the exchanges and
speculation (satta) was rampant.
It was in 1992 that in pursuance of LPG reforms that the Stock Exchanges were reformed. These
reforms were on the back of Legal provisions and technology.
One landmark legal reform was passage of Securities and Exchange Board of India Act, 1992, which
created an apex independent regulator for capital markets. Earlier, everything was under Finance
ministry, which resulted in consistent interference. Apart from this, earlier companies have to get their
issue price approved by finance ministry. With reforms, this control was also done away with.
Apart from this, Transactions were now settled in a separate Clearing House (as Cheque is cleared in
banking separately) which earlier was done mutually between members. Perhaps, most effective reform
was dematerialization of Securities which means conversion of securities from physical to electronic
form. In those days there were physical proofs such as Share Certificates which has to be transferred in
name of purchaser. This involved lot of time, efforts and also, stamp duty. In electronic form, securities
(share, debentures etc.) are held by depositories on behalf of actual owners. Two depositories in India
are NSDL and CDSL. So trade is handled by Stock Exchanges which have designated brokers like
Karvx, Parsavnath etc. These brokers have account with depositories and interface with prospective
buyers and sellers. A person willing to trade in securities has to open a demat account in Depository
with help of broker. As soon as he buys any security, it is transferred to this account.
Now there is highly sophisticated electronic and online trading system in plane. There is real time
transfer of market, industry and stock specific information across the country which removes
information asymmetry and ensure level playing field.
National Stock Exchange (NSE) is only other national Stock exchange apart from BSE and there are
numerous other regional exchanges.
In every country, biggest international stock exchange is located in its financial capital. E.g. New York
Stock Exchange, London Stock Exchange, Tokyo Stock Exchange, Shanghai Stock Exchange.
Another important point is that in post liberalization period, there enormous interface in global capital
markets. India allowed Foreign Institutional Investors to invest in Indian Markets and FII flows now
are its back bone. Many Indian companies have raised funds from outside India via. Global/American
Depository Receipts
In present times stock markets indicate health of an economy. They are primary means of
mobilization of long term savings and investment and fixed capital formation. Further, when
volume of trade in markets is significant, it leads to transparent price discovery. As we have read,
funds can be raised either as a debt or as equity. Stock Exchanges enable and facilitate businesses to
raise funds predominantly through equity. Forces of market (demand and supply) constantly interact
and this results in fluctuating prices. There is huge army of stock analysts who keep eye on price
movement, fundamentals of company and related industry, and health of national and world economy.
This way they try to find out intrinsic value of a share. Normally, Investments flows into shares which
are priced lower than their intrinsic value.

Further, Stock Markets, by providing ready secondary market for long term investment shares, gives
investors an option for easy exit from the industry. At the same time it provides avenues for entry of
new investors. For example, few year back significant shares in Essar telecom was acquired by
Hutchison, and then it was sold to Vodafone. Listed shares make it easy for transactions to take place.
To gauge movement in the market is not an easy task. There are thousands of shares listed and they
move in different quantum and may be in different directions. So how would we know how overall
stock market is performing? For this there are indices which represents broader trend of the market.
Stock Indexes
Sensex is one such index which is weighted average of 30 stocks (listed on BSE), which have highest
market capitalization (MC). MC practically means market value of equity of the company (no. of
equity share issued multiply by Market price of Share). When we are told that Sensex is up, then it
means these 30 shares have gone up together. Its same concept like determining Inflation rate, or Index
of Industrial production.
Similarly there is Nifty-50 for NSE stocks which represent weighted average of best 50 stocks. There
are also sector specific indices, such as IT sector Index, Cement, Iron & Steel, Real Estate etc. these
indices tells performance of companies in that sector put together.
Confidence of the investors in the market is imperative for the growth and development of the market.
For any stock market, the market Indices is the barometer of its performance and reflects the prevailing
sentiments of the entire economy. Stock index is created to provide investors with the information
regarding the average share price in the stock market. The ups and downs in the index represent the
movement of the equity market. These indices need to represent the return obtained by typical
portfolios in the country.
Stock market allows trading of diverse Capital Market Instruments. These instruments are used to lay
claim over specified financial asset. Some of the capital market instruments are: Equity, Preference
shares, Debenture/ Bonds, ADRs/ GDRs, Derivatives.
What are derivatives?
A derivative is an instrument which derives its value from an underlying asset.
Different people have difference perception about movement of prices of financial asset in future.
This provides them avenue for speculation and exploit potential created by current price and expected
price.
For example a person can buy an option to buy a specified asset, on specified future date and at a
specified price. Say some share is currently priced at Rs. 25 and Mr. X expects it will touch 30 rights
after 1 month. He, based on his perception will buy an option to buy this share at Rs. 25 next month. As
the date approaches and actual price of Rs. 25 will move. Any movement will create a value of this
contract as (either negative or positive) as he has right but not obligation to buy at Rs. 25, whatever
may be the rate.
This is example how derivative instrument gets its value and is traded separately on stock exchanges.
There are many such instruments like Futures, forward contracts etc.
One may ask that why doesnt Mr. X buy that share itself to exploit possible profit? Buying share will
require him to invest Rs 25, but in case of option hell pay small premium while entering into deal and
hell directly get profit on final date.

It should be noted that these contracts are standardized by exchanges and then sold as products. Its not
like for every individual investor brokers try to chart a separate deal.
A derivative picks a risk or volatility in a financial asset, transaction, market rate, or contingency, and
creates a product the value of which will change as per changes in the underlying risk or volatility.
Derivatives can be derived from Shares, Commodities, Foreign Exchange, and Interest rate
Differentials. Practically it also can be done from cricket/football matches or even from uncertainties of
climates
For commodity derivatives there is National Commodity and Derivative Exchange (NCDEX), Multi
Commodity Exchange (MCX) and National Multi Commodity Exchange (NMCE). Read about Its role
in Agriculture here
For Regulation of commodity derivative market Forward Market Commission acts as apex regulator.
Securities and Exchange Board of India (SEBI)
SEBI was enacted in 1992 in accordance with the provisions of the Securities and Exchange Board of
India Act, 1992 to protect the interests of investors in securities and to promote the development
of, and to regulate the securities market and for matters connected therewith or incidental
thereto. It is quasi legislative, quasi-judicial, quasi administrative body.
Time and again there have been Scams in stock exchanges like Harshad Mehta Scam, Ketan Parekh
Scam ore more recent one Satyam Scam. In all these scams lakhs of genuine investors lost their hard
earned money. With every such failure SEBI has emerged stronger with plugging up the loop holes. But
even today, participation and trust of common man in markets is wavering. It is general perception that
only upper few blue chip companies are governed genuinely observing all disclosure requirements and
other regulations. In other lesser known companies, manipulation of the stock prices by insiders
(promoters, directors and auditors) is rampant. In fact, Satyam before revelation of scam was one of the
best performing blue chip stock. But all this was happening on the basis of falsely cooked up books and
auditors were party to this manipulation. Indian laws dont provide stringent punishment for frauds
committed in the markets. It is ironical that Raju Ramalingams revelation about Satyam fraud and
subsequent collapse in share prices, claimed lives of few people who committed suicide and Raju is out
on bail. In contrast, US laws are very stringent in this case. It was observed in case of Rajat Gupta and
Raj Rajanatnam, who were American citizens are sentenced for life terms longer than 20 years. This is
just because they were accused of indulging into insider trading; in this case effect on market doesnt
matter. Insiders are people who are supposed to have access to price sensitive unpublished
information of a company. These people are Directors, Promoters, Auditors, Secretaries etc. If they
trade (buy or sell) in shares on basis of such information, that will be called insider trading.
When a company is listed, its shares are open for trading for anyone. So sovereignty of promoter,
directors etc. is substantially curbed. Practically, owner of the company can be anyone, and these
owners (shareholders) gather at annual general meet of the company to appoint new directors by
voting. One share carries one vote. Promotors, like Ambanis for Reliance hold majority shares in their
companies, so in effect will of Ambanis prevails and they end up keeping top position for themselves.
Now every decision, they have to make shall be in interest of these investors at large and company.
Stock prices fluctuates due to three reasons I.e. Macro-Economic events , Industry specific events and
Company specific events. Information about former two generates outside premises of the company,
but in last case its the company which generates the Information. Any price Sensitive information may
trigger the selloff, if its bad news or reverse may happen in case of good news. So insiders being in

position to influence, retain, block such information may cause harm to investors at large for their
personal gain.
SEBI strives to provide level playing field for insiders and outsiders and hence insider trading is
prohibited. Sometimes promoter creates artificial demand by overinvesting in their own shares, seeing
good performance of those shares public at large starts investing and then insiders pull the plug by
selling their investments at high prices.
Despite of SEBIs relentless efforts such things are not uncommon in Indian Markets. SEBI apart from
making general rules for whole market maintains a strict vigil of individual companies based on
information received by it through complaints and disclosure.
SEBIs basic functions
1. Regulates Stock Exchanges.
2. Registering and regulating the working of intermediaries like stock brokers, sub-brokers, share
transfer agents, bankers to Issues and other such persons involved in share market.
3. Registering and regulating Collective investment schemes, mutual funds, venture capital funds
etc.
4. Prohibiting fraudulent and unfair trade practices relating to securities markets
5. Prohibiting insider trading in securities
6. Promoting investors education and training of intermediaries of securities markets.
7. Controls and regulates FIIs
8. Ensure Corporate Governance
Every company willing to get listed has to enter into a listing agreement with SEBI, in which
company agrees certain terms and conditions in Interest of investors. Clause 49 of Listing agreement
is specifically directed towards Corporate Governance for it requires companies to appoint certain
independent directors.
Recently, by Securities Laws (amendment) bill, powers of SEBI over collective investment schemes
were increased. It was given authority to attach properties of non-complaint companies. This was
related Saradha Scam.
In Sahara case, it came out that SEBI has power to regulate any company which issues and security.
Prior position was that it only had powers over listed companies.
Corporate Governance
What is corporate governance?
CG concept holds that company should not ignore interest of its any stakeholder. Main stakeholders are
investors, employees, government and society at large.
1. Investors interest: Better Returns, Transparency & accountability in business, secure future of
company.
2. Employees Interest: Regular salaries, good working conditions, Career progress potential and
social status.
3. interest: Regular payment of taxes, Compliance with laws & rules, Non indulgence in antinational activities.
4. Societys Interest: generation of employment, less pollution, efficient utilization of scarce
resources, Healthy & affordable products etc.

SEBIs role in safeguarding interest of investors and curbing malpractices is significant from point of
view of Corporate Governance.
Apart from this Companies act, 2013 too gives sound stress on CG It provides for appointment of
Independent directors, Regulates remuneration of directors, Internal Audit Committee, increases
responsibility and penalties of auditors and provides that atleast 1 director should be woman.
New companies act also introduced mandatory Corporate Social Responsibility clause. Every
company having net worth of rupees five hundred crore or more, or turnover of rupees one thousand
crore or more or a net profit of rupees five crore or more during any financial year shall constitute a
Corporate Social Responsibility Committee of the Board consisting of three or more directors, out of
which at least one director shall be an independent director.
They also need to formulate a CSR policy which should be continuously monitored. Company should
spend for CSR, minimum, 2% of its average net profit during previous three years.
Two main committees for corporate governance in past were Kumar Manglam Birla Committee in
1999 and N.R. Narayan Murthy Committee in 2002. Read here and here
Mutual Funds
Different shares in the market carry different kind and degree of risks. So an investors instead of
putting all eggs in one basket, diversifies its portfolio. He attempts to minimize his risk and maximize
return by investing in both debt and equity and further within equity, he picks up various sectors
infra, textile, IT, Cement, Housing, banking etc.
A normal investor often faces information constraints and fails to get an adequate portfolio. For this
purpose there are Asset Management Companies which forms a fund by issuing units to the public.
These units are just like any other instrument shares or debentures. Public purchases these units and
money reaches AMC. Now this AMC is manned with financial market experts and they will invest this
money in different sectors so as to maximize returns and minimize risk. As profit from different
investment flows value of units of mutual fund increases. These units are also traded on stock
exchanges.
The mutual fund industry in India was started in 1963 with the formation of Unit Trust of India (UTI),
at the initiative of the government of India and Reserve Bank. The history of mutual funds in India can
be broadly divided into different phases. In the first phase UTI has enjoyed the status of monopoly in
the mutual fund industry. In the second phase some public sector mutual funds set up by the public
sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India
(GIC) were launched besides the UTI. In the third phase, which started in 1993, the government
allowed private players to offer mutual fund schemes giving the Indian investors a wider choice of fund
families.
Corporate Debt/bond Market in India
As we have read, resource for investment can be either mobilized in form of either Equity or Debt.
Foregone discussion was for equity. Any business prefers to get financed first from internal sources like
profit from its own operation, or capital infused by its owners. Second comes the debt and equity is
preferred only if debt is unavailable. This is because equity gets share of profit in return, while debt is
entitled only to fixed interest. Normally, former is significantly higher than latter. So all over the world
cooperate bond markets are well developed. In this corporates raise equity, not by issuing shares, but by
debentures or bonds, on which investors/lenders will get fixed rate of interest. In India government

bond market is well developed and it has been financing its fiscal deficit by such bonds, but corporate
bond market is quite laggard.
In India, the Government bond market has experienced a steady growth over the years due to the need
to finance the fiscal deficit. The Government bond market, which is around 39.5 per cent of GDP in
end-2010 in India compares favourably to most other Asian countries. The corporate bond market on
the other hand is just 1.6 per cent of GDP in end-2010 and small in relation to the economys size.
From 2008 to 2010 corporate bond market in India in value terms grew from $7.85 billion to $24.99
billion. In comparison to other countries such as South Korea ($380.62 billion) and China ($ 522.09
billion), the Indian corporate bond market appears to be under-developed. The under development of
the corporate bond market in India is not incidental and is mainly attributable to the structure of the
Indian financial system and regulatory structure.
Currently corporates and business get majority (almost all) of the lending from banks. Banks are
exposed to numerous other risks. If banks credit is exposed to a bad company (say kingfisher) than any
default by that company (in repayment) can cause harm to depositor, who otherwise wouldnt have
opted to get exposed to this bad company. So Corporate bond market provides investors option to
choose their risk and return. It also leaves finance with bank to lend to more socially productive
ventures. Last but not least, a company with good reputation can get cheap finance for its expansion as
this is directly from public and middleman bank is eliminated. By same logic, investor will also get
somewhat better deal. For corporate debt market to develop, it is imperative that regulatory mechanism
is strengthened at very first place.
Corporate bonds markets too have primary and secondary distinction.
Mobilization of Small Savings in Investment
Foregoing discussion was related mobilization of savings under which central objective of savers is just
to invest and increase their wealth. There are other forms of savings under which small denominations
of savings gets together to form significant investment figures. These are mainly Insurance, Provident
fund and pension Savings (also called contractual savings). These have an important social security
angle, but here focus is on resource mobilization through them. These funds have long maturity
(repayment) period so they are better placed to cater need of projects with long gestation periods like
infrastructure. But in India, the investment patterns of these funds are highly regulated with a bias
towards investment in Government securities. There is need to deregulate these long-term fund sources
and formulate prudential norms for such financing. Insurance sector is somewhat contributing to
private sector, but pension and provident savings are completely government controlled, so the will be
discussed in next article along with government finance.
Savings through these three forms 20-25% of total household savings, so efficient mobilization
becomes crucial.
Insurance
Insurance is service in which individual economic risk is spread over large number of people. Any loss
that can be quantified in money can be insured. For e.g. Life Insurance provides risk cover on life of a
person. Life cannot be quantified in itself, but economic hardships on survivors of a deceased
breadwinner can be undoubtedly quantified in money terms, so this way life insurance can be done.
How individual economic risk is spread over large number of people?

In insurance large number of people pay premium and their risk gets covered. In case of any
mishappening, under which claim can be invoked as per legal agreement; person will get compensated
by Insurance company. Not all covered vehicles will meet an accident, nor all covered persons will die.
But everyone certainly has risk of dying or getting trapped into an accident. So premium from all
people under risk is used to pay a person who really met accident or relatives of person who died.
Insurance is highly profitable and cash rich business. Premium is collected and claims are to be paid
when there is risk materialized. The insurance sector has been an important source of low cost funds of
long-term maturities all over the world. In the Indian context, however, the insurance companies,
particularly in life insurance, apart from covering risk are also committed to repayment of the
principal with interest although with long maturities and thereby tend to act as investment
funds. One of the reasons that this has happened is that the average premium charged by the
insurance companies in India tends to be relatively high due to obsolete and rigid actuarial
practices and inefficient operations.
This is the reason Life Insurance Corporation is one of the richest and omnipresent government
companies.
(Actuaries are Experts who tries to quantify risk in a particular segment and determine the appropriate
premium.)
Insurance industry is generally classified into Life Insurance Business and General Insurance. Former
was nationalized in 1950s and latter in 1970s. After LPG reforms there have been increasing
involvement of privates sector. A watershed moment came in 1999 when Insurance Regulatory and
Development Authority act was passed which establish IRDA. This independent authority remains at
apex of Insurance business. This was necessary because government was keen on promoting private
sector participation, for which independent and efficient regulators are prerequisite.
An ordinance recently has been promulgated to allow FDI upto 49% in insurance sector. This is
expected to bring much needed forex, Human Resource and differentiated products in the sector.
Capital markets, as name suggests, mobilize savings towards productive capital assets. High investment
in primary market will suggest high fixed capital formation, which in turn will have all around impact
on employment creation, tax collection and eventually higher standard of living. However, capital
markets at times can squeeze savings from large public to a handful of sectors. This results in income
inequalities. As was seen in last decade, that much growth was due to services sector and much of the
resources got concentrated into that sector. Government through its policy interventions has to make
sure that any growth is inclusive of all sects, regions, classes of the country, it is only then it can be
sustainable. Otherwise it will receive a backlash from disadvantaged people, which has strong
implications for political and economic stability of the country.
Questions
1. What reforms were undertaken in India to revive its Stock Exchanges? Explain how they help in
mobilization of resources. (200 words)
2. What is importance of corporate debt market? (200 words)
3. Do you think government should facilitate development of a burgeoning Corporate Bond
market? Why? (200 words)
4. How does Insurance helps in mobilization of small savings? Should FDI allowed in Insurance
sector at time when domestic industry is nascent? (200 words)

Mobilization of Resources 1 Banking

Table of Content
1.
2.
3.
4.
5.
6.
7.
8.
9.

Introduction to resource mobilization

Basic of Banking
Evolution of Banking in India
Banking and Agriculture
Types of Banks
Post offices as Financial Intermediary
Role and functions of RBI
Priority Sector Lending
Some other related Institutions DICGC, Bhartiya Mahila Bank etc.

Resource is anything which has some value and is required to accomplish some desired objective. For
life on earth sunlight is the supreme resource. It gave birth to all other current form of resources such as
Fuel and Food. Human beings (and every creature) constantly struggle and arrange for or mobilize
resources they need. Over thousands of years we have built evolutionary societies in which resource
mobilization, its means and methods have also evolved. Ancient barter trade was a system of resource
mobilization, and then later currencies developed to facilitate it. For a currency to be acceptable to all,
it needs a strong legitimacy. In ancient times this legitimacy was provided by Monarchies and now it is
done by numerous forms of governments.
Central thing to the concept of laisses Faire was concept of resource mobilization only. When East
India Company colluded with British Empire to get the exclusive rights to trade in the east, it created
resentment in newly emerged capitalist class. As we know, it was around this time that Adam Smith in

his book wealth of nations strongly pitched for free markets. This theory propagated that Ruling
regimes should let resources be distributed as per principles of demand and supply, without any
intervention. Prices of the different commodities or services will send signals to buyers and suppliers as
to what to consume and manufacture, respectively. Shortage will shoot up prices attracting more
investment in production and reverse will happen in case of abundance. This is what he called free
hand of markets.
This free hand or Capitalism went on undeterred for almost 2 centuries, when finally in 1920s there
arrived Great economic Depression in the west. Just before this in 1919, Russian revolution yielded a
new alternative ideology of resource mobilization, to be called socialism and communism. Great
depression dismantled the concept of free markets. British Economist John Keynes demonstrated that
markets were amenable to a failure and since then term market failure came in vogue. He professed
that government job in times of market failure should be to incur Fiscal Deficit so that demand in
economy is increased. Fiscal Deficit (in short) is expenditure by government over and above its
earning. So traditionally, government taxed citizens to fulfil its commitments, but now government will
be a net giver as expenditure will be more than its income. So this unfolded a new chapter in resource
mobilization, and fiscal deficit became an all pervasive mean to cause changes in resource distribution
toward weak and vulnerable.
By this time Banking System was highly evolved. Capital or Debt markets, Primary and Secondary
markets of different things also emerged. Topic of resource mobilization is so central to subject
economics that everything, be it budgeting, Taxation, Stock markets, self-help groups, APMCs,
Financial Inclusion and many more, are nothing but related means or issues. So, every topic should be
read keeping this thing in mind.
It should be noted that in modern societies all factors of production, trade or service like natural
resources, human resource, energy resource etc. and their value is represented by currency/money. So
study about distribution of money in market subsumes all other types of resource distribution under it.
So the institutions which basically facilitate Resource Mobilization are called financial Intermediaries
(FI). In last article we discussed importance of investments. Effective Resource mobilization will aim
at channelizing resources toward most productive sectors and avenues, which yield maximum good for
least advantaged people. It is precisely here that debate of growth vs. development becomes quite
relevant.
Most important FI are Banks, Insurance, Capital Markets and as we noted earlier, government also to
much extent. So well try to cover these Intermediators, along with related current issues.
This series will tentatively include following articles
1.
2.
3.
4.
5.

Banking Sector
Insurance and Capital Markets
Government Finance
Financial Inclusion
Monetary and Fiscal Policy

Well try to cover all the relevant topics with reasonable depth connecting them with recent
developments, but given the general nature of topic, it is likely that something important gets
unintentionally skipped. Further, all these topics are quite interrelated, for example financial inclusion
is a common theme running throughout the topic. So something might have been kept deliberately out
of this article to be covered in next articles.

Make sure you also read these articles already present on Insights (after this)
1. Basel Norms and Stability
2. NPAs
Banking Sector as resource mobilizer

Basic concepts
Ancient money lending systems used to serve a limited area, but current banking systems has gone
global. Now resource mobilization happens not only in an economy but also beyond political borders.
Obviously, degree of integration differs from country to country, as attested by after effects of Global
Financial crisis of 2008(discussed latter).
Different persons in an economy have different risk appetite or capacity to take risk. But at same time,
most important concept of finance is direct relation of risk and return/profit. More is the risk, more is
the profit. Banking system facilitates movement of money from risk averse people to risk ready ones.
Surplus money you have can be (among many other things) invested in Stock markets or deposited in
banks. Banks guarantee repayment of whole sum along with pre agreed interest, so there is high degree
of certainty and assurance to the depositor. In contrast, Stock exchanges provide no such assurances;

person may not be able to recover even his invested money. So risk averse person will prefer bank over,
stock markets, private business or any other riskier investment. This is a hypothetical scenario.
On the other hand, many people who have some knowledge for what else to do of money are ready to
invest, but they dont have money. These will borrow same money which was just deposited by risk
averse people. So bank insures its lending to these (so called) risk ready people by adequate risk
assessment, mortgages or hypothecation.
In Risk assessment, bank studies financial capacity and credibility of potential borrower. For this it
goes into matters like his annual income, past credit history etc. Term loans are disbursed by keeping
some physical property of borrower mortgage. Under mortgage bank keeps documents of such property
on understanding that those will be returned, on repayment of loan. Loan agreement includes a clause
in which borrower authorize bank to sell property on inability of borrower to repay such money. In case
loan is given against a financial asset such as shares or Debentures, it is called Hypothecation (not
mortgage).
In the initial phases of economic development, banks are main means of resource mobilization in an
economy. On same lines, this is case currently with India. This is because majority people in such
economies are too risk averse. New firms in developing economies find it difficult to raise much
money through capital markets and consequently, they naturally go to banks for loans. As Indian
economy is expanding, capital markets are getting stronger year by year. This makes banking industry a
most important backbone of Indian economy.
Evolution of Banking Nationalization and Later Private Licenses
For the past three decades India s banking system has several outstanding achievements to its
credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or
cosmopolitans in India. In fact, Indian banking system has reached even to the remote corner s
of the country . This is one of the main reason of India s growth process.
The government s regular policy for Indian bank since 1969 has paid rich dividends with the
nationalization of 14 major private banks of India.
The first bank in India, though conservative, was established in 1786. From 1786 till today, the
journey of Indian Banking System can be segregated into three distinct phases. They are as
mentioned below:
1. Early phase from 1786 to 1969 of Indian Banks
2. Nationalization of Indian Banks and up to 1991 prior to Indian banking sector Reforms.
3. New phase of Indian Banking System with the advent of Indian Financial & Banking Sector
Reforms after 1991.
Phase I
The General Bank of India was set up in the year 1786. Next, Bank of Hindustan and Bengal
Bank. The East India Company established Bank of Bengal ( 1809) , Bank of Bombay ( 1840) and
Bank of Madras ( 1843) as independent units and called it Presidency Banks. These three
banks were amalgamated in 1920 and Imperial Bank of India was established which started as
private shareholders banks, mostly Europeans shareholders. This bank later became State Bank of
India.
In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab
National Bank Ltd. was set up in 1894 with headquarter s at Lahore. Between 1906 and 1913,

Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank
of Mysore were set up. Reserve Bank of India came in 1935 (it was first government company).
During the first phase the growth was very slow and banks also experienced per iodic failures
between 1913 and 1948. There were approximately 1100 banks, mostly small. To streamline
the functioning and activities of commercial banks, the Government of India came up with
The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949
as per amending Act of 1965. As per this, Reserve Bank of India was vested with extensive
powers for the supervision of banking in India as the Central Banking Authority.
During those days public has lesser confidence in the banks. As an aftermath deposit
mobilization was slow. Abreast of it the savings bank facility provided by the
Postal department was comparatively safer. Moreover, funds were largely given to traders.
Phase II
Government took major steps in this Indian Banking Sector Reform after independence. In 1955,
it nationalized Imperial Bank of India with extensive banking facilities on a large scale especially in
rural and semi- urban areas. It formed State Bank of India to act as the principal agent of
Reserve Bank of India and to handle banking transactions of the Union and State Governments all
over the country.
Seven banks forming subsidiary of State Bank of India was nationalized in 1959. A major
process of nationalization was carried out when in 1969 14 major commercial banks in the country
were nationalized.
Second phase of nationalization Indian Banking Sector Reform was carried out in 1980 with
seven more banks. This step brought 80% of the banking segment in India under Government
owner ship.
The following are the steps taken by the Government of India to Regulate Banking Institutions in the
Country:
1949: Enactment of Banking Regulation Act.
1955: Nationalization of State Bank of India.
1959: Nationalization of SBI subsidiaries.
1961: Insurance cover extended to deposits.
1969: Nationalization of 14 major banks.
1971: Creation of credit guarantee corporation.
1975: Creation of regional rural banks.
1980: Nationalization of seven banks with deposits over 200 crore.
Banking in the sunshine of Government ownership gave the public implicit faith and immense
confidence about the sustainability of these institutions.
Phase III
This phase has introduced many more products and facilities in the banking sector in its
reforms measure. In 1991, a Committee was set up which worked for the liberalization of banking

practices. Phone banking and net banking is introduced. The entire system became more convenient
and swift. Time is given more importance than money.
Banking and Agriculture
In the past, farming was carried out in a traditional way. It was a subsidence farming and was more or
less self-sufficient and Credit needs of the farmer were limited and were met with mostly by the
money lenders, relatives, friends and to some extend by Taccavi loans from Government.
Money lenders used to exploit the farmers in various ways like exorbitant rates of interest, false
documents, etc.
With government intervention, share of institutionalized credit in total farm credit has raised
substantially. However, it is said that after reforms of 1991, ratio institutionalized credit has gone down.
(Institutional credit is one which is borrowed by farmers from institutions that are monitored by
government agencies)
After independence and particularly after the Green Revolution, agriculture entered the era of
modernization and the credit needs of the farming community started increasing. In the present
day market oriented farming, the credit has become one of the crucial inputs.
A changing environment and government policies are forcing banks to lend more to the
agricultural sector . Both private and public banks are now involving themselves in a lot of
agri- based lending activities. Besides financing traditional activities, banks are also involved in
training and setting up consultancies, agri clinics, the export and marketing of agricultural produce,
etc.
Specialized loans ( like horticulture, aquaculture, animal husbandry, floriculture and sericulture
businesses) to meet specific needs of the farmer s are offered by the banks. The Farmers can
benefit from these loans by timely approach and prompt repayment.
Types of Banks
RBI classify banks as
Commercial Banks refer to both scheduled and non-scheduled commercial banks which are
regulated under Banking Regulation Act, 1949.
1. Scheduled Commercial Banks are grouped under following categories:
(Those banks which are included under second schedule of RBI act of 1934 and whose paid up capital
and funds collected are not less than Rs. 5 Lakh. Further, they must not involve themselves in any
activity which adversely affects interests of depositors.)
1. State Bank of India and its Associates
2. Other Nationalized Banks
3. Foreign Banks
Foreign banks can either open their branch in India, or they can open wholly owned subsidiary (WOS).
WOS is a company in which 100% shares are held by parent company. RBI as per current policy is
promoting WOS route. This is because of apprehensions of western financial crisis. Branch office
remains more dependent and under control of head office, whereas WOS enjoys much autonomy and is
to some extent more immune from any problems of parent company or home country.
In case of branch 75% FDI is allowed and in case of WOS 100% FDI is allowed. WOS also receives
near national treatment. They are allowed to open branches anywhere in India (except certain sensitive

areas)
There were concerns that too much reliance on foreign banks can compromise long term security and
sovereignty of India, to address these it is provided that capital and reserves in hand of foreign
companies shall not go beyond 20% of capital and reserves of national banking system.
4. Regional Rural Banks (RRB) RRBs were established in 1975 with a view to develop the rural economy and to create a
supplementary channel to the Cooperative Credit Structure with a view to enlarge institutional
credit for the rural and agriculture sector.
RRBs have to be sponsored by some Commercial Bank.
The Government of India, the concerned State Government and the bank, which had sponsored the
RRB contributed to the share capital of RRBs in the proportion of 50%, 15% and 35%, respectively.
The area of operation of the RRBs is limited to notify few districts in a State.
The RRBs mobilize deposits primarily from rural/semi-urban areas and provide loans and advances
mostly to small and marginal farmers, agricultural laborers, rural artisans and other segments of priority
sector.
5. Other Scheduled Commercial Banks (also known as Private Banks)
Some banks escaped nationalization derives of pre 1990s and they continued to operate as private
banks for eg. ING vyasya or Jammu & Kashmir Bank. After LPG reforms, new bank licenses were
granted in pursuance of Banking Law amended in 1993, this time very competitive banks such as
HDFC, ICICI, AXIS bank, kotak Mahindra etc.
In latest round in principle license is granted to IDFC and Bandhan bank.
The in-principle approval granted will be valid for a period of 18 months during which the applicants
have to comply with the requirements under the Guidelines and fulfil the other conditions as may be
stipulated by the RBI. On being satisfied that the applicants have complied with the requisite conditions
laid down by the RBI as part of in-principle approval, they would be considered for grant of a license
for commencement of banking business under Banking Regulation Act, 1949. Until a regular licence is
issued, the applicants would be barred from doing banking business.
(b) Non-Scheduled Commercial Banks
Banks not included under second schedule of RBI act 1934. These banks require maintaining statutory
cash reserve requirement. But they are not required to keep them with the RBI; they may keep these
balances with themselves. They are not entitled to borrow from the RBI for normal banking purposes,
though they may approach the RBI for accommodation under abnormal circumstances.
Cooperative Banks

A co-operative bank is a financial entity which belongs to its members, who are at the same time the
owners and the customers of their bank. This is western concept which came in In beginning of 1900s.
Initial capital of these banks is contributed by RBI, state and Central government in different rations.
Cooperative banks operate on principle of no profit and no loss. So they are instrumental in dismantling
hegemony of money lenders in rural finance.
Cooperative banks constituted about 80% of institutional credit in 1960s when nationalization drive
was yet to start. But after nationalization they face stiff competition from commercial banks and their
share has gone down substantially. Cooperative banks can scheduled or non-scheduled.
As initial investment comes from RBI and government, these banks suffer high degree of outside
interference. Cooperative banks in India are not cooperative in spirit. There is need to promote banks in
which ownership and management is actually in hand of people. This if supported by policy makes will
led to mushrooming of cooperative banks in far flung areas, purely on base of local demand and supply.
It is well known that our rural areas are generally self-sufficient, and it is intervention of outside
markets which results in distortions.
There are different types of cooperative banks such as Primary Agriculture Credit Societies (PACS),
State or centre land development banks (SLDB/CLDB) , Urban or rural Cooperative Banks
(UCB/RCB).
Rural cooperatives structure (under super vision of NABARD) is bifurcated into short-term and longterm structure. The short-term cooperative structure is a three-tier structure with State Cooperative
Banks (SCBs) at the apex (State) level, District Central Cooperative Banks (DCCBs) at the
intermediate (district) level and Primary Agricultural Credit Societies (PACS) at the ground (village)
level. The short term structure caters primarily to the various short / medium-term production and
marketing credit needs for agriculture.
Similarly, long-term cooperative structure has the State Cooperative Agriculture and Rural
Development Banks at the apex level and the Primary Cooperative Agriculture and Rural Development
Banks at the district or block level. These institutions were conceived with the objective of meeting
long-term credit needs in agriculture.
There are currently around 93000 cooperative banks, among them huge majority is of PACS. This
collectively forms backbone of rural banking system.
Post Offices as Financial Intermediary
India Post is undoubtedly oldest and largest organization in India involved in resource mobilization. It
has huge network of 1.55 lakh post offices, about 2.5 lakh dak sevaks (postmen) and 5 lakh employees .

Among these 90% are operating in rural areas. With advent of other modes of communication,
importance of India Post as foundation of Indian communication network has collapsed. But it remains
quite relevant for wide array of financial services it provides such as saving and other time deposit
accounts, Public provident fund, Monthly Investment schemes, National saving certificates. (But it
cant provide current accounts)
It comes to rescue government when banking system is not able to deliver cash benefits such as under
NREGA, Old age/Widow/disability Pension Schemes etc. In fact, India post applied for banking
licence this year, but RBI deferred application saying that India Post should separately consult
government (finance Ministry) for the purpose.
If it is granted banking licence, then 155 thousand branches will become bank branches and India post
will have to adhere to RBI guidelines on CRR, SLR, Priority Sector Lending, and Capital Adequacy
Ratio. Currently India Post only accept deposits, it cant lend. In order to be a bank organization will
need to be infused with magnificent sums of capital.
But given its deep penetration in rural India, there is strong case for its full-fledged foray into
banking.
It is said that organization holds around Rs 4 lakhs of Deposits and Rs 6 lakh saving certificates. But
these deposits get interest rate as low as 4%.
Role and functions of Reserve Bank of India
In 1926, Hilton-Young Commission recommended the creation of a central bank for India to separate
the control of currency and credit from the Government and to augment banking facilities throughout
the country. The Reserve Bank of India Act of 1934 established the Reserve Bank and set in motion a
series of actions culminating in the start of operations in 1935. Since then, the Reserve Banks role and
functions have undergone numerous changes, as the nature of the Indian economy and financial sector
changed.
The functions of the Reserve Bank today can be categorized as follows:
1. Monetary policy
The objectives of monetary policy in India have evolved to include maintaining price stability,
ensuring adequate flow of credit to productive sectors of the economy for supporting economic
growth, and achieving financial stability.
The Governor of the Reserve Bank announces the Monetary Policy in April every year for the financial
year that ends in the following March. This is followed by bi monthly policy reviews in which overall
macroeconomic stability is sought to be ensured by tinkering with means such as CRR, SLR, and MSF
etc.
Year 2014, saw major changes in monetary policy. Earlier there was review every 45 days, it was
increased to 60 days so that impact of changes in policy is clearly visible and need for further actions
could be properly gauged. Further, Urjit Patel Committee recommended use of Inflation targeting for
purpose of monetary policy, instead of previous multiple indicators regime. (More on this later) So
now RBIs monetary policy is solely based to target Inflation in the economy.
2. Regulation and supervision of the banking and non-banking financial institutions.
Traditionally, the Reserve Banks regulatory and supervisory policy initiatives are aimed at protection
of the depositors interests, orderly development and conduct of banking operations, and liquidity and

solvency of banks. Efficiency of RBIs regulation and supervision is attested by the fact that Indian
banking system almost remained untouched by recent global banking crisis.
3. Regulation of money, forex and government securities markets and also certain financial
derivatives. It interacts with other institutions like SEBI and FMC and some time comes into
conflict with them.
4. Banker, Debt and cash management for Central and State Governments
The Reserve Bank of India Act, 1934 requires the Central Government to entrust the Reserve Bank
with all its money, remittance, exchange and banking transactions in India and the management of its
public debt.
The Reserve Bank may also, by agreement, act as the banker to a State Government. Currently, the
Reserve Bank acts as banker to all the State Governments in India, except Jammu & Kashmir and
Sikkim. It has limited agreements for the management of the public debt of these two State
Governments.
(Other relevant things such as management of public debt etc. will be discussed in articles on fiscal
policy and Government budgeting)
5. Management of foreign exchange reserves
The Reserve Bank, as the custodian of the countrys foreign exchange reserves, is vested with the
responsibility of managing their investment. In recent years flow and volatility of forex reserves have
increased substantially and this has made RBI job to preserve real value of reserves highly
sophisticated.
Where our Forex reserves are invested? (its not at all kept in lockers)
The Reserve Bank of India Act permits the Reserve Bank to invest the reserves in the following types
of instruments:
Deposits with Bank for International Settlements and other central banks
Deposits with foreign commercial banks
Debt instruments representing sovereign or sovereign-guaranteed liability of not more than 10
years of residual maturity
Other instruments and institutions as approved by the Central Board of the Reserve Bank in
accordance with the provisions of the Act
Certain types of derivatives
The Reserve Banks approach to foreign exchange reserves management has also undergone a change.
Until the balance of payments crisis of 1991, Indias approach to foreign exchange reserves was
essentially aimed at maintaining an appropriate import cover. The committee stressed the need to
maintain sufficient reserves to meet all external payment obligations, ensure a reasonable level of
confidence in the international community about Indias capacity to honor its obligations, and counter
speculative tendencies in the market. After the introduction of system of market-determined exchange
rates in 1993, the objective of smoothening out the volatility in the exchange rates assumed importance.
It was in this backdrop that foreign Exchange Management act was repealing regulation act which was
much stringent.
6. Banker to banks - Banks are required to maintain a portion of their demand and time liabilities
as cash reserves with the Reserve Bank, thus necessitating a need for maintaining accounts with

the Bank. It also acts as banker of last resort.

For example, in yearly 2014 United Bank of India was in crisis, its non-performing assets were around
5% and its own capital was depleting. Then RBI intervened and Rs. 1000 Crore were infused in UBI
with certain conditions.
Apart from this RBI helps as following
Enabling smooth, swift and seamless clearing and settlement of inter-bank obligations.
Providing an efficient means of funds transfer for banks.
Enabling banks to maintain their accounts with the Reserve Bank for statutory reserve
requirements and maintenance of transaction balances.
Acting as a lender of last resort.
7. Oversight of the payment and settlement systems
Payment and settlement system is instrumental in settling interbank, customer, government and other
transactions in an economy. For this RBI has constantly modernized banking system by
computerization, online transfers, new Cheque truncation system and now mechanisms like Real time
gross settlement and NEFT etc. has made transfers much reliable and quicker.
8. Currency management
Management of currency is one of the core central banking functions of the Reserve Bank. Along
with the Government of India, the Reserve Bank is responsible for the design, production and overall
management of the nations currency, with the goal of ensuring an adequate supply of clean and
genuine notes.
The printing of Re.1 and Rs.2 denominations has been discontinued. However, notes in these
denominations issued earlier are still valid and in circulation. The Reserve Bank is also authorized to
issue notes in the denominations of five thousand rupees and ten thousand rupees or any other
denomination, but not exceeding ten thousand rupees.
Central government has exclusive right to mint all kinds of coins and Re 1 note. RBI can mint currency
of Re 2 note and above.
Note that only in currency printed by RBI there are words I promise to pay bearer. These are not
there in currency issued by CG. Former are signed by RBI governor and later by Finance Secretary.
Rules are governed by Coinage act of 2011. Also, as per this Central Government can authorize
production of upto Rs 1000 Coin.
To combat the incidence of forged notes, the Reserve Bank has taken certain measures like publicity
campaigns on security features of bank notes and display of Know Your Bank note poster at bank
branches including at offsite ATMs. The Reserve Bank, in consultation with the Government of India,
periodically reviews and upgrades the security features of the bank notes to deter counterfeiting. It also
shares information with various law enforcement agencies to address the issue of counterfeiting. It has
also issued detailed guidelines to banks and government treasury offices on how to detect and impound
counterfeit notes.
9. The Reserve Bank represents India in various international fora, such as, the Basel Committee
on Banking Supervision (BCBS) and the Financial Stability Board (FSB). Its presence on such
bodies has enabled the Reserve Banks active participation in the process of evolving global
standards for enhanced regulation and supervision of banks.

Apart from this RBI is licensing authority for private and foreign banks. It ensures corporate
governance in Banking Companies. It guards banks from market risks and guides banks to adopt low
risk approaches. Lastly, it has important development role of ensuring financial Inclusion.
Priority sector lending
Priority sector refers to those sectors of the economy which may not get timely and adequate credit in
the absence of this special dispensation. Typically, these are small value loans to farmers for agriculture
and allied activities, micro and small enterprises, poor people for housing, students for education and
other low income groups and weaker sections.
Priority Sector includes the following categories:
1.
2.
3.
4.
5.
6.

Agriculture
Micro and Small enterprises
Education
Housing
Export Credit
Others

Total target for banks is to lend 40% of their total lending to priority sector. Out of this 40, 18% should
be in agriculture and 10% to weaker sections. Read more
In 2014, Nachiket Mor committee recommended to increase this PSL ration to 50%. It should be noted
that PSL mandates lending to borrower who may not be otherwise credit worthy. This increases NPAs
and Bad debts of the banks. In turn banks will pass on these costs to other borrowers. This way it may
push up general rates of Interests. High rate of interest results in financial Exclusion instead, defeating
whole purpose of PSL which is Financial Inclusion.
Deposit Insurance and Credit Guarantee Corporation (DICGC)
As the name suggests it has two functions Deposit insurance when money is deposited in bank, theres always market risk (may be
negligible) that bank will not be able to repay deposit when due or when demanded. To instill
confidence in depositors about banking system it is imperative to insure their deposits. DICGC
maintains a Deposits Insurance Fund for the purpose. Interestingly, premium in these banks for
this insurance is given by banks and not by depositors. In this case DICGC is serving publics
(depositors) interest.
Credit Guarantee in this case DICGC aims to cover credit risk of bank. This implies that bank
is insured against Bad Debts or NPAs going into loss. For this it maintains a credit guarantee
fund
These functions initially were under two separate organizations but latter they both were merged. It is
wholly owned subsidiary of RBI.
All India Financial Institutions These are under full control and supervision of RBI
1. Exim Bank
2. National Bank for Agriculture and Rural Development (NABARD)
It has been accredited with matters concerning policy, planning and operations in the field of credit

for agriculture and other economic activities in rural areas in India. RBI sold its stake in NABARD to
the Government of India, which now holds 99% stake. NABARD is active in developing financial
inclusion policy and is a member of the Alliance for Financial Inclusion
3. National Housing Bank (NHB)
4. Small Industries Development Bank of India (SIDBI)
Non-Banking Finance Companies (NBFCs)
Non-banking Financial Companies play an important role in the financial system. An NBFC is defined
as a company engaged in the business of lending, investment in shares and securities, hire purchase,
chit fund, insurance or collection of monies. Depending upon the line of activity, NBFCs are
categorized into different types. Recognizing the growth in the sector, initially the regulatory set-up
primarily focused on the deposit taking activity in terms of limits and interest rate. These companies
cannot open current accounts and issue Cheque books.
Bhartiya Mahila Bank
Bharatiya Mahila Bank Ltd is the first of its kind in the Banking Industry in India formed with a vision
of economic empowerment for women. Bank received license from RBI on sept 2013
While the Bank focuses on the entire pyramid of Indian women, special attention is sought to be given
to economically neglected, deprived, discriminated, underbanked, unbanked, rural and urban women to
ensure inclusive and sustainable growth.
The Bank has designed many women centric products keeping in mind the core strengths of women so
as to enable them to unleash their hidden potentials, engage in economic activities and contribute to the
economic growth of the country. Most of the products are offered with a concession in the rate of
interest for women customers.
From seven branches in December 2013, the BMB is now looking to cross 80 this year with new ones
in Kochi, Dholpur and other places. It already has a presence in 23 states. The Bank is slowly emerging
as a chief option for women to get credit on easier terms than commercial banks. It lends money to
women who set up small businesses, beauty parlors, day care centers and home based initiatives and
customers get upto Rs one crore without a credit guarantee (mortgage or hypothecation). They only
have to take an insurance policy under the governments Credit Guarantee Fund Trust Scheme
(which is for MSMEs) and pay an annual premium. (So its collateral free credit is not insured by
DICGC, but by CGFTS)
As it is known that at time of independence there was very limited resource mobilization. Reason
obviously was lack proper specialized institutions. With continuous efforts of RBI and Finance
Ministry today there is highly sophisticated and specialized banking system. Here is evolution timeline
of various parts of this humungous system 1962: Deposit Insurance Corporation
1963: Agricultural Refinance Corporation
1964: Unit Trust of India
1964: Industrial Development Bank of India
1969: National Institute of Bank Management
1971: Credit Guarantee Corporation

1978: Deposit Insurance and Credit Guarantee Corporation (The DIC and CGC were merged and
renamed as DICGC)
1982: National Bank for Agriculture and Rural Development (It replaced the Agricultural Refinance
and Development Corporation)
1982: Export-Import Bank of India (EXIM)
1987: Indira Gandhi Institute of Development Research
1988: Discount and Finance House of India
1988: National Housing Bank
1990: Small Industries Development Bank of India
1994: Securities Trading Corporation of India
1995: Bharatiya Reserve Bank Note Mudran Private Limited
1996: Institute for Development & Research in Banking Technology
2001: Clearing Corporation of India Limited
2008: National Payments Corporation of India

Understanding Banking System Basel Norms

and Banking Stability
Introduction
Banking system is the backbone of any nations economy. For an economy to remain healthy and
going, it is important that the banking system grows fast and yet be stable.
This catches the biggest dilemma of policymakers. How to achieve both the objectives simultaneously?
Over a period of time, several indicators have been developed which gauge the depth and stability of
the banking system. Examples can be Non-performing assets, Capital adequacy ratio (CAR) etc.

Similarly, mechanisms to ensure their stability have also been developed. Some of the examples can be
CRR; SLR; Basel conventions; regular directions of the RBI; Financial Stability and Development
Council etc.
In this section, we will talk about some of these indicators and mechanisms. They have also been in
news for quite some time Basel III norms and Non-Performing assets (NPAs).
We will try to first clarify the related concepts; then understand the seriousness of the issue; gauge their
impact on the Indian economy and then offer some possible solutions as well as look into some of the
committees reports which have examined the matter.
In this article (Part-1 of a two part series), we will only deal with Basel norms. NPAs will be dealt with
comprehensively in the next article.

About Basel norms

Basel is a city in Switzerland which is also the headquarters of Bureau of International Settlement
(BIS). BIS fosters co-operation among central banks with a common goal of financial stability and
common standards of banking regulations. Currently there are 27 member nations in the committee.
Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called
the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which
mainly focuses on risks to banks and the financial system are called Basel accord.
The purpose of the accord is to ensure that financial institutions have enough capital on account to meet
obligations and absorb unexpected losses. India has accepted Basel accords for the banking system.
So, if the Basel norms are banking standards, then who has the authority to make them? Are they
mandatory for every country?
As said earlier, the Basel Committee makes these norms. The Committees decisions have no legal
force. Rather, the Committee formulates supervisory standards and guidelines and recommends
statements of best practice in the expectation that individual national authorities will implement them.
In this way, the Committee encourages convergence towards common standards and monitors their
implementation, but without attempting detailed harmonisation of member countries supervisory
approaches.
So, India can either accept them or reject them depending on the kind of financial system it wants. So
far, we have implemented or wished to implement all Basel norms.

Basel I
In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel
1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
Naturally if the capital with the banks is adequate to cover the risks ( e.g. a power plant) they have
invested in, then the bank is safe.
The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets
with different risk profiles. For example, an asset backed by collateral would carry lesser risks as
compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999. The
Basel norms are set up by the Basel committee on Banking supervision.

It is important to understand that the Basel accords have been the result of cooperation by the countries
over the years.
But why cooperate between member countries when banks operate within national boundaries?
It is because these banks lend not only to its country men but also other nations. Also, private investors
and sovereign nations take loans from banks across other nations. Further, the financial system of the
world is so interconnected that one incident of a banking collapse has its repercussions all over the
world. There can be no better example that the 2008 Global recession.
Therefore, global cooperation on banking matters is a absolute necessity in todays world. And, not
only cooperation but also adoption of some uniform standards is also important.
Again, Why uniform standards?
Bankers and investors invest over the world preferably in markets where they get best returns. The
markets will give returns only when the economy is stable. And, economy will be stable only when the
banking system is stable. Hence, it is important for investors and agencies to measure the stability of
the banking system. If all the nations adopt different standards, then calculating stability figures will be
a big headache for investors.
Also, suppose some nations run banks on better standards i.e. better risk management, better returns,
lower exposure to volatile markets etc., then they have a better chance of getting foreign investment.
But, if all nations adopt uniform standards, then at least the investors can be attracted by only the
strength of the economy.
Hence, it is important to have uniform standards especially when it comes to the banking system which
is so complex and vast.
The Basel norms try to achieve exactly the same. Till date three different Basel accords ( or norms)
have come each with a better safeguard than the next one.

Basel II
In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined
and reformed versions of Basel I accord. The guidelines were based on three parameters.
1. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets,
In India, such a practice is equivalent to maintaining a Capital Adequacy ratio (CAR).
2. Banks were needed to develop and use better risk management techniques in monitoring and
managing all the three types of risks that is credit and increased disclosure requirements.
Increased disclosure requirements raise the confidence of investors and depositors in the bank.
The more transparent a bank is, the more stable it is deemed to be.
3. Banks need to mandatorily disclose their risk exposure, etc to the central bank.
This is important so that the central bank (RBI in India) is aware of the risks that the banking
system is going through.

There is a practice in India to publish bi-annual Financial Stability reports by the RBI. The latest report
published recently is of June 2014.
Basel II norms in India and overseas are yet to be fully implemented.
You will find some technical words like risk exposure etc. in the text. We do not need to go into details.
We only need to know their general meaning.

Basel III
In 2010, Basel III guidelines were released. These guidelines were introduced in response to the
financial crisis of 2008.
A need was felt to further strengthen the system as banks in the developed economies were undercapitalized, over-leveraged and had a greater reliance on short-term funding. Too much short-term
funding makes the banks prone to risks. Banks generally rely on short-term funding because it is
profitable.
Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further
risk. This was because the banking system was growing. The world economy was growing too. Hence,
what is sufficient earlier was not sufficient now.
Basel III norms aim at making most banking activities such as their trading book activities more
capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four
vital banking parameters viz. capital, leverage, funding and liquidity.
Again we need not go in technicalities, just the broad picture.
This is how it was broadly done.
Capital
The capital requirement (as weighed for risky assets) for Banks was more than doubled. ( e.g. 4.5%
from 2% in Basel-II accord for common equity)
Leverage
Leverage basically means buying assets with borrowed money to multiply the gain. The underlying
belief is that the asset will return the investor more than the interest he has to pay on the loan.
Obviously doing so is risky business. Thus the Basel III puts a limit on the banks for doing this. The
numbers are not important here. Getting the concept is important.
Funding and liquidity
Banks can be subjected to a lot of risk if all depositors come and ask all their money at the same time.
This is a hypothetical situation but it has happened in real with Lehman Brothers the bank whose
collapse gave us the 2008 recession.
So, Basel III puts a requirement for the banks to maintain some liquid assets all the time. Liquid assets
are those which can be easily converted to cash.
In India, this practice can be correlated with that of maintaining CRR and SLR.

Implementation of Basel III norms in India

The RBI has postponed the implementation of these norms to 2019.
It is important to note that it is not easy to implement these norms as it requires several changes in the
present banking system.
There are several challenges in the successful implementation of Basel III norms.
1. Higher capital requirement for banks The private banks have the autonomy to raise
capital from the markets. But the Public sector banks have to rely on the government mostly.
The government has recently decided to infuse 12000 Cr. rupees in the PSBs. In the coming
years even more will be required.
2. More technology deployment Implementing the norms would require much more
sophisticated technology and management styles that the Indian banks are presently using.
Upgrading both will impose huge cost on the banks and hurt their profitability in the coming
years.
3.Liquidity crunch Banks would need to invest more on liquid assets. These assets do not
give handsome returns usually which would reduce the banks operating profit margin. Further
higher deployment of more funds in liquid assets may crowd out good private sector
investments and also affect economic growth.

The way ahead for the banks

To address these issues and to protect their profitability margins, banks need to look beyond regulatory
compliance and take proactive actions.
In this regard the following strategies need to be adopted:
1. Change in Business Mix They will need to lend more to profitable yet safe sectors. For
e.g. corporate loans. But even corporate loans in India have been under a lot of stress. Banks are
facing increasing NPAs (we will talk about it in the next article). Still they are safer and more
profitable than retail loans. Priority Sector lending (PSL) however limits their options.
2. Low-Cost Funding One of the most important factors to meet the new regulations is to
have a stable low-cost deposit base. For this, banks need to focus more on having business
correspondents/facilitators to reach customers as adding branches will increase costs and have
an impact on the profit margin.
The RBI is thinking of introducing UID based mobile wallets to increase the reach of the
financial system. Perhaps the banks can tie up with wallet operators based on some innovative
business model. There are many opportunities.
3. Improvement in systems and procedures - Refining the systems and procedures may help
banks economise their risk-weighted assets, which will help reduce capital requirements to
some extent. It is possible that they would impose cost in the short-run, but they would yield
great returns in the future.

Conclusion
It is clear that the banking system in the coming times will have to go through a lot of rough weather.
Increasing operational complexities, global interconnectedness and high economic growth worldwide
will present several challenges for the banks. While strategies like Basel III will of course address these
challenges, what is even more important is their proper implementation. More than this, the banks will
need to have a wider outlook. They must anticipate changes in the Indian economic system and react
accordingly. Indian banking regulations are one of the most stringent and consequently one of the safest
in the world. Let us evolve each time better and stronger.

Model questions
Prelims
1. Consider the following statements:
1. Basel norms are mandatory for every member nation.
2. India has not implemented Basel III norms till date.
Which of these is/are correct?
a) Only 1
b) Only 2
c) Both
d) None
Solution: b)
2. Consider the following statements key focus areas in the banking system:
1. Merger of banks
2. Regular disclosure of information to the Central bank
3. Investment in risky assets
Which of these areas are dealt with by the Basel III norms?
a) 1 and 2
b) 2 and 3
c) 1 and 3
d) All of the above
Solution: b)

Mains

1. The Indian banking system has been exposed to a lot of vulnerabilities in past few years due
to the global economic climate. Critically examine some of the important mechanisms
available to address these vulnerabilities in India. (300 words)
2. The Basel III norms present a much safer regulation of the banking system than Basel II,
yet it has not been implemented in India. Examine the key issues and challenges in their
implementation and offer some solutions to address the same. (300 words)

Banking System in India Non Performing

Assets
INTRODUCTION
In the last article on Understanding the banking system, we had
discussed the Basel norms.
We learnt what Basel norms are and why they hold such importance for the
Indian banking system. Then we understood the challenges the banks will
have to face in implementing them. Further, we suggested a possible way
out.
Previous discussion highlighted why stability in the banking system is
important. Following that discussion, in this article we will be discussing one
of the biggest challenges threatening the stability of the Indian banking
system the Non-Performing assets (NPAs).
The banking business has boomed since Independence, particularly after
the LPG reforms. The sector is currently valued at Rs 115 lakh crore and
expected to more than double at Rs 288 lakh crore by 2020. Out of this 70
per cent of business is being done by PSU banks. An interesting fact is that
SBIs market share out of total banking business is 22 per cent!
Looking at the enormous size of the banking industry, the NPAs are a big
cause of concern.
We will first look at some of the basics of NPAs; then move on to understand
their causes and implications; then examine the challenges that the banks
will face because of them; and finally put forward possible solutions.
The discussion will also cover the social agenda behind the banking and
whether it is unviable for the Indian banks.

WHAT ARE NPAS?

Generally speaking, NPA is any asset of a bank which is not producing any
income.
In other words, a loan or lease that is not meeting its stated principal and
interest payments.
On a banks balance sheet, loans made to customers are listed as assets.
The biggest risk to a bank is when customers who take out loans stop

making their payments, causing the value of the loan assets to decline.
Criteria
Loans dont go bad right away. Most loans allow customers a certain grace
period. Then they are marked overdue. After a certain number of days, the
loan is classified as a nonperforming loan.
Banks usually classify as nonperforming assets any commercial loans which
are more than 90 days overdue and any consumer loans which are more
than 180 days overdue.
For agricultural loans, if the interest and/or the installment or principal
remains overdue for two harvest seasons; it is declared as NPAs. But, this
period should not exceed two years. After two years any unpaid
loan/installment will be classified as NPA.

Categories
1. Sub-standard: When the NPAs have aged <= 12 months.
2. Doubtful: When the NPAs have aged > 12 months.
3. Loss assets: When the bank or its auditors have identified the loss, but it
has not been written off.
After a certain amount of time, a bank will try to recoup its money by
foreclosing on the property that secures the loan. The way money is
recouped is a highly contentious issue not just with banks but also with
Micro-Finance Institutions (MFIs). We will discuss it later in the article.
All of this can be explained in a much more technical manner, but that is
not required here. For example, we do not need to list all the conditions that
make the banks declare an asset as NPAs like In respect of derivative
transactions, the overdue receivables representing positive mark-to-market value
of a derivative contract, if these remain unpaid for a period of 90 days from the
specified due date for payment.

Only understanding the basic concepts will suffice. UPSC is not going to ask
you these details, but about the impact and solutions of NPAs. Even in
prelims, these details will not be asked. So we avoid technicalities and
jargons here. It is not useful for a GS paper, even if some of it may be useful
for Economics optional paper.

EXTENT OF NPAs
Gross NPAs of domestic banks jumped to 4.2 % of total lending by the end
of September 2013 from 3.6 % six months before, according to the Reserve
Bank of India (RBI).
As per a recent warning by the RBI, bad loans (NPAs) could climb to 7% of
total advances by 2015.
In absolute terms, gross NPAs are estimated to touch Rs 2.50 lakh crores by
the end of March this year. This is equal to the size of the budget of Uttar
Pradesh. The biggest chunk of the soured debts is with state-run banks
(Public sector banks or PSBs), which account for two-thirds of loans but 80
% of the bad assets.
This is how the NPA curve has been moving in the recent years, as per a
news report in the Business Standard:

Private-sector and foreign lenders are better placed. Their NPAs in

proportion of their lending is lesser than that of the PSBs.

WHY IT MATTERS?
The higher is the amount of non-performing assets (NPAs), the weaker will
be the banks revenue stream.
In the short-term, many banks have the ability to handle an increase in
nonperforming assets they might have strong reserves or
other capital that can be used to offset the losses. But after a while, if that
capital is used up, nonperforming loans will imperil a banks health. Think of
nonperforming assets as dead weight on the balance sheet.
Here is the impact of the NPAs:
As the NPA of the banks will rise, it will bring a scarcity of funds in the
Indian security markets. Few banks will be willing to lend if they are
not sure of the recovery of their money.
The shareholders of the banks will lose a lot of money as banks
themselves will find it tough to survive in the market.
This will lead to a crisis of confidence in the market. The price of loans,
i.e. the interest rates will shoot up badly. Shooting of interest rates will
directly impact the investors who wish to take loans for setting up
infrastructural, industrial projects etc.
It will also impact the retail consumers like us, who will have to shell
out a higher interest rate for a loan.

 All of this will lead to a situation of low off take of funds from the
security market. This will hurt the overall demand in the Indian
economy. And, finally it will lead to lower growth rates and of course
higher inflation because of the higher cost of capital.
This trend may continue in a vicious circle and deepen the crisis.
Total NPAs have touched figures close to the size of UP budget.
Imagine if all the NPA was recovered, how well it can augur for the
Indian economy.
RBI governor Raghuram Rajan has recently said that NPAs must be
curbed before the problem becomes alarming.

WHY SUCH A SITUATION?

The rising incidence of NPAs has been generally attributed to the domestic
economic slowdown. It is believed that with economic growth slowing down
and rate of interest going up sharply, corporates have been finding it
difficult to repay loans, and it has added up to rising NPAs. Even finance
minister P Chidambaram stated that bad loans are a function of the
economy and hence, having bad loans during distressed times is very
natural.
However, The NPA mess is not entirely because of the reversal of economic
cycles.
Here we look at the other reasons behind this mess. Basically the whole
problem can be divided into two parts External problems and internal
problems as faced by the banks.
External Factors
Reasons related to the corporate sector
1. Apart from the slowdown in India, the global economy has also slowed
down.
This has adversely impacted the corporate sector in India. Continuing
uncertainty in the global markets has lead to lower exports of various
products like textiles, engineering goods, leather, gems etc. It can be
noted that imports and exports combined equal to around 40% of
Indias GDP!
A hurt corporate sector is finding it difficult to pay loans
2. The ban in mining projects, delay in environmental related permits
affecting power, iron and steel sector, volatility in prices of raw
material and the shortage in availability of power have all impacted

the performance of the corporate sector. This has affected their ability
to pay back loans.
Other sectors
Banks in India are highly regulated. Priority sector lending (PSL) is one
of these regulations which require the banks to give a certain % of
their loans to certain sections of society. These are farmers, SCs, STs,
IT parks, MSMEs etc.
Naturally one would assume that the weaker sections covered under
PSL are the ones to be blamed for the situation. However, it is not the
case.
As per recent news reports, the Standing Committee on Finance will
be now examining the reasons for high NPAS in PSBs.
The data, shared with the Standing Committee, shows that NPAs in the
corporate sector are far higher than those in the priority or agriculture
sector.
Within the priority sector, incremental NPAs were more in respect to
micro small and medium enterprises followed by agriculture.
However, even the PSL sector has contributed substantially to the NPAs.
As per the latest estimates by the SBI, education loans constitute 20%
of its NPAs!
The sluggish legal system (Judiciary in India) and lack of
systematic and constant efforts by the banks make it difficult to
recover these loans from both corporate and non-corporate.
Internal Factors
1. Indiscriminate lending by some state-owned banks during the high
growth period (2004-08) is one of the main reasons for the deterioration
in asset quality.
2. Bankers say there is a lack of rigour in loan appraisal systems and
monitoring of warning signals at state-run banks. This is particularly true
in case of infrastructure projects, many of which are struggling to repay
loans. Besides, these projects go on for 20 to 30 years.

3. Poor recovery and use of coercive techniques by banks in recovering

loans
4. The wait and watch approach of banks have been often blamed as the
reason for rising NPAs as banks allow deteriorating asset class to go from
bad to worse in the hope of revival and often offer restructuring option to
corporates.
A Parliamentary panel, examining increasing incidents of NPAs, has
observed that state-owned banks should stop ever-greening or
repeated restructuring of corporate debt to check the constant bulging
of their non-performing assets. Members of the panel were of the view
that NPAs are the result of bad economic situation, but there were also
management issue of every-greening of loans, which could be avoided
by not renewing loans, particularly of corporate.
Therefore, it can be clearly seen that it is only the economic slowdown that
is behind the NPAs. There are a whole range of factors.

WAY OUT
The simplest approach to cut down NPAs is to recover the bad loans.
Apart from the regular guidelines released by the RBI, to strengthen further
the recovery of dues by banks and financial institutions, Government of
India promulgated:
1.The Recovery of Debts Due to Banks and Financial Institutions
Act, 1993
2. The Securitization Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002.
So, how can the banks legally recover their loans?
(i)
The Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002 The Act
empowers Banks / Financial Institutions to recover their non-performing
assets without the intervention of the Court, through acquiring and
disposing of the secured assets in NPA accounts with outstanding amount of
Rs. 1 lakh and above. The banks have to first issue a notice. Then, on the
borrowers failure to repay, they can:
Take possession of security and/or

 Take over the management of the borrowing concern.

Appoint a person to manage the concern.
(ii) Recovery of Debts Due to Banks and Financial Institutions (DRT)
Act: The Act provides setting up of Debt Recovery Tribunals
(DRTs) and Debt
Recovery
Appellate
Tribunals (DRATs) for
expeditious and exclusive disposal of suits filed by banks / FIs for recovery
of their dues in NPA accounts with outstanding amount of Rs. 10 lac and
above. Government has, so far, set up 33 DRTs and 5 DRATs all over the
country.
(iii) Lok Adalats: Section 89 of the Civil Procedure Code provides
resolution of disputes through ADR methods such as Arbitration,
Conciliation, Lok Adalats and Mediation. Lok Adalat mechanism offers
expeditious, in-expensive and mutually acceptable way of settlement of
disputes.
Government has advised the public sector banks to utilize this mechanism
to its fullest potential for recovery in Non-performing Assets (NPAs) cases.
Among the various channels of recovery available to banks for dealing with
bad loans, the SARFAESI Act and the Debt Recovery Tribunals (DRTs) have
been the most effective in terms of amount recovered.
The recent controversy surrounding loan recovery in India Views
of the SC
Banks have been alleged to engage in coercive practices to recover the loans.
Recently, there have been some judicial pronouncements by the apex court
determining the scope of powers of enforcement of securities without the
intervention of the courts, by the banks and FIs under the SARFAESI Act. The apex
court has reiterated the need to protect the interest of borrowers, and
emphasized that the exercise of extraordinary powers of recovery, by banks and
FIs must be in compliance with the provisions of the SARFAESI Act.
As per the Supreme Court (SC) Liquidity of finances and flow of money is
essential for any healthy and growth oriented economy. But certainly, what
must be kept in mind is that the law should not be in derogation of the rights
which are guaranteed to the people under the Constitution. The procedure
should also be fair, reasonable and valid, though it may vary looking to the
different situations needed to be tackled and object sought to be achieved.

But, these are steps which cure the disease of NPAs. The issue of NPAs
needs to be tackled at the level of prevention rather than cure.
Therefore, the steps that can prevent the piling up of NPAs are as follows:
1. Conservatism:
Banks need to be more conservative in granting loans to sectors that
have traditionally found to be contributors in NPAs. Infrastructure
sector is one such example. NPAs rise predominantly because of long
gestation period of the projects. Therefore, the infrastructure sector,
instead of getting loans from the banks can be funded from
Infrastructure Debt Funds (IDFs) or other specialized funds for
infrastructural development in the country.
2. Improving processes:
The credit sanctioning process of banks needs to go much more
beyond the traditional analysis of financial statements and analyzing
the history of promoters. For example, banks rely more on the
information given by credit bureaus. However, it is often noticed that
several defaults by some corporate are not registered in their credit
history.
3. Relying less on restructuring the loans:
Instead of sitting and waiting for a loan to turn to a bad loan, and then
restructure it, the banks may officially start to work to recover such a
loan. This will obviate the need to restructure a loan and several
issues associated with it. One estimate says that by 2013 there will be
Rs 2 trillion worth of restructured loans.
4. Expanding and diversifying consumer base by Innovative
business models:
Contrary to popular perceptions,the NPA in non-corporate sector is
less than that in the corporate sector. Hence, there is a need to reach
out to people in remote areas lacking connectivity and accessibility.
More and more poor people in rural pockets should be brought under
the banking system by adopting new technologies and electronic
means. Innovative business models will play a crucial role here.
Otherwise, the NPAs may increase instead of decreasing.
As said by the new M.D. of SBI, Mr. Viswanathan proposed ideas such
as a single demat account for all investments and credit cards for

school students (above class 8th) to make them aware with the
banking system.

CONCLUSION
Looking at the giant size of the banking industry, there can be hardly any
doubt that the menace of NPAs needs to be curbed. It poses a big threat to
the macro-economic stability of the Indian economy. An analysis of the
present situation brings us to the point that the problem is multi-faceted
and has roots in economic slowdown; deteriorating business climate in
India; shortages in the legal system; and the operational shortcoming of the
banks. Therefore, it has to be dealt at multiple levels. The government cant
be expected to rescue the state-run banks with tax-payers money every
time they fall into a crisis. But, the kind of attention with which this problem
has been received by policymakers and bankers alike is a big ray of hope.
Right steps, timely and concerted actions and a revival of the Indian
economy will put a lid on NPAs. Prevention, however, has to become a
priority than mere cure.

MODEL QUESTIONS
Mains
1. In your view, what can be the possible reasons behind the increasingly
high NPAs of the Indian banks? How far can this be attributed to the
conditions prevailing in the Indian and global economy? (300 words)
2. Explain how high NPAs can be damaging to the Indian economy. (200
words)
3. How far can financial inclusion help in containing the high level of NPAs
of banks in India? Substantiate your views with two examples. (200
words)
4. What are the legal mechanisms that can be used to contain the NPAs?
Bring out clearly the role of each actor the RBI, the Government of India,
and the banks in achieving lower NPAs through legal mechanisms. (300
words)
5. The Infrastructural projects are faced with several problems especially
related to financing of the projects by commercial banks. Examine the
bottlenecks in the present system of financing. What can be done to
address these issues? (200 words)
6. Despite having a much larger share in the Banking market, the stateowned banks have not performed well financially. Critically examine. Can
the problem be resolved by de-nationalizing the poorly performing banks?

(300 words)