History of Banking—its Evolution and Development

History of Banking—its Evolution and Development
ROLE OF BANKS IN INDIAN ECONOMY - SALIENT FEATURES
Banks play a crucial role in the economic development of any country. Many developed

countries such as Japan, Germany etc. owe their growth and development to strong financial
system including banking system. In most of the growing economies including India strong
healthy banks are pivotal to development. In countries with growing economies like India,
banks are important from four angles. These are:
One, banks help in developing other financial intermediaries and markets as per the need
of the country.
Two, help the corporate sector to meet its money needs because of less developed equity
and bond markets.
Third, banks help mobilize the savings of large number of savers, which look for assured
income and liquidity and safety of funds, and
Lastly, Banks also provide financial stability in the economy.
HOW BANKS HAVE CHANGED OVER YEARS?
Banking has changed with the needs of the economy over the years and evolved as a strong
instrument of development. The various phases of changes that have made banks an instrument
of development are given below:
1. Countries world over have been divided into two major groups viz. “underdeveloped”
(backward) and “developed” (advanced) countries.
FYP defined “underdeveloped” economy as one where the economy has not been able to
unutilize the given/available resources or have underutilized the resources like natural
resources, manpower resources etc. “Developed” economy on the other hand means
where full or large utilization of such resources have taken place for the growth and
development of the economy. Underdeveloped or growing economies like India, are
also characterized by nature of occupational pattern which in India is mainly agriculture,
and the population is largely “agrarian population”.
Reason for non-utilization of resources could be:
• non-availability of technology;
• prevailing socio-economic factors that may hinder the use of available resources etc.
Under-developed economies are normally characterized by “poverty”.
2. Agriculture largely remains labour intensive in India. Most farmers as well as labourers
live at subsistence level or even below subsistence level. In order to increase agricultural
production, investment in agriculture is necessary which will generate surplus to form
capital base of the farmers.
At present majority of farmers and farm labourers are unable to save anything because
of poor to low surplus. Poor Capital level results in low to even no reinvestment in the
business which may lead to poor standard of living. Addition in population is also one
of the many major causes of poor savings and poor standard of living.
3. Common basis for comparing underdeveloped economies and developed economies has
been per capita income. India’s per capita income as compared to many developed and
even underdeveloped countries has been low.
4. Capital–Output ratio is also a determinant of economic development. It means number
of units of capital required to produce one unit of output. In other words, this term refers to the
productivity of capital in various economic sectors at a point of time.
5. In order to reduce the economic disparity, it is necessary to increase capital–out ratio and
improve public savings. For this, investment level is required to increase. For investments
to increase there is need for generating surpluses and savings. To avoid diversification of
savings there is need to mobilize public or community savings. Purpose of mobilization
of savings are:
(i) to help improve production through reinvestment thus improving capital output
ratio and,
(ii) to channelise the idle funds from the public into the productive channels.
STEPS TAKEN TO MOBILIZE RESOURCES
6. In order to mobilize public savings, Government initiated many steps through Five Year
Plans.
(i) Taxation is first measure.
(ii) Other measures to mobilize monies from the people by spreading of banking facilities
in the needed areas.
(iii) Other steps included encouraging surplus of public sector enterprises, and
(iv) mobilization of internal and external loans/deposits.
7. Public sector and other organizations like Banks and private organizations became major
source of mobilizing small savings of the people from all sectors of the economy as well
as from every corner of the country.
8. There may not always be dearth of savings in the rural areas but it may be failure of
deposit mobilization efforts which allow the savings being put into unproductive channels.
Government found enough scope of deposit mobilization, both in the rural and non-rural
areas and took decisions to create infrastructure for collecting savings.
9. As a step towards such mopping up of savings, banking industry took the initiative to
open up new banks and branches all over the country.
HISTORY AND EVOLUTION STAGES OF BANKING - HIGHLIGHTS
For reaching the modern day banking business, banking industry has to pass through various
stages of evolution and development. The stages are briefly discussed below:
Stage-1 Indigenous Banks
• Business of banking has been reported origin in Vedic period. Records show giving and
receiving of credits during that period.
• Indigenous money lenders were known as Seths or Shahs existed during that period and
ran lucrative business in money lending.
• Discounting of bills was common in those times.
• Hundi (traditional bills) system was in vogue during that time.
• During 17th century, a foreign traveller quoted the existence of money changer in India
known as Shroffs.
• Moghul period also refers to Jagat Seth called Manak Chand. Lord Clive also mentioned
about him around 1859.
Defects of Indigenous Banking
Certain shortcomings were observed in the indigenous banking in India vis-à-vis the
requirement of trade and commerce. Some important shortcomings that existed at that time
are listed below:
(i) Indigenous banking is unorganized and does not sensitize the need and working of the
different sectors of the economy, including banking sector.
(ii) They only do business for trade and commerce and work on commission basis resulting
into trade risk in their financial business.
(iii) They did not distinguish between short term and long term finance purposes.
(iv) Methods of accounting was based on local practices and hence could not match with
modern methods of financial accounting.
(v) Many of the indigenous bankers charged very high rate of interest.
Stage-2 Opening of Presidency Banks
(a) Bank of Hindustan established in 1770 was founded by M/s Alexander & Co., an English
agency in Calcutta.
(b) First Presidency Bank namely Bank of Calcutta came up in 1806 in Calcutta in collaboration
with Government of Bengal and East India Company. Total capital was Rs.50 lakh of which
Rs.10 lakh was share of East India Company.
(c) However, in 1809, Bank of Calcutta was renamed as Bank of Bengal.
(d) Bank of Bombay, as second Presidency Bank was established in 1840 in the then Bombay
(now Mumbai).
(e) Third Presidency bank came up in Madras (now Chennai) in the year 1843.
In 1860, concept of limited liability was introduced in India leading to the establishment
of Joint Stock Banks.
All banks in India are registered under the Indian Companies Act as Joint Stock Company.
MODERN BANKING - ADVENT AND DEVELOPMENT
The commercial banking industry in India started in 1786 with the establishment of the
Bank of Bengal in Calcutta.
It was only with the establishment of Reserve Bank of India (RBI) as the central bank of the
country in 1935 under the Reserve Bank of India Act (1934) that the quasi-central banking role
of the Imperial Bank of India came to an end.
In 1865, the Allahabad Bank was established with Indian shareholders.
Punjab National Bank came into being in 1895 by purely Indian nationalist people like Lala
Lajpat Rai, Babu Purshotam Lal Tandon, S.Dayal Singh and others.
Between 1906 and 1913, other banks like Bank of India, Central Bank of India, Bank of
Baroda, Canara Bank, Indian Bank, Bank of Mysore etc. were set up.
• The brand ambassador of bank of Baroda is Rahul Dravid.
• The branding line of Bank of Baroda is ‘India’s International Bank’.
• The logo of Bank of Baroda is known as ‘Baroda Sun’.
In 1921, the three Presidency banks were amalgamated to form the Imperial Bank of India,
which took up following roles:
(i) role of a commercial bank,
(ii) a bankers’ bank, and
(iii) a banker to the Government. (quasi central banking role)
The Imperial Bank of India was established with mainly European shareholders.
Reserve Bank of India was established in 1935 under RBI Act (1934)
After independence, the Government of India started taking steps to encourage the spread
of banking in India that led to the stage -3 of banking development in India.
Stage-3 Banking in Post Independence Period
After independence, in order to serve the economy better, the All India Rural Credit Survey
Committee was set up by RBI. This Committee recommended that Imperial Bank of India be
taken over and with it are merged / integrated former state-owned and state-associate banks.
Accordingly, State Bank of India (SBI) was constituted in 1955 under the State Bank of India
Act (1955). Subsequently in 1959, the State Bank of India (subsidiary bank) Act was passed,
enabling the SBI to take over five major former state-associate banks as its subsidiaries. These
were State Bank of Patiala; State Bank of Hyderabad; State Bank of Travancore; State Bank of
Bikaner & Jaipur and State Bank of Mysore.
After creating a subsidiary of SBI, arrangement made was that 55 per cent of the capital will
be owned by the SBI and rest 45 per cent remains with old shareholders.
However, this arrangement also saw some weaknesses like reduced bank profitability,
weak capital base, and banks getting / burdened with large amounts of bad loans (un-
recovered loans).
Commercial banks in India have traditionally focused on meeting the short-term financial
needs of industry, trade and agriculture but long term financial needs were left for other agencies
or government to meet. There was no coordination between commercial banks and long term
lending organizations. Hence when one was available the other was not available.
• As such with the growing need for long term funds for financing industrial projects
Government established Industrial Development Bank of India (IDBI) in 1964 to help
industrial sector with long term financial resources to boost industrial growth.
ADVENT OF MODERN BANKING - STAGES OF DEVELOPMENT
• Present day banking is the result of continuous research and development in the field of
financial and economic aspects of Indian banking system.
• After independence of the country, today’s banking has passed through various stages
of development. Banking was held to be a strong institution to respond to the growing
financial needs of various sectors of the economy. Many policy decisions, amendments in laws, new enactments etc. were initiated to make banking industry respond to growing
financial requirements of different sectors of the economy.
Broadly, four stages could be identified that Indian banking has passed through or is passing
through after independence. These are as follows:
Stage-1 Period covering 1948 onwards till late sixties (say 1969), identifies with the
foundation stage. During this period government ensured the enactment of
necessary legal / legislative framework for consolidating and reorganization
of the banking system. Banking during this period was cautious, selective
and securitized. Loans were advanced against tangible securities only i.e.
to persons who were able to offer good securities and deposits to the bank.
Banks overlooked the importance of project (purpose), person (borrower) and
repayment capacity.
• In order to overcome above difficulties and others, social control on banks was initiated
in 1968 on the recommendations of the National Credit Council in 1967. (Gadgil Study
Group, established by RBI).
SOCIAL CONTROL AND NATIONALIZATION OF BANKS – NEED AND OBJECTIVE
Factors that led to the decision to nationalize commercial banks were:
1. Ownership and control in few hands.
2. Concentration of wealth and power by few big industrial houses who used the bank
funds to build their own empires.
3. Failure of banks to mobilize resources from small towns and villages by not opening
branches in small towns and villages
4. Misutilization of resources and powers by some vested interests. In other words money
mobilized by banks was not being used for the economic benefit or development.
5. Discrimination against small business units.
6. Needs of the agriculture sector of the economy was neglected by banks by ignoring small
farmers taking the plea that it is risky sector.
7. Misuse of funds by banks. Some banks were financing anti-social elements who in order
to get large profits created shortages of essential commodities, thus affecting the general
public at large.
8. Banks failed to follow the objectives of the five year plan policies and framework wherein
priority sectors of the economy were given priority. Private control of the banks led to
various development obstacles to the achievement of the plan objectives.
NATIONALIZATION OF BANKS
To make banking system align itself to the needs of economy and policies of the
Government, on July 19, 1969 fourteen (14) of the major private sector banks were
nationalized as a part of social control over banks. This was an important milestone in
the history of Indian banking. This was followed by the nationalization of another six
private banks in 1980.
• The 14 banks were nationalized under the Banking Companies (Acquisition and Transfer
of Undertakings) Act, 1970. Criterion for selection of these banks was that those which
had deposit of Rupees 50 crores and above as on the date of Ordinance issued on 19th
July, 1969. These banks were:
1. Allahabad Bank 2. Bank of Baroda
3. Bank of India 4. Central Bank of India
5. Dena bank 6. Canara Bank
7. Indian Overseas Bank 8. Bank of Maharashtra
9. Punjab National Bank 10. United Bank of India
11. Union Bank of India 12. Syndicate Bank
13. Indian Bank 14. United Commercial Bank
This process was followed again in 1980 when another lot of six banks were nationalized
under Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980. Banks
nationalized in second stage were:
1. Punjab & Sind Bank
2. Oriental Bank of Commerce
3. New bank of India (now merged with Punjab National Bank)
4. Vijay Bank
5. Andhra Bank
6. Corporation Bank
With the nationalization of these banks, the major segment of the banking sector came under
the control of the Government. The nationalization of banks imparted major impetus to branch
expansion in un-banked, rural and semi-urban areas, which in turn resulted in huge deposit
mobilization, thereby giving boost to the overall savings rate of the economy. It also resulted
in scaling up of lending to agriculture and its allied sectors.
In 1975 five Regional Rural banks were established on 2.10.1975 through an Ordinance. The
ordinance was replaced by Regional Rural Banks Act, 1976, with the main objective to extend
banking facilities to the un-banked rural areas along with commercial banks and cooperative
banks.
Stage-2 Expansion Stage
This stages / phase covers the period from late sixties (1969 to mid eighties). There was
rapid expansion, both vertical and horizontal i.e. geographical spread as well as administrative
spread. There was effort to fulfill nationalization objectives of expansion.
There was re-orientation of credit flow policy during this period so as to benefit the neglected
sectors of the economy, like agriculture, small scale industries and small borrowers.
Stage-3 Consolidation Phase
This phase started from early eighties to start nineties when rapid expansion of banks
faced with certain serious problems of control and economic viability of certain branches, more
particularly rural branches. This phase also saw the problem of manpower, their training and
positioning of branches. Branch expansion was slowed down during this period and banks
started addressing the gaps that occurred during period. Staff productivity, recovery of advances,
profitability etc. were some major problems.
Stage-4 Banking Reform Phase
To create a strong and competitive banking system, a number of reform measures were
initiated in 1991. The thrust of the reforms was on increasing operational efficiency, strengthening
supervision over banks, creating competitive conditions and developing technological and
institutional infrastructure. These measures led to the improvement in the financial health,
soundness and efficiency of the banking system.
One important feature of the reforms of the 1990s was the permission to open new private
sector banks. Following this decision, new banks such as ICICI Bank, HDFC Bank, IDBI Bank,Development Credit Bank (DCB), Kotak Mahindra Bank, InduSind Bank, Yes Bank and UTI
Bank (now Axis bank) were set up.
From 1991 onwards till today, banking industry has seen the reforms in terms of their
management and business policies. The main aim of reforms is to create a vibrant financial sector
that is efficient, competitive and responsive to the needs of the economy and the people at large.
(a) Main focus of the reforms was:
(b) Strengthening of financial institutions, and integration of domestic financial system with
global system of banking and economic system.
Policies were made in such a way that it could provide banks with:-
(a) greater flexibility in banking operations
(b) greater accountability to shareholders, and
(c) greater control over bank functions, and
(d) safety through prudential norms and supervision.
Based on the happenings in the domestic and international market, Indian banking system
is gearing up for meeting new challenges like:
(i) Banks entering into greater specialized business like retail, housing, personal sector,
corporate sector etc.
(ii) Banks have to look for more non-fund based business (NFB), like advisory services.
merchant banking advisory services, guarantee business, consultancy business services
etc.
(iii) Creating a strong image of the organization (brand image); customer delight and excellence
etc.
(iv) The concept of Universal Banking is catching up fast. (Universal bank means where a bank takes up both the functions of long term lending development financial institutions
as well as that of commercial banks. In other words a universal bank lends both short
term (working capital) as well as term loan (long tern finance).
• Export-Import Bank (Exim Bank) was established in 1982 (1.1.1982) to help entrepreneurs
financially, in terms of long term and short term funds, to increase exports and to act as
a controller of the business of the export and import.
• Then came the National Bank for Agriculture & Rural Development (NABARD) in 1984
on the recommendation of Committee to Review Arrangements for Institutional Credit
for Agriculture and Rural Development (CRAFICARD). NABARD was set up under the
Parliament Act 61 of 1981.
FINANCE COMMISSION AND ITS ROLE
The Finance Commission was established in 1951 to look into the following aspects:
• To suggest as to how the revenues earned by the government through taxes etc. at centre
could be shared between the States and the Centre.
• Finance Commission is set up under Articles 280 of the Constitution of India.
• Since 1951, 13 Finance Commissions have been set up. The Fourteenth Finance Commission has been set up under the Chairmanship of ex-Governor of Reserve Bank of India, Y V Reddy. Thirteenth Finance Commission was headed by Finance Secretary Vijay Kelkar.
The first Finance Commission was constituted in 1951 and was headed by K C Neogy.
• Period of Commission is five years.
• Finance Commission has four other members. Finance Commission is appointed by the
President of India.
• Main focus of the Finance Commission is to reduce the imbalances between taxation
fixation and expenditure controls of the Centre and the States respectively.
• Presently the 13th Finance Commission has recommended that States share from the
Central Revenue should be 32 per cent.

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