Role of Banks in Development of Economy

ROLE OF BANKS IN DEVELOPMENT OF ECONOMY-
A saIe and sound Iinancial sector is a prerequisite Ior sustained growth oI any economy.
Globalization, deregulation and advances in inIormation technology in recent years have brought
about signiIicant changes in the operating environment Ior banks and other Iinancial institutions.
These institutions are Iaced with increased competitive pressures and changing customer
demands. These, in turn, have engendered a rapid increase in product innovations and changes in
business strategies. While these developments have enabled improvement in the eIIiciency oI
Iinancial institutions, they have also posed some serious risks.
Banks play a very useIul and dynamic role in the economic liIe oI every modern state. A study oI
the economic history oI western country shows that without the evolution oI commercial banks
in the 18th and 19th centuries, the industrial revolution would not have taken place in Europe.
The economic importance oI commercial banks to developing countries may be viewed thus:
Promoting capital Iormation
Encouraging innovation
Monestation
InIluence economic activity
Facilitator oI monetary policy
Above all view we can see in brieIly, which are given below:

PROMOTING CAPITAL FORMATION
A developing economy needs a high rate oI capital Iormation to accelerate the tempo oI
economic development, but the rate oI capital Iormation depends upon the rate oI saving.
UnIortunately, in underdeveloped countries, saving is very low. Banks aIIord Iacilities Ior saving
and, thus encourage the habits oI thriIt and industry in the community. They mobilize the ideal
and dormant capital oI the country and make it available Ior productive purposes.
ENCOURAGING INNOVATION
Innovation is another Iactor responsible Ior economic development. The entrepreneur in
innovation is largely dependent on the manner in which bank credit is allocated and utilized in
the process oI economic growth. Bank credit enables entrepreneurs to innovate and invest, and
thus upliIt economic activity and progress.


MONETSATION- Banks are the manuIactures oI money and they allow many to play its role
Ireely in the economy. Banks monetize debts and also assist the backward subsistence sector oI
the rural economy by extending their branches in to the rural areas. They must be replaced by the
modern commercial bank`s branches.
INFLUENCE ECONOMIC ACTIVITY- Banks are in a position to inIluence economic
activity in a country by their inIluence on the rate interest. They can inIluence the rate oI interest
in the money market through its supply oI Iunds. Banks may Iollow a cheap money policy with
low interest rates which will tend to stimulate economic activity.
FACILITATOR OF MONETARY POLICY- Thus monetary policy oI a country should be
conductive to economic development. But a well-developed banking system is on essential pre-
condition to the eIIective implementation oI monetary policy. Under-developed countries cannot
aIIord to ignore this Iact.
A Iine, an eIIicient and comprehensive banking system is a crucial Iactor oI the developmental
process oI economy.

RESERVE BANK OF INDIA AS A REGULATORY INSTITUTION IN INDIAN
ECONOMY-
The RBI was established under the Reserve Bank oI India Act, 1934 on April 1, 1935 as a
private shareholders' bank but since its nationalization in 1949, is Iully owned by the
Government oI India. The Preamble oI the Reserve Bank describes the basic Iunctions as 'to
regulate the issue oI Bank notes and keeping oI reserves with a view to securing monetary
stability in India and generally, to operate the currency and credit system oI the country to its
advantage'. The twin objectives oI monetary policy in India have evolved over the years as those
oI maintaining price stability and ensuring adequate Ilow oI credit to Iacilitate the growth
process. The relative emphasis between the twin objectives is modulated as per the prevailing
circumstances and is articulated in the policy statements by the Reserve Bank Irom time to time.
Consideration oI macro-economic and Iinancial stability is also subsumed in the mandate. The
Reserve Bank is also entrusted with the management oI Ioreign exchange reserves (which
include gold holding also), which are reIlected in its balance sheet.
While the Reserve Bank is essentially a monetary authority, its Iounding statute mandates
it to be the manager oI market borrowing oI the Government oI India and banker to the
Government.
The Reserve Bank's aIIairs are governed by a Central Board oI Directors, consisting oI
Iourteen non-executive, independent directors nominated by the Government, in addition to the
Governor and up to Iour Deputy Governors. Besides, one Government oIIicial is also nominated
on the Board who participates in the Board meetings but cannot vote.

IMPORTANT FUNCTIONS PLAYED BY RESERVE BANK OF INDIA IN ECONOMY

MAIN FUNCTIONS

MONITORY AUTHORITY
The Reserve Bank oI India Iormulates implements and monitors the monetary policy. Its
main objective is maintaining price stability and ensuring adequate Ilow oI credit to productive
sectors.

REGULATOR AND SUPERVISOR OF FINANCIAL SYSTEM
Prescribes broad parameters oI banking operations within which the country`s banking
and Iinancial system Iunctions. Their main objective is to maintain public conIidence in the
system, protect depositors` interest and provide cost-eIIective banking services to the public.

MANAGER OF EXCHANGE CONTROL
The manager oI the exchange control department manages the Foreign Exchange
Management Act, 1999. Its main objective is to Iacilitate external trade and payment and
promote orderly development and maintenance oI Ioreign exchange market in India.




ISSUER OF THE CURRENCY
The person who is issuer issues and exchanges or destroys currency and coins not Iit Ior
circulation. His main objective is to give the public adequate quantity oI supplies oI currency
notes and coins and in good quality.

DEVELOPMENTAL ROLE
The reserve bank oI India perIorms a wide range oI promotional Iunctions to support
national objectives. The promotional Iunctions are such as contests, coupons, maintaining good
public relations, and many more...

RELATED FUNCTIONS

There are also some oI the relating Iunctions to the above mentioned main Iunctions.
They are such as Banker to the Government, Banker to banks etc..

BANKER TO THE GOVERNMENT

It perIorms merchant banking Iunction Ior the central and the state governments;
also acts as their banker.

BANKER TO THE BANKS

Maintains banking accounts oI all scheduled banks.


SUPERVISORY FUNCTIONS
The Reserve Bank act, 1934 and the Banking Regulation act, 1949 have given the RBI
wide powers oI supervision and control over commercial and co-operative banks, relating to
licensing and establishments, branch expansion, liquidity oI their asset, management and
methods oI working, amalgamation, reconstruction, and liquidation.
The RBI is authorized to carry out periodical inspections oI banks and to call Ior returns
and necessary inIormation Irom them. The supervisory Iunctions oI the RBI have helped a great
deal in improving the standard oI banking in India to develop on sound lines and to improve the
methods oI their operation.

PROMOTIONAL FUNCTIONS
With economic growth assuming a new urgency since Independence, the range oI the
Reserve Bank`s Iunctions has steadily widened. The bank now perIorms a variety oI
developmental and promotional Iunctions, which, at one time were regarded as outside the
normal scope oI central banking. The RBI was asked to promote banking habit, extend banking
Iacilities to rural and semi-urban areas, and establish and promote new specialized Iinancing
agencies.



PROBLEMS FACED BY INDIAN ECONOMY-

Macro-economic environment in India has taken a serious turn since the beginning oI the
year. Unprecedented rise in crude prices, surge in inIlation and continued strong growth in
money supply (M3) have Iorced the government and RBI to take strong Iiscal and monetary
measures leading to liquidity tightening, signiIicant rise in interest rates and slowdown in
economic growth.
Economic shocks are events which adversely aIIect the economy and the government`s
macroeconomic objectives such as growth, inIlation, unemployment and the balance oI
payments.
CERTAIN PROBLEMS FACED BY INDIAN ECONOMY
FALL IN SAVINGS RATIO
The savings ratio is the ° oI income that is saved not spent. A Iall in the savings ratio
implies that consumer spending is increasing; oIten this is Iinanced through increased borrowing.
EFFECTS OF FALL IN SAVINGS RATIO
HIGHER LEVEL OF CONSUMPTION
This results in increase in Aggregate Demand. The increase in AD will
cause an increase in economic growth and lower unemployment. However, rising
Aggregate Demand may cause inIlation. InIlation will occur when growth is Iaster
than the long run trend rate. This is now a potential problem in the India. InIlation
has recently gone above 12°

BOOM AND BUST
A Iall in the savings ratio is usually accompanied by a rise in conIidence. It is
the rise in conIidence which encourages borrowing and consumers to run down
savings. ThereIore, there is always a danger that a Ialling savings ratio can be a
precursor to a boom and bust situation.
ECONOMY MORE SENSITIVE TO INTEREST RATES
With a Iall in the savings ratio interest rate changes will have a bigger eIIect
in reducing spending. This is because levels oI borrowing are higher and thereIore a
rise in interest rates has a signiIicant impact on increasing interest repayments. Also,
higher rates will not be increasing incomes Irom savings as much.
BALANCE OF PAYMENT
With higher levels oI consumer spending, there will be an increase in imports.
ThereIore this will lead to deterioration in the current account. The current account
deIicit could put downward pressure on the exchange rate in the long term.
However, some people argue a Iall in the savings ratio is not a problem, but, it is just a
reIlection oI strong economy and booming housing market, which increases scope Ior equity
withdrawal.


INFLATION
InIlation is posing a serious challenge to the economic growth oI India. Since Jan`08
onwards, inIlation in the country has surged by 8.2° to hit a 13-year high oI ~12°. M3 growth
in the economy too continued to remain strong at 20° (in July`08), well above the RBI`s
comIort level oI 17°.
The WPI inIlation rate Ilared up during the period driven by signiIicant increase in the
prices oI commodities, primary articles and manuIactured products, even though very small part
oI global crude price increase has been passed on to the Indian consumers.
GLOBAL RECESSION
It appears that Europe, Japan and the US are entering into recession. Falling house prices,
crisis in the Iinancial system, and lower conIidence could lead to a sharp downturn, with the
worst still to come. Many argue that India`s growth is not so dependent on growth in the West.
However, the Indian stock markets have been hit by the global crisis. India`s growing service
sector and manuIacturing sector would be adversely impacted by a global downturn.
RISE IN CRUDE PRICES
How global crude prices would behave probably has no easy answers; however we
believe that the current challenging and uncertain macro-economic conditions does not lead
Indian Iinancials into a state oI crisis. But continued rise in crude prices and its resultant impact
on inIlation, interest rates and government Iinances has the potential to do so. Hence, crude price
remains the key risk to our positive stance on the Indian Iinancials.
In the last couple oI months oil prices have surged by 45° Irom US$ 100 to US$ 145
(and now back to US$ 115). India currently imports 70° oI its crude requirement, resulting in
pressure on government coIIers on back oI rising crude prices.
DEPRICIATING INR
Surge in crude prices has severely impacted current account deIicit oI the country. This
coupled with the outIlow oI FII investments has resulted in INR to depreciate sharply against
dollar Iurther Iueling inIlation.


IMPACT OF ECONOMIC PROBLEMS ON INDIAN FINANCIALS-

The current macro-economic conditions are expected to result in
SLOWDOWN IN CREDIT GROWTH
IMPACT ON MARGINS OF BANKS
PREASURE ON CREDIT QUALITY
SLOWDOWN IN CREDIT GROWTH
While the rise in interest rates should lead to a moderation in demand Ior credit, Indian
banks too are exercising caution while lending. Credit growth oI 18° in FY09E and 17° in
FY10E vs. 22° in FY08. Risks and uncertainties in the system have increased given the higher
crude and commodity prices and its inIlationary impact. This would curtail consumption, which
would impact economic growth adversely. Further higher rates will not only impact the
proIitability oI Indian corporate but also impact IRRs oI various proposed capex projects. This
coupled with elections next year could lead to some postponement oI capex plans oI corporate,
leading to negative impact on demand Ior credit.
Higher rates have particularly impacted retail loan growth. As can be seen in the exhibit
below, retail loan growth has slowed down signiIicantly Irom 26.5° in FY07 to ~13° in FY08.
SLR Ratio oI the system has started rising since mid FY08 and currently stands at 28.7°. Given
the expected negative impact on credit growth.



IMPACT ON MARGINS OF BANKS
During the past 18 months, CRR has increased by 400 bps to 9.0° currently and RBI has
also discontinued with interest payment on CRR balances. Every 50 bps hike in CRR generally
negatively impacts margins by ~5 bps. Till June`08, most oI the banks had restrained Irom
hiking lending rates despite signiIicant monetary tightening. However on account oI recent
measures by RBI, banks have resorted to hiking PLRs in July/August by 50-150 bps to preserve
their margins.
In Iact in an environment, where liquidity is tight, interest rates are at elevated levels and
risk premiums have increased, the banks tend to regain the pricing power. This would not only
help the banks to adequately price in risks but also help protect their margins. Apart Irom hiking
PLRs, banks are also resorting to reprising (in Iact right-pricing) the loans that were sanctioned
well below PLRs. SigniIicant portion oI Iixed rate loans would also get re-priced over the period
oI 12-18 months.
PRESSURE ON CREDIT QUALITY
Higher lending rates are expected to impact credit quality Ior the banking system. The
extent oI the impact on credit quality would also be bank speciIic given the loan mix (retail vs.
corporate), proportion oI unsecured lending, credit proIile oI corporate loan book and industry
wise exposure. Indian banks` Iundamentals are relatively resilient with better risk management
systems, dramatically improved asset quality, stronger recovery mechanisms (legal provisions)
and with adequate capitalization and provisioning.

Even Certain sectors (like real estate, airlines industry) might Ieel the stress due to the
changing macro environment and rise in interest rates. Many companies where crude Iorms a key
raw material component are expected to get hit more severely. Similarly, sectors like real estate
and SMEs, which are interest rate sensitive, would Iace higher delinquencies iI interest rates
strengthen Iurther by 100-200 bps.

RECENT INNOVATIONS IN INDIAN BANKING-

HDFC Bank`s Net SaIe` card is a one-time use card with a limit that`s speciIied, taken Irom
Tendon`s credit or debit card. Even iI Tendon Iails to utilize the Iull amount within 24 hours oI
creating the card, the card simply dies and the unspent amount in the temporary card reverts to
his original credit or debit card. Welcome to one oI the myriad ways in which bankers have been
trying to innovate. They`re bringing ATMs, cash and even Ioreign exchange to their customers`
doorsteps. Indeed, innovation has become the hottest banking game in town.

Want to buy a house but don`t want to go through the hassles oI haggling with brokers
and the mounds oI paperwork? Not to worry. Your bank will tackle all this. It`s ready to come
every step oI the way Ior you to buy a house. Standard Chartered, Ior instance, has property
advisors to guide a customer through the entire process oI selecting and buying a house. They
also lend a hand with the cumbersome documentation Iormalities and the registration.

Don`t Iret iI you`ve already bought your house or car you can do other things with both.
You can leverage your new house or car these days with banks like ICICI Bank and Stanchart
ready to extend loans against either, till it`s about Iive years old. Loans are available to all car
owners Ior almost all brands oI cars manuIactured in India that are up to Iive years old.

Last month, Kotak Mahindra Bank introduced a variant oI the sweep-in account. II the
balance tops Rs 1.5 lakh, the excess runs into Kotak`s liquid mutual Iund. 'Even iI the money is
there only Ior the weekend, a liquid Iund can earn you a clean 4.5 per cent per annum,¨ points
out Shashi Arora, vice president, marketing, Kotak Mahindra Bank. That`s not a small gain
considering that your current account does not pay you any interest. And iI, meanwhile, you
want to buy a big-ticket home theatre system, the minute you swipe your card the invested sum
will return to your account.

Banks are also attempting to reach out to residents oI metropolitan cities where people
are pressed Ior time (what with long commuting hours, traIIic jams and both spouses working),
beyond conventional banking hours. ICICI Bank, Ior example, introduced eight to eight banking
hours, seven days oI the week, in major cities. Not to be outdone, some oI the other private banks
have also done this too. HDFC Bank even has a 24-hour branch at Mumbai`s international
airport.


INDIAN BANKING IN 2010-

The interplay between policy and regulatory interventions and management strategies
will determine the perIormance oI Indian banking over the next Iew years. Legislative actions
will shape the regulatory stance through six key elements: industry structure and sector
consolidation; Ireedom to deploy capital; regulatory coverage; corporate governance; labor
reIorms and human capital development; and support Ior creating industry utilities and service
bureaus. Management success will be determined on three Ironts: Iundamentally upgrading
organizational capability to stay in tune with the changing market; adopting value-creating M&A
as an avenue Ior growth; and continually innovating to develop new business models to access
untapped opportunities.
Through these scenarios, we can paint a picture oI the events and outcomes that will be
the consequence oI the actions oI policy makers and bank managements. These actions will have
dramatically diIIerent outcomes; the costs oI inaction or insuIIicient action will be high.
SpeciIically, at one extreme, the sector could account Ior over 7.7 per cent oI GDP with over Rs..
7,500 billion in market cap, while at the other it could account Ior just 3.3 per cent oI GDP with
a market cap oI Rs. 2,400 billion. Banking sector intermediation, as measured by total loans as a
percentage oI GDP, could grow marginally Irom its current levels oI ~30 per cent to ~45 per cent
or grow signiIicantly to over 100 per cent oI GDP. In all oI this, the sector could generate
employment to the tune oI 1.5 million compared to 0.9 million. Today availability oI capital
would be a key Iactor the banking sector will require as much as Rs. 600 billion (US$ 14
billion) in capital to Iund growth in advances, non-perIorming loan (NPL) write oIIs and
investments in IT and human capital up gradation to reach the high-perIorming scenario. Three
scenarios can be deIined to characterize these outcomes:

HIGH PERFORMANCE

In this scenario, policy makers intervene only to the extent required to ensure system
stability and protection oI consumer interests, leaving managements Iree to drive Iar reaching
changes. Changes in regulations and bank capabilities reduce intermediation costs leading to
increased growth, innovation and productivity. Banking becomes an even greater driver oI GDP
growth and employment and large sections oI the population gain access to quality banking
products. Management is able to overhaul bank organizational structures, Iocus on industry
consolidation and transIorm the banks into industry shapers.
In this scenario we witness consolidation within public sector banks (PSBs) and within
private sector banks. Foreign banks begin to be active in M&A, buying out some old private and
newer private banks. Some M&A activity also begins to take place between private and public
sector banks. As a result, Ioreign and new private banks grow at rates oI 50 per cent, while PSBs
improve their growth rate to 15 per cent. The share oI the private sector banks (including through
mergers with PSBs) increases to 35 per cent and that oI Ioreign banks increases to 20 per cent oI
total sector assets. The share oI banking sector value adds in GDP increases to over 7.7 per cent,
Irom current levels oI 2.5 per cent. Funding this dramatic growth will require as much as Rs. 600
billion in capital over the next Iew years.


EVOLUTION

Policy makers adopt a pro-market stance but are cautious in liberalizing the industry. As
a result oI this, some constraints still exist. Processes to create highly eIIicient organizations have
been initiated but most banks are still not best-in-class operators. Thus, while the sector emerges
as an important driver oI the economy and wealth in 2010, it has still not come oI age in
comparison to developed markets. SigniIicant changes are still required in policy and regulation
and in capability-building measures, especially by public sector and old private sector banks.
In this scenario, M&A activity is driven primarily by new private banks, which take over
some old private banks and also merge among themselves. As a result, growth oI these banks
increases to 35 per cent. Foreign banks also grow Iaster at 30 per cent due to a relaxation oI some
regulations. The share oI private sector banks increases to 30 per cent oI total sector assets, Irom
current levels oI 18 per cent, while that oI Ioreign banks increases to over 12 per cent oI total
assets. The share oI banking sector value adds to GDP increases to over 4.7 per cent.

STAGNATION

In this scenario, policy makers intervene to set restrictive conditions and management is
unable to execute the changes needed to enhance returns to shareholders and provide quality
products and services to customers. As a result, growth and productivity levels are low and the
banking sector is unable to support a Iast-growing economy. This scenario sees limited
consolidation in the sector and most banks remain sub-scale. New private sector banks continue
on their growth trajectory oI 25 per cent. There is a slowdown in PSB and old private sector bank
growth. The share oI Ioreign banks remains at 7 per cent oI total assets. Banking sector value
adds meanwhile, is only 3.3 per cent oI GDP.

NEED TO CREATE A MARKET DRIVEN BANKING SECTOR WITH ADEQUATE
FOCUS ON SOCIAL DEVELOPMENT

The term 'policy makers¨, reIers to the Ministry oI Finance and the RBI and includes the
other rele÷vant government and regulatory entities Ior the banking sector. The coordinated
eIIorts between the various entities are required to enable positive action. This will spur on the
perIormance oI the sector. The policy makers need to make coordinated eIIorts on six Ironts:

Help shape a superior industry structure in a phased manner through 'managed
consolidation¨ and by enabling capital availability. This would create 3-4 global sized
banks controlling 35-45 per cent oI the market in India; 6-8 national banks controlling
20-25 per cent oI the market; 4-6 Ioreign banks with 15-20 per cent share in the market,
and the rest being specialist players (geographical or product/ segment Iocused).

Focus strongly on 'social development¨ by moving away Irom universal directed norms
to an explicit incentive-driven Iramework by introducing credit guarantees and market
subsidies to encourage leading public sector, private and Ioreign players to leverage
technology to innovate and proIitably provide banking services to lower income and rural
markets.

Create a uniIied regulator, distinct Irom the central bank oI the country, in a phased
manner to overcome supervisory diIIiculties and reduce compliance costs.

Improve corporate governance primarily by increasing board independence and
accountability.

Accelerate the creation oI world class supporting inIrastructure (e.g., payments, asset
reconstruction companies (ARCs), credit bureaus, back-oIIice utilities) to help the
banking sector Iocus on core activities.

Enable labor reIorms, Iocusing on enriching human capital, to help public sector and old
private banks become competitive.


NEED FOR DECISIVE ACTION BY BANK MANAGEMENT

Management imperatives will diIIer by bank. However, there will be common themes
across classes oI banks:

PSBs need to Iundamentally strengthen institutional skill levels especially in sales and
mar marketing, service operations, risk management and the overall organizational
perIormance ethic. The last, i.e., strengthening human capital will be the single biggest
challenge.

Old private sector banks also have the need to Iundamentally strengthen skill levels.
However, even more imperative is their need to examine their participation in the Indian
banking sector and their ability to remain independent in the light oI the discontinuities in
the sector.

New private banks could reach the next level oI their growth in the Indian banking sector
by continuing to innovate and develop diIIerentiated business models to proIitably serve
segments like the rural/low income and aIIluent/ HNI segments; actively adopting
acquisitions as a means to grow and reaching the next level oI perIormance in their
service platIorms. Attracting, developing and retaining more leadership capacity would
be key to achieving this and would pose the biggest challenge.

Foreign banks committed to making a play in India will need to adopt alternative
approaches to win the 'race Ior the customer¨ and build a value-creating customer
Iranchise in advance oI regulations potentially opening up post 2009. At the same time,
they should stay in the game Ior potential acquisition opportunities as and when they
appear in the near term. Maintaining a Iundamentally long-term value-creation mindset
will be their greatest challenge.

The extent to which Indian policy makers and bank managements develop and execute
such a clear and complementary agenda to tackle emerging discontinuities will lay the
Ioundations Ior a high-perIorming sector in 2010.



CONCLUSION-

We can conclude that the Iinancial sector is a nerve system oI Indian economy. Banking plays an
important role in development oI economy. For steady growth in economy innovations and
development in Iinancial sector is very important.
Economy oI any country Iaces lots oI challenges and problems. To tackle those problems
Iinancial sector plays a vital role. The Iinancial sector makes the economy eIIicient to the extent
where it can rival other developed economies in the world.
Financial sector also Iaces lots oI problems but it should develop certain strategies to
come out oI these problems which is very important Ior healthy growth oI economy.