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ROLE OF BANKS IN DEVELOPMENT OF ECONOMYA safe and sound financial sector is a prerequisite for sustained growth of any economy.

Globalization, deregulation and advances in information technology in recent years have brought about significant changes in the operating environment for banks and other financial institutions. These institutions are faced 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 efficiency of financial institutions, they have also posed some serious risks. Banks play a very useful and dynamic role in the economic life of every modern state. A study of the economic history of western country shows that without the evolution of commercial banks in the 18th and 19th centuries, the industrial revolution would not have taken place in Europe. The economic importance of commercial banks to developing countries may be viewed thus: Promoting capital formation Encouraging innovation Monestation Influence economic activity Facilitator of monetary policy Above all view we can see in briefly, which are given below:

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

MONETSATION- Banks are the manufactures of money and they allow many to play its role freely in the economy. Banks monetize debts and also assist the backward subsistence sector of the rural economy by extending their branches in to the rural areas. They must be replaced by the modern commercial banks branches. INFLUENCE ECONOMIC ACTIVITY- Banks are in a position to influence economic activity in a country by their influence on the rate interest. They can influence the rate of interest in the money market through its supply of funds. Banks may follow a cheap money policy with low interest rates which will tend to stimulate economic activity. FACILITATOR OF MONETARY POLICY- Thus monetary policy of a country should be conductive to economic development. But a well-developed banking system is on essential precondition to the effective implementation of monetary policy. Under-developed countries cannot afford to ignore this fact. A fine, an efficient and comprehensive banking system is a crucial factor of the developmental process of economy.

RESERVE BANK OF INDIA AS A REGULATORY INSTITUTION IN INDIAN ECONOMYThe RBI was established under the Reserve Bank of India Act, 1934 on April 1, 1935 as a private shareholders' bank but since its nationalization in 1949, is fully owned by the Government of India. The Preamble of the Reserve Bank describes the basic functions as 'to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally, to operate the currency and credit system of the country to its advantage'. The twin objectives of monetary policy in India have evolved over the years as those of maintaining price stability and ensuring adequate flow of credit to facilitate 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 from time to time. Consideration of macro-economic and financial stability is also subsumed in the mandate. The Reserve Bank is also entrusted with the management of foreign exchange reserves (which include gold holding also), which are reflected in its balance sheet. While the Reserve Bank is essentially a monetary authority, its founding statute mandates it to be the manager of market borrowing of the Government of India and banker to the Government. The Reserve Bank's affairs are governed by a Central Board of Directors, consisting of fourteen non-executive, independent directors nominated by the Government, in addition to the

Governor and up to four Deputy Governors. Besides, one Government official is also nominated on the Board who participates in the Board meetings but cannot vote.


MAIN FUNCTIONS MONITORY AUTHORITY The Reserve Bank of India formulates implements and monitors the monetary policy. Its main objective is maintaining price stability and ensuring adequate flow of credit to productive sectors. REGULATOR AND SUPERVISOR OF FINANCIAL SYSTEM Prescribes broad parameters of banking operations within which the countrys banking and financial system functions. Their main objective is to maintain public confidence in the system, protect depositors interest and provide cost-effective banking services to the public. MANAGER OF EXCHANGE CONTROL The manager of the exchange control department manages the Foreign Exchange Management Act, 1999. Its main objective is to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

ISSUER OF THE CURRENCY The person who is issuer issues and exchanges or destroys currency and coins not fit for circulation. His main objective is to give the public adequate quantity of supplies of currency notes and coins and in good quality. DEVELOPMENTAL ROLE The reserve bank of India performs a wide range of promotional functions to support national objectives. The promotional functions are such as contests, coupons, maintaining good public relations, and many more..

RELATED FUNCTIONS There are also some of the relating functions to the above mentioned main functions. They are such as Banker to the Government, Banker to banks etc. BANKER TO THE GOVERNMENT It performs merchant banking function for the central and the state governments; also acts as their banker. BANKER TO THE BANKS Maintains banking accounts of all scheduled banks.

SUPERVISORY FUNCTIONS The Reserve Bank act, 1934 and the Banking Regulation act, 1949 have given the RBI wide powers of supervision and control over commercial and co-operative banks, relating to licensing and establishments, branch expansion, liquidity of their asset, management and methods of working, amalgamation, reconstruction, and liquidation. The RBI is authorized to carry out periodical inspections of banks and to call for returns and necessary information from them. The supervisory functions of the RBI have helped a great deal in improving the standard of banking in India to develop on sound lines and to improve the methods of their operation. PROMOTIONAL FUNCTIONS With economic growth assuming a new urgency since Independence, the range of the Reserve Banks functions has steadily widened. The bank now performs a variety of developmental and promotional functions, which, at one time were regarded as outside the normal scope of central banking. The RBI was asked to promote banking habit, extend banking facilities to rural and semi-urban areas, and establish and promote new specialized financing agencies.

PROBLEMS FACED BY INDIAN ECONOMYMacro-economic environment in India has taken a serious turn since the beginning of the year. Unprecedented rise in crude prices, surge in inflation and continued strong growth in

money supply (M3) have forced the government and RBI to take strong fiscal and monetary measures leading to liquidity tightening, significant rise in interest rates and slowdown in economic growth. Economic shocks are events which adversely affect the economy and the governments macroeconomic objectives such as growth, inflation, unemployment and the balance of payments. CERTAIN PROBLEMS FACED BY INDIAN ECONOMY FALL IN SAVINGS RATIO The savings ratio is the % of income that is saved not spent. A fall in the savings ratio implies that consumer spending is increasing; often this is financed 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 inflation. Inflation will occur when growth is faster than the long run trend rate. This is now a potential problem in the India. Inflation has recently gone above 12%

BOOM AND BUST A fall in the savings ratio is usually accompanied by a rise in confidence. It is the rise in confidence which encourages borrowing and consumers to run down savings. Therefore, there is always a danger that a falling savings ratio can be a precursor to a boom and bust situation. ECONOMY MORE SENSITIVE TO INTEREST RATES With a fall in the savings ratio interest rate changes will have a bigger effect in reducing spending. This is because levels of borrowing are higher and therefore a rise in interest rates has a significant impact on increasing interest repayments. Also, higher rates will not be increasing incomes from savings as much. BALANCE OF PAYMENT

With higher levels of consumer spending, there will be an increase in imports. Therefore this will lead to deterioration in the current account. The current account deficit could put downward pressure on the exchange rate in the long term. However, some people argue a fall in the savings ratio is not a problem, but, it is just a reflection of strong economy and booming housing market, which increases scope for equity withdrawal.

INFLATION Inflation is posing a serious challenge to the economic growth of India. Since Jan08 onwards, inflation in the country has surged by 8.2% to hit a 13-year high of ~12%. M3 growth in the economy too continued to remain strong at 20% (in July08), well above the RBIs comfort level of 17%. The WPI inflation rate flared up during the period driven by significant increase in the prices of commodities, primary articles and manufactured products, even though very small part of 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 financial system, and lower confidence could lead to a sharp downturn, with the worst still to come. Many argue that Indias growth is not so dependent on growth in the West. However, the Indian stock markets have been hit by the global crisis. Indias growing service sector and manufacturing 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 financials into a state of crisis. But continued rise in crude prices and its resultant impact on inflation, interest rates and government finances has the potential to do so. Hence, crude price remains the key risk to our positive stance on the Indian financials. In the last couple of months oil prices have surged by 45% from US$ 100 to US$ 145 (and now back to US$ 115). India currently imports 70% of its crude requirement, resulting in pressure on government coffers on back of rising crude prices. DEPRICIATING INR

Surge in crude prices has severely impacted current account deficit of the country. This coupled with the outflow of FII investments has resulted in INR to depreciate sharply against dollar further fueling inflation.

IMPACT OF ECONOMIC PROBLEMS ON INDIAN FINANCIALSThe 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 for credit, Indian banks too are exercising caution while lending. Credit growth of 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 inflationary impact. This would curtail consumption, which would impact economic growth adversely. Further higher rates will not only impact the profitability of Indian corporate but also impact IRRs of various proposed capex projects. This coupled with elections next year could lead to some postponement of capex plans of corporate, leading to negative impact on demand for credit. Higher rates have particularly impacted retail loan growth. As can be seen in the exhibit below, retail loan growth has slowed down significantly from 26.5% in FY07 to ~13% in FY08. SLR Ratio of 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 June08, most of the banks had restrained from hiking lending rates despite significant monetary tightening. However on account of recent measures by RBI, banks have resorted to hiking PLRs in July/August by 50-150 bps to preserve their margins.

In fact 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 from hiking PLRs, banks are also resorting to reprising (in fact right-pricing) the loans that were sanctioned well below PLRs. Significant portion of fixed rate loans would also get re-priced over the period of 12-18 months. PRESSURE ON CREDIT QUALITY Higher lending rates are expected to impact credit quality for the banking system. The extent of the impact on credit quality would also be bank specific given the loan mix (retail vs. corporate), proportion of unsecured lending, credit profile of corporate loan book and industry wise exposure. Indian banks fundamentals 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 feel the stress due to the changing macro environment and rise in interest rates. Many companies where crude forms 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 face higher delinquencies if interest rates strengthen further by 100-200 bps. RECENT INNOVATIONS IN INDIAN BANKINGHDFC Banks Net Safe card is a one-time use card with a limit thats specified, taken from Tendons credit or debit card. Even if Tendon fails to utilize the full amount within 24 hours of 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 of the myriad ways in which bankers have been trying to innovate. Theyre bringing ATMs, cash and even foreign exchange to their customers doorsteps. Indeed, innovation has become the hottest banking game in town. Want to buy a house but dont want to go through the hassles of haggling with brokers and the mounds of paperwork? Not to worry. Your bank will tackle all this. Its ready to come every step of the way for you to buy a house. Standard Chartered, for instance, has property advisors to guide a customer through the entire process of selecting and buying a house. They also lend a hand with the cumbersome documentation formalities and the registration. Dont fret if youve 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 its about five years old. Loans are available to all car owners for almost all brands of cars manufactured in India that are up to five years old.

Last month, Kotak Mahindra Bank introduced a variant of the sweep-in account. If the balance tops Rs 1.5 lakh, the excess runs into Kotaks liquid mutual fund. Even if the money is there only for the weekend, a liquid fund can earn you a clean 4.5 per cent per annum, points out Shashi Arora, vice president, marketing, Kotak Mahindra Bank. Thats not a small gain considering that your current account does not pay you any interest. And if, 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 of metropolitan cities where people are pressed for time (what with long commuting hours, traffic jams and both spouses working), beyond conventional banking hours. ICICI Bank, for example, introduced eight to eight banking hours, seven days of the week, in major cities. Not to be outdone, some of the other private banks have also done this too. HDFC Bank even has a 24-hour branch at Mumbais international airport.

INDIAN BANKING IN 2010The interplay between policy and regulatory interventions and management strategies will determine the performance of Indian banking over the next few years. Legislative actions will shape the regulatory stance through six key elements: industry structure and sector consolidation; freedom to deploy capital; regulatory coverage; corporate governance; labor reforms and human capital development; and support for creating industry utilities and service bureaus. Management success will be determined on three fronts: fundamentally upgrading organizational capability to stay in tune with the changing market; adopting value-creating M&A as an avenue for growth; and continually innovating to develop new business models to access untapped opportunities. Through these scenarios, we can paint a picture of the events and outcomes that will be the consequence of the actions of policy makers and bank managements. These actions will have dramatically different outcomes; the costs of inaction or insufficient action will be high. Specifically, at one extreme, the sector could account for over 7.7 per cent of GDP with over Rs.. 7,500 billion in market cap, while at the other it could account for just 3.3 per cent of GDP with a market cap of Rs. 2,400 billion. Banking sector intermediation, as measured by total loans as a percentage of GDP, could grow marginally from its current levels of ~30 per cent to ~45 per cent or grow significantly to over 100 per cent of GDP. In all of this, the sector could generate employment to the tune of 1.5 million compared to 0.9 million. Today availability of capital would be a key factor the banking sector will require as much as Rs. 600 billion (US$ 14 billion) in capital to fund growth in advances, non-performing loan (NPL) write offs and

investments in IT and human capital up gradation to reach the high-performing scenario. Three scenarios can be defined to characterize these outcomes: HIGH PERFORMANCE In this scenario, policy makers intervene only to the extent required to ensure system stability and protection of consumer interests, leaving managements free to drive far reaching changes. Changes in regulations and bank capabilities reduce intermediation costs leading to increased growth, innovation and productivity. Banking becomes an even greater driver of GDP growth and employment and large sections of the population gain access to quality banking products. Management is able to overhaul bank organizational structures, focus on industry consolidation and transform 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, foreign and new private banks grow at rates of 50 per cent, while PSBs improve their growth rate to 15 per cent. The share of the private sector banks (including through mergers with PSBs) increases to 35 per cent and that of foreign banks increases to 20 per cent of total sector assets. The share of banking sector value adds in GDP increases to over 7.7 per cent, from current levels of 2.5 per cent. Funding this dramatic growth will require as much as Rs. 600 billion in capital over the next few years.

EVOLUTION Policy makers adopt a pro-market stance but are cautious in liberalizing the industry. As a result of this, some constraints still exist. Processes to create highly efficient organizations have been initiated but most banks are still not best-in-class operators. Thus, while the sector emerges as an important driver of the economy and wealth in 2010, it has still not come of age in comparison to developed markets. Significant 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 of these banks increases to 35 per cent. Foreign banks also grow faster at 30 per cent due to a relaxation of some regulations. The share of private sector banks increases to 30 per cent of total sector assets, from current levels of 18 per cent, while that of foreign banks increases to over 12 per cent of total assets. The share of 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 fast-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 of 25 per cent. There is a slowdown in PSB and old private sector bank growth. The share of foreign banks remains at 7 per cent of total assets. Banking sector value adds meanwhile, is only 3.3 per cent of GDP. NEED TO CREATE A MARKET DRIVEN BANKING SECTOR WITH ADEQUATE FOCUS ON SOCIAL DEVELOPMENT The term policy makers, refers to the Ministry of Finance and the RBI and includes the other rele=vant government and regulatory entities for the banking sector. The coordinated efforts between the various entities are required to enable positive action. This will spur on the performance of the sector. The policy makers need to make coordinated efforts on six fronts: 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 of the market in India; 6-8 national banks controlling 20-25 per cent of the market; 4-6 foreign banks with 15-20 per cent share in the market, and the rest being specialist players (geographical or product/ segment focused). Focus strongly on social development by moving away from universal directed norms to an explicit incentive-driven framework by introducing credit guarantees and market subsidies to encourage leading public sector, private and foreign players to leverage technology to innovate and profitably provide banking services to lower income and rural markets. Create a unified regulator, distinct from the central bank of the country, in a phased manner to overcome supervisory difficulties and reduce compliance costs. Improve corporate governance primarily by increasing board independence and accountability. Accelerate the creation of world class supporting infrastructure (e.g., payments, asset reconstruction companies (ARCs), credit bureaus, back-office utilities) to help the banking sector focus on core activities.

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

NEED FOR DECISIVE ACTION BY BANK MANAGEMENT Management imperatives will differ by bank. However, there will be common themes across classes of banks: PSBs need to fundamentally strengthen institutional skill levels especially in sales and mar marketing, service operations, risk management and the overall organizational performance ethic. The last, i.e., strengthening human capital will be the single biggest challenge. Old private sector banks also have the need to fundamentally 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 of the discontinuities in the sector. New private banks could reach the next level of their growth in the Indian banking sector by continuing to innovate and develop differentiated business models to profitably serve segments like the rural/low income and affluent/ HNI segments; actively adopting acquisitions as a means to grow and reaching the next level of performance in their service platforms. 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 for the customer and build a value-creating customer franchise in advance of regulations potentially opening up post 2009. At the same time, they should stay in the game for potential acquisition opportunities as and when they appear in the near term. Maintaining a fundamentally long-term value-creation mindset 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 foundations for a high-performing sector in 2010.


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