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Banking System


Banks are financial institutions which accept deposits from its customers and lend out the money either directly to borrowers as loans or indirectly through capital markets. In India, modern banking system originated towards the end of the eighteenth century. The Reserve Bank of India is the central bank and supreme monetary authority. The State Bank of India is the largest commercial bank in the country. In 1969, 14 of the largest commercial banks were nationalised in India, followed by 6 more banks in 1980. In the early 1990s, with the liberalisation policy in India, licenses were issued to a small number of private banks such as ICICI Bank, HDFC Bank and UTI Bank (since then it has been renamed as Axis Bank).


In the banking system, people hold money in the form of bank deposits. The banks pay an interest on the deposits. The account holders can keep their money in safety and also earn an interest for it. They can withdraw money any time on demand; hence these deposits are also called demand deposits. Cheque facilities are available to the account holders in the bank. As a medium of exchange, the cheques are used, which are paper instruments used for accepting or making payments. Cheques are drawn out in the name of the payee, and act as a medium of exchange in place of cash. Thus, along with currency, cheques constitute money in a modern banking system.


A person can withdraw money from his bank account on any day. However, all people do not withdraw their money at the same time. Therefore, banks keep a small proportion (about 15 per cent) of their deposits in cash, in case some depositors would want to withdraw money on a day.

The major portion of the bank deposits are extended as loans. Banks charge a higher rate of interest on the money which it lends out than on deposits and this constitutes the main source of income for the bank.


A large number of transactions on a day involve credit. Credit refers to the arrangement in which the lender lends money to the borrower who does not reimburse the lender immediately, but instead pays back at a later date. Any form of deferred payment is called credit. The borrower can use the money to meet the financial requirements. Credit can meet the working capital needs of production to increase the entrepreneurs’ earnings. In rural areas, credit is mainly required by farmers to meet the expenses of crop production.


The farmer purchases seeds, fertilisers, equipments, etc. with the money at the beginning of the season and repays back the loan with the earnings from harvest. In case the crops fail due to some reason, the farmers cannot pay back the loan. There are instances where the poor farmers are forced to sell off a part of their land to repay back the loan. This situation is called the debt-trap, and the borrower gets into a situation of accumulating debt from which he can hardly recover. Therefore, before advancing credit to a borrower, there is a need to assess the risks from loss.


The lending institutions advance loan on the basis of gaining some profit from the loan repayment interest. The borrower has to agree to pay back the principal amount along with an interest amount. Moreover, to ensure that all borrowers repay back as per the term of agreement, the lending institutions demand for some collaterals or securities against the loan amount. Collaterals can be any asset owned by the borrower, such as land, building, livestock or bank deposits. These collaterals are considered as guarantee for the lender, so that in situations when the borrower fails to repay the loan, the lender can sell these collaterals to recover the loan amount. For example, home loans are extended by banks in which the original documents of the property are pledged by the borrower as collaterals. The borrower can get back these documents once he pays the lender entirely. These collaterals, documents and agreed rate of interest are together known as terms of credit.

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