How banks works? History and risk associated to banks

how banks

Bank gets deposits from its deposit customers. Customers in return get interest. The number of people who deposit money is generally larger than lending customers(who takes loans). So the bank has enough money to pay interest(to depositors) and give loans(to lending customers). Lending customers have to pay an interest which is a larger amount. That becomes income to the bank. That is how banks earn to sustain their operations.

That is why when you deposit money we get very less interest. But when we take loans then we have to pay large money as an interest rate

How can a bank face a problem then?

The income of a bank relies on the money they get from lending customers. What if a customer fails to pay his debt? What if the number of such customers gets increased day by day. In these scenarios, their income will be affected and will create a problem for the economy. This is what we call the rise of NPA(Non-Performing Assets).

According to Reserve Bank of India NPA is-: An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. A ‘non-performing asset’ (NPA) was defined as a credit facility in respect of which the interest and/ or installment of principal has remained ‘past due’ for a specified period of time.

So, Is it the only way to make money? Obviously no. There are plenty of ways a bank earn money.

How a bank make money?

  • They charge money for proving services. Example: ATM services. When your distant friend sends you money then extra charge taken by the bank. Charging fee on transactions, Processing cheques, Unauthorised borrowing, Penalty to customers.etc
  • Banks trade financial instruments in the market to earn money.
  • Lending at a higher rate than pay to depositors.
  • Banks pursue customers to deposit money by giving small interest for their deposits. Which leads to more lending and more income.
  • Banks advise(Specifically Investment Banks) companies where to invest and all that. For that, they charge huge money.
  • Some banks are authorized to perform buying and selling of different nations currencies. In this, they can get benefits of appreciated to depreciated currencies.
  • Credit card servies in which customer can take immediate withdrawal of any amount. For these banks charge a fee.
  • From government securities. The government needs money for their functioning. Banks take govt securities and give government money. Government is a reliable source so its not a risky investment.

    So NPA problems can lead to a financial crisis in the economy of a country. If that is the case then why we created banks in the first place. To know this answer we have to know how banks were created? Since when countries got the idea to set up banks?

Why banks were created?

In simple terms, if all the money in the hands of the public. Then the government will not be able to spend much for the growth of the economy. Government can’t rely on only taxes to spend for the country. Banks are reliable resources, trusted by both government and people. Thus can be utilized by people and government to get services.This way government and people will always have money. 

History of Banks in India

Formally started by Bank of Hindustan in 1770 but failed in the 1790s. The Indian banking sector is broadly classified into scheduled and non-scheduled banks. The scheduled banks are those included under the 2nd Schedule of the Reserve Bank of India Act, 1934. The scheduled banks are further classified into nationalized banks; State Bank of India and its associates; Regional Rural Banks (RRBs); foreign banks; and other Indian private sector banks. The term commercial banks refer to both scheduled and non-scheduled commercial banks regulated under the Banking Regulation Act, 1949. Imperial Bank of India in 1955 via State Bank of India Act considered as the first major step towards nationalizing of banks. But after that, no major step was taken up to 1969. During India Gandhi, nationalization wave came and major banks were nationalized.

The second phase of nationalization started in the 1980s. Now a total of 20 banks was in control of the government. Means more than 85% of banks were public sector. The major impact was that people start to have faith in the banks. 

RBI

The Reserve Bank of India was established in1935, in accordance with the provisions of the Reserve Bank of India Act, 1934.

The Central Office of the Reserve Bank was initially established in Calcutta. But was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated.

Though originally privately owned. Nationalized in 1949. The Reserve Bank is fully owned by the Government of India.

Functions of RBI

  • Supervising of Other Banks. RBI is banker to banks, government. RBI has powers to control the money supply. Controls inflation by various monetary policies and works in the interest of nation.
  • RBI as currency issuer: Reserve Bank of India Act 1934 gives RBI sole right to issue Banknotes of all denominations. Except for one-rupee coins and notes. One rupee coins and notes issued by the Department of Economic Affairs, Ministry of Finance.
  • Decides Monetary Policy to target inflation. To control the money supply in the economy.
  • RBI provides Ways and Means Advances to government. Which helps government to manage public debt and day to day operations.
  • RBI is the one who manages foreign exchange reserves.
  • RBI is the one who manages foreign exchange reserves.
  • The RBI acts as a clearinghouse for all member banks. This avoids the unnecessary transfer of funds between the various banks
  • In conclusion, RBI functions for the national interest.

Operational risk of banks

  • Credit risk is when the possibility that borrower will not be able to return the money.
  • Banks hold equity by securities. Thus market risk is also associated with it. If the market crashes that can lead to loss to banks.
  • They hold foreign reserves so they are also at Forex risk.
  • Liquidity risk: There are circumstances when a large number of depositors aggressively withdraws money. That leads to non-availability of cash in the banks. Thus further liquidity risk rises.
  • Moral Hazard:Moral hazard is a risk that occurs when a big bank or large financial institution takes risks. Knowing that someone else will have to face the burden of those risks.
  • Any action that affects banks reputation is also considered as a risk.
  • Financial crisis
  • Hot money risk
  • Global Financial crisis like the Great Depression, the Asian financial crisis, the Financial crisis of 2008. These always affects a bank very badly.
  • Systematic risk: Failure of one bank may cause a domino effect. Example: People may see a bank failure as a risk to their bank. And start to withdraw money aggressively which will lead to liquidity risk. Thus it can affect the whole banking industry

To know about Open Market Operations. click here.