Economics

Digital Banking

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Last Updated: Feb 2025 (Digital Banking)

Digital Banking

This article deals with ‘Digital Banking / Cashless Economy.’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Indian Case: More Cash in Circulation

India uses too much cash for transactions. The ratio of Cash to GDP in India is one of the highest in the world 

Digital Banking

Pros and Cons of Cashless Economy

Pros of Cashless Economy

  • Control Tax Evasion: It will be challenging to evade taxes as all transactions can be tracked in a cashless economy. Money laundering, black money and terrorist financing can be easily controlled.
  • No fear of Physical Theft: In Sweden, where 50% of transactions have gone cashless, robberies have fallen to 30 years low because people don’t have any cash.
  • Cash transactions in small denominations can happen easily. One can pay even a single paisa (or cent). 
  • Curb the menace of Counterfeit Currency: No issue of counterfeit currency and wearing and tearing of currency notes.
  • Positive Examples: The Cashless Currency is working fine in Sweden & Norway, where 50% of transactions have gone cashless. 
  • Cash Currency is Expensive: Ratan Watal Committee (2016) quoted that the dependency on cash costs the country about ₹1 Lakh crore on account of the cost of printing new currency, operating currency chests, maintaining supply to ATM networks etc.
  • Building Credit History: If small vendors start to take payment via digital means in Bank Accounts, their credit history will develop, and they can use this to get credit from institutional lenders. 

Cons of Cashless Economy

  • Extreme Surveillance: Every payment is traceable. This hands over enormous power in the hands of the government, which can carry out Orwellian levels of surveillance. 
  • Exclusion Issue: It can lead to the exclusion of segments of the population who are slow to embrace new technologies, especially the elderly.
  • Vulnerability to Fraud: The problem of electronic fraud increases and the whole system can be hacked.
  • Cashlessness may produce a peculiar human problem as people are sentimental about coins and notes.
  • For payment to happen cashlessly, infrastructure is required at point-of-sale destinations that small businesses can’t afford. 
  • Ultimately, digital payment costs are borne by consumers even when they are charged from producers or vendors. Charges can range from 0.1 per cent to as much as 4 per cent of the value of the transaction. 

International Case Study: mPesa

In Kenya, M-PESA in partnership with Vodafone’s local operator Safaricom has ushered Cashless Revolution.

Digital Banking

Problems in the adoption of Digital Payment in India

As seen by Chandrababu Naidu Committee & Ratan Watal Committee, problems associated with Digital Payment in India are

1 . Lesser Points of Sale

  • India has 160 ATMs per million (UK = 1000 / million)
  • India has 1000 Point-of-Sale (PoS) per million (UK = 30,000 / million)

2. MDR Issue

  • MDR = Merchant Discount Rate
  • Banks charge around 2% from Merchants for providing Cashless Payment Services. Due to this, the profit margin of merchants decreases. It restricts the adoption of digital payment by Merchants.

3. KYC norms for Point of Sale Devices

  • Vendors cant buy Point of Sale devices as they don’t have any permanent address.

4. Interoperability

  • There is no interoperability between different payment systems (Eg: PayTM to PhonePe) and between different Financial Institutions (Eg: SBI to PayTM).

5. Regulatory Problems

  • The Banking Ombudsman doesn’t have the required powers to deal with Internet Banking Frauds. 
  • IT Act is not comprehensive enough to deal with such financial frauds.

6. The Government doesn’t act as a Role Model

  • Although the Government is promoting a Cashless economy, one can’t pay taxes via mobile wallets like PayTM, and bidding fees for various e-Tenders are to be paid in cash (only). Hence, the Government doesn’t act as a role model.

7. Low Digital Financial Literacy

  • People aren’t aware enough to handle a cashless payment system.

8. Behavioural Issue

  • Changing behaviour to use cashless transactions is a complex process.

Issue: Interoperability

  • Interoperability is the ability of customers to transact across commercially and technically independent payment platforms. 
Interoperability
  • Due to legal complications under the Payment & Settlement System Act of 2007, users don’t have full interoperability i.e. 
    • Users can’t transfer money from one wallet to another (can’t transfer money from Paytm to Phonepe).
    • Users can’t use wallets to pay all types of taxes, fees, insurance premiums etc.
  • It acts as an obstacle to the ‘cashless economy’. 

In 2018, RBI issued guidelines for interoperability with the Know Your Customer check, customer grievances redressal mechanism etc., so that transactions can be made between different platforms. 

Issue Analysis: Regulation over Payment Settlement

Regulation of Digital Banking
  • 1998: Banking Reforms / Narsimham-II Committee suggested a regulatory framework for e-banking, card payment etc. 
  • 2007: Payment & Settlement Systems Act enacted according to the recommendations of Narsimham Committee under which RBI supervises e-banking, card payment, and other digital money-related issues through Board for Regulation and Supervision of Payment & Settlement Systems (BPSS). All Payment System providers have to register with RBI’s BPSS – whether a bank, non-bank, wallet-PPI etc. 
  • 2016: Ratan Watal Committee on digital payment suggested replacing BPSS with a Payments Regulatory Board (PRB) in RBI to regulate Interoperability, Consumer protection, Innovation, R&D in digital payments (as BPSS looks after only Payment and Settlement).
  • 2018: RBI opposed the formation of the Payments Regulatory Board due to differences with the government over the issue of who should be Chairman, how many members should be from the Government side etc.

RBI made Ombudsman Scheme for Digital Transactions (OSDT) in 2019 with the following functions

  1. To look into matters of Digital Payment like Consumer Protection.
  2. The consumer can make a free complaint about matters up to Rs 20 lakh against Mobile Wallets, Payment Payment Instruments (PPI) and other digital transactions. 
  3. It can charge a penalty of up to Rs 1 lakh for the victim for their mental agony, loss of time etc. 

Issue Analysis: Merchant Discount Rate (MDR)

  • MDR is the merchant’s fee paid to a bank for every credit/debit card transaction. 
  • MDR hurts merchants’ profit margins and discourages them from adopting Point of Sale terminals, a digital payment system. 
  • 2017-18: RBI put ceilings on MDR fees to encourage the digital economy. 
  • In 2019, the government announced that no MDR would be charged from a firm whose annual turnover is less than Rs 50 crore. RBI and Bank will absorb this burden for not handling so much money.

Developments Related to Cashless/Less Cash Economy

1. Suggestion of various committees to promote the Cashless Economy

1.1 Ratan Watal Committee

  • Formed in December 2016. 
  • To suggest Medium Term Recommendations to strengthen the digital payment ecosystem in India. 

Recommendations of Ratan Watal Committee

  • Form a separate Regulator for Digital Payments under RBI known as Payments Regulatory Board. 
  • The committee envisaged a prominent role for Aadhaar as the primary identification for (KYC) purposes.
  • Government departments should levy a cash-handling charge to discourage cash transactions. 
  • Give incentives like discounts to consumers to make cashless payments.
  • It also suggested interoperability between banks and non-bank digital payment gateways.
  • Rewards for government departments, state governments, districts, and Panchayats to promote digital payments. 
  • Create a fund proposed as DIPAYAN from savings generated from cash-less transactions to expand digital payments. 
  • Reduce or eliminate import duty on the import of ATMs & Point of Sale machines.

1.2 Chandra Babu Naidu Committee

  • Formed in Nov 2016 & submitted a report in Jan 2017
  • Name of Committee: Chief Minister’s Committee to promote Digital Payment in India by NITI Aayog.

Recommendations

  • Tax incentives should be given for domestic production of Point of Sale machines & ATMs.
  • Banks should charge 0% MDR from Government Bodies like Railways, Electricity etc.
  • Develop a Common QR based payment system for Vendors (led to the formation of BHARAT QR).

1.3 Nandan Nilekani Committee

  • In Jan 2019, RBI appointed Nandan Nilekani Committee to suggest ‘how to deepen the digital payments’. 
  • Its main recommendations were
    1. Give tax incentives to companies using digital payments.
    2. Reduce the taxes on devices required for digital payments.
    3. Raise awareness about BHIM-UPI. 
    4. Setup Computer Emergency Response Team for Finance (CERT-Fin).
    5. Prepare area-wise ‘Digital Financial Inclusion Index’ to monitor progress. 

2. Schemes to promote Cashless System

2.1 Rupay Card

  • RuPay is the Payment Gateway started by the National Payment Corporation of India (NPCI).
  • It aims to increase financial inclusion by decreasing the operating cost of Banks to service their customers using debit & credit cards.

How Payment Gateway system work?

Case 1: If there is no payment gateway
  • Each bank has to tie up with merchants separately.
  • It leads to duplication of effort. 
How Payment Gateway system work?

Case 2: In presence of payment gateways
  • Each bank can tie up with a payment gateway & the payment gateway will tie-up with the merchants.
RuPay

Banks are paying ₹300 cr per year to payment gateways (Banks charge them from Merchants as Merchant Discount Rate (MDR) per transaction)

What Rupay will do?

  • Rupay will do the same work at 40% lower rates. Hence, the user will have to pay lower Credit/ Debit card charges, and Merchants will have to pay lower Merchant Discount Rates to the banks. 
Working of RuPay
  • Rupay is the 7th payment gateway in the world. 
  • 3 channel payment can be made using this: ATM, PoS (Point of Sale) and Online. 
  • Under Jan Dhan Scheme, Rupay Debit Card is given to the customers. 

2.2. FastTag

  • FASTags are prepaid rechargeable tags for automatic toll collection at toll collection booths using RFID technology.
  • It helps in faster mobility by solving the issue of Jams at toll booths. It is also a step in the direction of a cashless economy.
  • From 15th January 2020, it is mandatory for all vehicles passing through tolls to have FASTags.  
FasTag

2.3 Payment Infrastructure Development Scheme (PIDF)

  • PIDF aims to strengthen digital payment infrastructure across Tier-3 to Tier-6 cities, focusing on the North-Eastern States. 
  • PIDF will subsidize merchants, street vendors, artisans etc. for deploying digital payment systems like Point of Sale (PoS) terminals, a QR-based payment system, etc.
  • The scheme was started on 1st January 2021 for 3 years. Subsequently, the government has extended it for another 2 years till 31 Dec 2025.

2.4 Scheme For Financial Support To Digital Payments

  • It is an incentive scheme for promotion of RuPay Debit Cards and low-value BHIM-UPI transactions (person-to-merchant or P2M)
  • It is an initiative of Ministry of Electronics and Information Technology with the financial outlay of ₹ 2,600 crore. 
  • Banks will be provided financial incentive for promoting Point-of-Sale (PoS) and e-commerce transactions using RuPay Debit Cards and low-value BHIM-UPI transactions (P2M).

2.5 NEFT System

  • Using a bank, a person can settle the amount with another person even if they have a bank account in another bank. The NEFT (National Electronic Funds Transfer) system is used in the backend to settle these payments. 
  • NEFT settles the net amount between banks at the interval of 30 minutes. After 30 minutes, it will check the lakhs of transactions made between particular two banks throughout the country and settle the remaining amount between two banks. 
  • RBI operates this system. 
  • Using this system, transactions of up to ₹10 lakhs can be made.
  • After the 2021 update, even Prepaid Payment Instruments such as AmazonPay, Mobikwick etc., can use the NEFT system.
NEFT System

2.6 White Label ATMs

  • White Label ATMs are operated by private non-banking companies that own & operate their brand of ATMs.
  • All the other Bank ATMs can use these White Label ATMs & get service but at a nominal charge.
  • It is a step towards financial inclusion. ATM penetration will increase because of this.
  • E.g., Tata’s Indicash, Muthoot Finance, Srei Infra, Vakrangee Software, Prizm Payments etc.

2.7 Schemes by NPCI

NPCI is a not for profit company made by 10 promoter banks in 2008 to provide cost-effective payment solutions for banks

NPCI

NPCI is running various initiatives related to high-end technology in Banking & Payment Systems.

Initiatives of NPCI

1. UPI

  • UPI = Unified Payment Interface
  • It was started in 2016.
  • It is a technology for building digital payment apps (i.e. UPI is not an app but technology made by NPCI, which banks use in their apps).
  • Features provided by UPI
    • Scan the QR Code and pay directly to the merchant’s account.
    • Link your bank account to directly transfer money from your bank account without storing it in an e-wallet first.
    • The facility of ‘push transaction’ (e.g. Sending Remittances to family).
    • The facility of ‘pull transaction’ (e.g. Cable operator sending a request for the monthly bill within the app).
    • The facility of Bill sharing. 
    • Overdraft facility  
    • Cash on Delivery
    • User mandate for a future date, e.g. DTH 
    • Invoice in the inbox
    • It can also be used in Basic Phones (i.e. Non-Smartphones) using 123 Pay
  • Examples of UPI-based apps: are SBI Pay, AxisPay, PhonePe and NPCi’s BHIM.

UPI Lite

  • Users can add money from their bank account to UPI lite Wallet on their mobile app (such as the BHIM app or Google Pay).
  • The user can use money stored in the UPI Lite wallet to settle transactions without requiring a PIN.
  • The maximum amount that can be used per transaction is Rs. 500, and the maximum amount which can be stored in the UPI Lite wallet is Rs. 2000.
  • UPI Lite helps make transactions faster, and there are fewer chances of transaction failures when  the server of the bank is facing issues.

Internationalisation of UPI

  • In 2022, Nepal became the first foreign country to adopt the UPI system. UPI is now accepted in Nepal, Bhutan, Singapore, UAE, Oman, Sri Lanka, Mauritius and France.
  • In 2024, France became the first European country where UPI is accepted.
  • Project Nexus: RBI has joined this international initiative, which aims to connect Fast Payment Systems like India’s UPI and the UAE’s Instant Payment Platform (IPP).
  • UPI has changed the digital payment landscape in India as UPI’s share in the total digital transaction in India is continuously increasing.
UPI share in India's Digital Transactions

Side Topic: Unified Lending Interface (ULI)

  • ULI is proposed by the RBI Governor to revolutionize the lending ecosystem in India (similar to UPI for payments)
  • Issue it intends to solve: Currently, Lending Institutions cannot make quick credit appraisals as the data required for this are stored with different entities, such as banks, the government, credit information companies, etc.
Unified Lending Interface (ULI)
  • ULI will facilitate the seamless flow of information between these institutions so that the Lending Institution can make a quick decision regarding credit appraisal, especially for small and rural borrowers.
  • API of ULI can be easily integrated into apps and websites in the Plug and Play Model.
Explanation of the working of Unified Lending Interface (ULI)

2. e-RUPI

  • The issue to be solved:
    • Poor and rural populations don’t have bank accounts.
    • Money given by the government, even in a well-targeted way via Direct Benefit Transfer, can be used by the beneficiary for any other purpose.
  • e-RUPI is a QR-based purpose-specific digital voucher where it is not required for the customer to have a bank account and is operable on basic phones, even in areas that lack an internet connection.
e-RUPI

3. Bharat QR Code

  • It was started in Feb 2017.
  • Bharat QR code has been developed jointly by the National Payments Corporation of India (NPCI), Visa, MasterCard and American Express under instructions from the Reserve Bank of India (RBI). 
  • Note – QR is a two-dimensional machine-readable matrix. QR Code can store up to 7089 digits compared to conventional bar codes that can store a max of 20 digits.
Bharat QR Code

Advantages

  • It eliminates the need to use card-swiping machines for digital payments. There is no need to have ‘Swiping Machines’ in shops. Just have QR printed & payments can be easily done via that. 
  • Interoperability: Using the BharatQR code, the merchants will be required to display only one QR code instead of multiple ones. 
  • For the buyer, there is no need to carry a card. Payment can be made via mobile. 

4. Aadhar Enabled Payment System  (AePS)

The customer has to tell the Aadhar number and name to the merchant or Bank Business Correspondent, who authenticates it using the customer’s fingerprint. Following this simple step, his transaction is completed.

Aadhar Enabled Payment System (AePS)

5. Cheque Truncation System (CTS)

  • If somebody from Delhi gives a Cheque from the Delhi Bank Branch to a person in say Chandigarh. Earlier, that cheque was physically sent to Delhi Branch for settlement. 
  • Under CTS, a Scanned image of the cheque can be sent to Delhi Branch, and settlement can be done rapidly. 

6. National Financial Switch (NFS)

  • ATM Card of one Bank can be used in other Banks too. The system that is working in the backend to make this possible is NFS. 
  • NFS helps re-route transactions to the Core Banking Solution Network of the Bank whose ATM card is being used. 
National Financial Switch

7. NACH (National Automated Clearing House)

  • NACH helps with Automated Payments, which are to be paid periodically, like each month or year, e.g., salaries, bills, EMI etc. 
  • NACH is finding great attraction among customers, companies and government departments to pay bills, EMIs, salaries, pensions etc.

8. IMPS

  • IMPS = Immediate Payment Settlement System 
  • It is available 24X7.  
  • It is used for real-time settlement of all online payments up to Rs. 5 lakh. 
  • It is not free. A service fee is charged on the transactions.

9. Bharat Bill Payment System (BBPS)

  • BBPS is an initiative of NPCI.
  • It builds an interoperable service through a network of agents to facilitate all types of bill payments through different modes and instant generation of payment receipts. 

10. Offline Retail Payments using Card and Mobile Devices

  • RBI has allowed offline payment using the card and mobile devices to deal with the issue of internet connectivity.
  • The maximum transaction allowed under the scheme
    1. Rs. 200 per transaction
    2. Subject to an overall limit of Rs 2000 (after that person will have to go online to settle the transactions)

2.8 Lightweight Payment and Settlement System (LPSS)

  • The Lightweight Payment and Settlement System (LPSS) is developed by RBI as an alternative backup to existing platforms of payment and settlement, such as NEFT, IMPS, RTGS, etc., during an emergency such as a natural disaster or war.
  • The system is designed to be lightweight, meaning it does not require heavy infrastructure or large teams to function.
Lightweight Payment and Settlement System (LPSS)

Side Topic: ATM security features introduced to prevent frauds

1. ATM Card Technology changed to EMV Technology

Magnetic Technology

  • Magnetic Technology used in the ATMs has been used since the 1960s. 
  • In this, data is stored on the magnetic strip. But it is insecure as the data can be duplicated, cloned, skimmed while swiping the card, which increases the chances of fraud.
  • So, RBI stopped such cards from 1/1/2019 using the Payment & Settlement Act powers. 

EMV Technology

  • Full form: Europay + Mastercard+ Visa  
  • It is based on chip infrastructure with encryption. 
  • RBI had ordered migration in 2013. It has become operational on 1/1/2019. 
  • Two sub-types
    • EMV-Contact: cards must remain in the Point of Sale (PoS) Terminal during the transaction. 
    • EMV-contactless cards: Tap the card on the terminal using RFID technology. 
EMV Technology

2. Card Tokenisation

  • When we shop on sites like Amazon, Flipkart etc. or pay bills using PayTM, they allow us to store our Debit or Credit Card information like Card Number, Expiry date etc., for future convenience. But this thing has security implications in case the server of such a company is hacked, and user information is leaked. 
  • To prevent such incidents, Card Tokenization was introduced by RBI in Jan 2019. It was fully implemented on 1 October 2022.
    • Tokenization = Token number is generated for a given credit/debit card.
    • Card customer gives the token number during any type of online/physical shop transaction. His original card number, expiry date, etc., remains hidden from the third party seller.

Financial Inclusion

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Last Updated: Feb 2025 (Financial Inclusion)

Financial Inclusion

This article deals with ‘Financial Inclusion.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

What is Financial Inclusion?

As defined by Rangarajan Committee on Financial Inclusion in 2008, Financial inclusion means everyone is given access to financial services, i.e. Banking, Credit, Insurance & Investment, at affordable cost & in an appropriate time frame.

Financial Inclusion

Importance of Financial Inclusion

  • It helps the family to cope with unforeseen circumstances like the breadwinner’s death.
  • It helps in converting savings to investments, which helps in nation-building. Japan, the USA etc., have earlier followed the same path.
  • Protect common people from exploiting informal money lenders who charge exorbitant interest rates. 
  • Providing good investment schemes can protect people from falling into traps such as Ponzi Schemes like Saradha & Rose Valley Chit Fund Schemes.
  • E – Payment: Cashless subsidies & salaries can save the government ₹1 Lakh crore, according to McKinley’s study.

Challenges

  • In rural areas, there is the problem of accessibility. The number of branches in rural areas is low.
  • Geographically hilly and desert regions don’t have extensive bank penetration.
  • Gender: Access of women to banks is low. Women have a disproportionately lower number of accounts than men.
  • 55% of rural Dalits borrow from money lenders at exorbitant rates.
  • MSMEs are given a low value of loans compared to big industrial houses. 

New steps taken by Government for Financial Inclusion

Government is very much concerned to increase Financial Inclusion and taking various steps in this regard.

1 . Committees

Various committees have been formed like

  • Nachiket Mor Committee: Suggested various measures like Payment Banks, Small Banks etc.
  • Deepak Mohanty Committee for Mid Term Path to Financial Inclusion: Suggested various measures like (1) Use USSD on simple mobiles, (2) Scrap Interest Subvention Scheme for farmers and concentrate on Insurance instead, (3) promote Sukanya Samridhi Scheme to cultivate saving habit in girls etc. 

2. New types of Differential Banks started

3. Schemes

  • Jan Dhan Yojana is the main one (we are going to read it in detail below).

4. Digital Schemes

The government has taken various initiatives in this regard like

  • Introduction of Rupay Card 
  • UPI, UPI 2.0 & BHIM
  • Bharat pay

5. Small Investment Schemes

  • The government has launched Small Investment Schemes to promote the habit of savings among the poor and save them from Ponzi scams
  • Main schemes include
    1. Kisan Vikas Patra (doubles money in 8 years 4 months)
    2. Indira Vikas Patra 
    3. Public Provident Fund 
    4. Sukanya Samridhi Yojana (component of Beti Bachao, Beti Padhao): Scheme for small girl children in which the parents can deposit money (between Rs 250 to 1.5 lakh per annum) till girl reaches the age of 14 years and can be later withdrawn by the girl when she reaches the age of 18 years for her studies or marriage. Government offers higher interest than normal rates on such deposits.

6. Digital Banking Units

  •  A digital banking unit is a specialized fixed point business unit or hub housing only digital infrastructure for providing banking services  digitally in self-service mode at any time.
  • It was announced in Budget 2022. Government opened 75 DBUs in 65 districts . Commercial banks (other than regional rural banks, payment banks and local area banks) with past digital banking experience are permitted to open DBUs in tier 1 to tier 6 centres.

Earlier Schemes for Financial Inclusion

  • Bank Nationalization was done in 1969 and 1980. 
  • Regional Rural Banks & Cooperative Banks have been opened. 
  • Micro Finance Institutions have been promoted by the government.
  • Various banks have started no-frills accounts (i.e. accounts with zero balance) schemes.
  • 25% rural bank mandate: Banks have to open 25% of their branches in rural unbanked areas.
  • Post Office Schemes to deposit money. 

Jan Dhan Yojana

Works on following pillars pillars

  • Free Bank Account for every family (with no opening charges or maintenance charges)
  • Free Rupay Card
  • Rs 2 lakh accident insurance (initially it was Rs. 1 lakh and increased to 2 lakh in 2018)
  • Rs. 10,000 overdraft facility
  • Banking outlet for each household within 5 km.
  • Impart financial literacy.
  • Direct Benefit Transfer (DBT) of government schemes and subsidies through Jan Dhan Accounts.

Financial Inclusion

The scheme completed 10 years in August 2024 (it was started on 28th August 2014)

As of August 2024

  • 53 crore PMJDY Accounts have been opened.
  • 29.5 crore accounts out of above are of Women.
  • Rs. 1.45 lakh crore have been deposited in the PMJDY accounts.

Benefits

  • According to Global Findex Report, 80% of adults in India now have Bank accounts due to Jan Dhan Scheme. Bank accounts have increased from 14.72 crores in 2015 to 53 crores in 2024.
  • It has helped in Women empowerment as many women’s accounts have been opened. About two-thirds of the accounts opened under PMJDY are of women belonging to rural and semi-urban areas.
  • It has helped the government implement Direct Benefit Transfers and prevent leakage of subsidies.
  • It has helped in breaking the hold of local moneylenders. 
  • It has helped in the formalization of the financial system in India and gave an avenue to the poor for bringing their savings into the formal financial system.

Issues

  1. Account Dormancy (72% of accounts opened under the scheme are dormant, according to Microwave (think tank survey).
  2. Account Duplication (33% duplicate accounts have been opened due to the attraction of insurance & overdraft facility).
  3. Rupay cards are not given to 70% of Jan Dhan Account holders. Overdraft facility can’t be used without that.
  4. Jan Dhan Account Holders are being used as money mules by Hawala Agents.
  5. The operating cost of Banks is increasing because they have to keep on servicing the dormant account. It costs ₹100 to 150 / annum to banks to maintain each account.
  6. In 2016, Indian Express reported that Bank Officials made one ₹ deposit to Jan Dhan accounts to hide their zero balance status. It shows that these can be used in money laundering too.

Priority Sector Lending

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Last Updated: Jan 2025 (Priority Sector Lending)

Priority Sector Lending

This article deals with ‘Priority Sector Lending .’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Introduction

  • The basic principle in Economics states that ‘No Risk-No Reward’ & ’High Risk-High Reward’.
  • Hence, Banks will charge a high rate of interest from farmers, students, small entrepreneurs, etc. To tackle this, RBI in the 1980s came with PSL norms.

Who is covered under Priority Sector Lending (PSL)?

Priority Sector Lending

The following classes of Banks are required to give a certain percentage of their total loans to Priority Sector

  • Domestic Scheduled Commercial Bank (Public and Private) = 40%
  • Foreign Scheduled Commercial Bank (SCB) = 40%
  • RRB = 75 %
  • Small Finance Banks = 75%
  • Urban Cooperative Banks: 65% in FY 2024-25 which will be increased to 75% in FY2025-26
  • Cooperative Banks (other than Urban Coop Banks) = No Requirement

What includes PSL?

Category% SCB  
Weaker Sections 10%  
Agriculture & Allied Activities 10%  
Marginal & Small farmer 8% – Added as a new category in April 2016.
– Earlier Agriculture and Allied Activities were given 18% but due to broad categories, small & marginal farmers weren’t getting anything.
Micro-Enterprise – Khadi-Village industry 7.50%  
All other PSL categories 4.5% These include
1. Small & Medium Enterprises
2. Affordable housing loans to beneficiaries under PMAY
3. Food Processing Companies
4. Vermicompost, Biofertilizer and Seed Production
5. Student-Education Loans (up to Rs.10 lakh)
6. Social Infrastructure (schools, health care, drinking water and sanitation facilities)
7. Renewable Energy Projects (windmills,  solar  etc.)  
Total PSL 40%  

Note: For Foreign Banks with less than 20 branches, 40% PSL is there, but there is no internal classification. Their consolidated PSL should be 40%.

Revised Priority Sector Lending Norms

RBI announced this in 2024 to promote PSL in districts with low average loan sizes.

  • Incentive Framework: To incentivise the banks in giving loans in districts with lower credit flow (less than Rs.9k per person), more weight, i.e. 125%, will be given to fresh PSL disbursed in those districts.
  • Disincentive Framework:  To disincentivise the banks in giving loans in districts with higher loan availability (higher than 42k per person), less weight, i.e. 90%, will be given to fresh PSL disbursed in those districts.
Revised Priority Sector Lending Norms

For rest of the districts, there will be no change with weight being 100%.

Benefits of Priority Sector Lending

  • It helps in channelizing credit to the vulnerable section.
  • PSL helps in financial inclusion.
  • PSL provides higher social returns on lending.
  • It helps in the diversification of the credit portfolio of the banks.
  • Credit Formalization: It helps break the hold of non-institutional lenders, especially in rural areas.

Issues with Priority Sector Lending

  • Rising NPA: Second Narsimham Committee (1998) observed that 47% of all NPA have come from PSL. It recommended ending the system of PSL for the betterment of the Banking Sector. 
  • Lethargy in Lending: Most banks seem reluctant to lend to the priority sectors due to higher NPAs, more administrative costs etc.
  • Not used for the intended purpose, especially in the Agriculture sector. The loan given to farmers under PSL is to increase productivity, but it is used for unproductive purposes like marriages and other social obligations. 
  • Targeting issues: Suitcase farmers benefit instead of poor farmers.
  • Increased Costs: The administrative costs of PSL loans are high.
  • Deter banks from expanding their scale of lending as the more they lend, the more they will have to contribute to PSL.

What if the PSL quota is not met?

Most banks aren’t able to meet their PSL quotas. In this case, they have to invest the remainder in RIDF or SIDF as the case may be

Indian Banks + Foreign banks (with 20 or more branches)

1. RIDF =Rural infra. Development fund

  • Managed by NABARD
  • For funding rural infrastructure projects

2. UIDF = Urban Infrastructure Development Fund

  • New Fund announced in Budget 2023
  • Managed by National Housing Bank (NHB)
  • For funding urban infrastructure projects, especially in Tier-2 cities.

Foreign Banks with less than 20 branches

SEDF = Small Enterprises development fund

  • Managed by SIDBI

But the problem with both of the above is that money is given for the long term, i.e. around 20 years. Hence, banks’ money is gone for a long time which they cant use & as a result, they suffer in the meantime. To address this, RBI came with Priority Sector Lending Certificates.

Priority Sector Lending Certificates

  • In this arrangement, the overachieving Banks can sell their excess PSL in the form of ‘certificates’ to underachieving banks without transferring the loan assets or its risk. 
Priority Sector Lending Certificates
  • Four kinds of PSLCs are traded through RBI’s e-Kuber Portal, viz
    • Agriculture (PSLC-A)
    • Small and Marginal Farmers (PSLCSM)
    • Micro Enterprises (PSLC-ME)
    • General (PSLC-G)

Rural Banking

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Last Update: Jan 2025 (Rural Banking)

Rural Banking

This article deals with ‘Rural Banking.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Steps taken to promote Rural Banking

1. Before Independence

  • During the British Raj & initial years of independence, Banks (& insurance companies) operated in Urban Areas only.
  • Result: Villagers used to rely on money lenders, who lend money at exorbitant rates & people remained in debt & poverty forever.

2. After Independence

1950s Cooperative Banks/Societies
1955 Birth of SBI & ICICI
1960s Bank Nationalisation (1960 & 1969)
1969 Lead Bank Scheme
1975 Regional Rural Banks (RRB) setup
1980s NABARD setup + Bank Nationalisation(2nd Round)
Early 90s Self Help Group & Bank Linking
Late 90s Kisan Credit Card
Mid 2000s – No Frills Account
– Banking Business Correspondent
– Interest Subvention Schemes on Crop Loans
Present RRB Amendment + Payment Banks

Lead Bank Scheme

  • During the 1960s, Narsimham Committee recommended that the responsibility of development should be given to banks. Hence, Lead Bank Scheme was launched.
  • In 1969, the State Bank of India and its subsidiaries, along with 14 National Banks and 3 Private Banks, were selected under the Lead Bank Scheme. Every district was given to a specific bank (called Lead Bank) making it responsible for the development of Banking in that district.
  • Later, in 1975, these banks were asked to set up subsidiary banks in their districts known as Regional Rural Banks.

Rural Infrastructure Development Fund (RIDF)

  • RIDF was started in the mid-1990s.
  • NABARD operates RIDF.
  • This fund provides cheap loans to state & state-owned corporations so that they can complete projects related to 
Medium & Minor Irrigation Community Irrigation Wells
Soil ConservationVillage Knowledge Centres
Watershed Management Desalination Plants in Coastal Areas
Flood Protection Building Schools & Anganwadi Centres
Forest DevelopmentBuilding Toilet Blocks
Cold StorageRural Roads & Bridges
  • Banks who don’t meet their Priority Sector Lending requirements provide money to RIDF.

Regional Rural Banks

Cooperative Banks

  • Dealt below

Priority Sector Lending

Cooperative Banks

Cooperative Banks
  • A Cooperative Bank is a financial entity that belongs to its members, who are at the same time the owners and the customers of their bank.
  • These banks work on the principle of NO PROFIT & NO LOSS and ONE MEMBER, ONE VOTE.
  • They are subjected to CRR & SLR requirements. However, the requirements are less than for commercial banks. 
  • PSL requirements are not applicable to them. 
  • They can be Scheduled or Non-Scheduled.
  • They were instrumental in dismantling the hegemony of money lenders in rural finance.
  • Before the nationalization drive took place in the 1960s, Cooperative Banks constituted 80% of institutional credit. But after the nationalization of banks, their share decreased significantly due to stiff competition from commercial banks.
  • Due to the One Member, One Vote, they suffer from caste politics. 
  • These banks don’t have an all-India presence & are present in selected regions like Gujarat, Maharashtra, Andhra Pradesh and Tamil Nadu, where the cooperative movement was strong. 
  • In 2018, RBI allowed Urban Cooperatives to voluntarily transform into Small Finance Banks, with conditions. Consequently, Shivalik Mercantile Cooperative Bank became a Small Finance Bank in 2021.

Comparison

  Commercial Cooperative
Banking Regulation Act Yes Yes (Since 1966)
CRR and SLR requirements Yes Yes ( but lesser than Commercial Banks)
PSL Yes No
Who can borrow? Anyone Only Members
Voting Power Proportionate to Shareholding One Member, One Vote
Profit Motive Yes No Profit, No Loss
Presence All India Present all over India but mainly concentrated in Gujarat, Maharashtra, Andhra & Tamil Nadu.

Who Regulates Cooperative Banks?

Earlier, Cooperative Banks were under the dual regulation of RBI and the Registrar of Cooperative Societies, as shown in the figure below. But this led to delays in the corrective actions, which culminated in corruption and the fall of banks (like Punjab and Maharashtra Cooperative Bank)

regulation of Cooperative Banks

Hence, Banking Regulation Act has been amended, and the problem of dual regulation has been solved wrt Urban and Multi-State Cooperative Banks. Now, RBI has been made the sole regulator in the case of Urban and Multi-State Cooperative Banks.

Regulation of Cooperative Banks in India

Rural Co-Operative Banks

Structure and Funding of Rural Co-operative banks is as follows

Structure of Rural Cooperative Banks
Rural Cooperative Bank (Example)
Rural Cooperative Bank Structure (Example)

Challenges

  • Rural Cooperatives suffer from huge NPAs. The NPA level in these banks was around 25% in 2015.
  • Due to 1 person 1 vote, they suffer from Casteism during voting. After getting elected, elected officials serve people belonging to their caste only. 
  • Although SARFAESI Act powers are given to these banks, these banks don’t take action on defaulters due to political backing.
  • Deposits are very low because rates are not competitive against Scheduled Commercial Banks & Post Office Deposits. Hence, they have to depend on NABARD funding.
  • Large-scale manipulation goes on in District Central Cooperative Banks (DCCBs) and PACS as their operations are not digitalized and aren’t connected to Core Banking Solution. During demonetization, District Cooperative Banks changed black money in the back-date. 
  • They are under the dual supervision of RBI and the Registrar of Cooperative Societies (RCS) of the respective states. It has led to poor supervision and control.

Solution

  • Close down PACS & form LAMPS (LArge Sized Multipurpose Society) in their place. Their operations will not be restricted to giving loans. Apart from banking, LAMPS will also be involved in food processing, supplying fertilizers and seeds etc. 

Urban Cooperative Banks (UCBs)

  • Traditionally, the area of operation of the UCBs was confined to metropolitan, urban or semi-urban centres and catered to the needs of small borrowers, including MSMEs, retail traders, small entrepreneurs, professionals and the salaried class. However, there is no formal restriction as such, and today UCBs can conduct business in the entire district in which they are registered, including rural areas.
  • UCBs are suffering from losses.

Reasons for losses

  • Poor Governance: UCBs are dominated by builders and manipulators. They indulge in Zombie-lending. E.g., Punjab and Maharashtra Cooperative Bank kept on doing zombie-lending to a weak company called HDIL due to corrupt nexus between directors and HDIL owners. When HDIL failed, the NPA of the bank increased exponentially, and the depositor’s money was stuck in the bank. 
  • Stiff Competition: Urban Cooperatives are facing stiff competition from Small Finance Banks and FinTech Companies to attract new customers.
  • High NPA: The level of NPAs in Urban Cooperatives is high (10.9% as of September 2023).
  • Although they are given powers under the SARFAESI Act, bank officials don’t use them because debtors are their friends and relatives.

Steps taken

  • RBI’s 4-tiered Regulatory Framework for Urban Cooperative Banks: To ensure the safety of deposits in Urban Cooperative banks, a 4-tiered Regulatory Framework has been introduced. It will ensure that banks with more deposits are subjected to stricter regulations (explained in the diagram below). 
RBI’s 4-tiered Regulatory Framework for Urban Cooperative Banks:
  • National Urban Cooperative Finance and Development Cooperation: It is an umbrella organization for UCBs set up in 2024 on the recommendations of the NS Vishwanathan Committee. Such Umbrella Organizations are also present in countries such as the USA, Canada, France, etc., where cooperative banks (Credit Unions) thrive. Its primary functions include
    • Expand the number of UCBs.
    • Extend the liquidity and capital support to UCBs. It is registered with RBI as non-deposit taking NBFC and UCBs can subscribe to its capital.
    • Facilitate UCBs to comply with regulatory compliance .
    • Setup IT infrastructure for shared use of members. It will enable UCBs to provide wide array of services to their clients at lower cost.
  • In 2020, the power of the Union and State Government’s Registrar for Cooperative Societies to regulate the Cooperative Banks had been scrapped. These Cooperative Banks have been brought under the direct regulation of RBI. It will ensure effective regulation and curtail scams such as PMC Bank (Punjab and Maharashtra Cooperative Bank).
  • Banking (Regulation) Act has been amended, and according to the new provisions, 51% of the Directors should have knowledge of accountancy, banking, economics or law. This will solve the problem of the nomination of directors based on political considerations. 
  • RBI has offered all Urban Cooperative Banks to convert to Small Finance Banks so that RBI can have more regulation over these Banks. But most UCBs are least interested in converting because of the benefits accruing from present loopholes. 
  • RBI is forcing shutdowns (reduced from 1900 (2004) to 1500 (2018)) and mergers (Maharashtra = 72 mergers between 2004 to 2018) due to frauds and scams.
Urban Cooperative Banks

This marks the end of ‘rural banking.’ For more articles, CLICK HERE.

Differential Banks

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Last Updated: Jan 2025 (Differential Banks)

Differential Banks

This article deals with ‘Differential Banks (Payment Banks, Small Area Banks, Local Area Banks etc.).’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Differential Banks vs. Universal Banks

Differential Banks

Differential Banks are different from Universal Banks in the following ways

  Universal Banks Differential Banks
Branches Universal Banks can open Branch anywhere. For example: SBI, ICICI etc.Differential Banks have geographical restrictions on branch opening. For Example:  Local Area Bank (LAB), Regional Rural Banks (RRB) etc.
Money acceptance Universal Banks can accept both Time & Demand Deposits of any amountRestrictions are there. Eg: Payment Bank: Can accept the maximum amount of Rs 1 lakh only in deposit.
Give Loans to Anyone Restrictions are present. Eg:
1. Small Finance Bank, Regional Rural Bank: must give 75% to Priority Sector.
2. Payment Bank can’t give loans.

1. Regional Rural Banks  (RRB)

Need of RRBs

  • In 1975, the government appointed MM Narsimham Committee to look into Rural Banking.
  • Observations of the Narsimham Committee were as follows:-
    • The staff of the Banks has expertise in banking & financial matters but is not aware of rural people’s problems. 
    • Primary Agriculture Credit Societies (PACS) have members from villages & are aware of the needs and problems of the villagers.
  • Recommendation:  CREATE HYBRID OF BOTH, i.e. BANKS HAVING FINANCIAL STRENGTH OF COMMERCIAL BANKS & GRASSROOT PROBLEM AWARENESS OF COOPERATIVES. Hence, the concept of RRB came to being. 
  • As a result, Regional Rural Banks (RRBs) were first set up on 2 October 1975 under RRB Act. 
  • Presently, there are 43 RRBs in India (Click Here for the List)

Client of RRBs

RRB provide loan & saving facilities to villagers & they include

Farmers Rural Entrepreneurs
Agricultural Labourers Cooperative societies
Rural Artisans Primary Agricultural Credit Societies

Structure

  • RRBs are sponsored by Commercial Banks
    • Sponsor Bank provides training to the staff of RRB.
    • Sponsor Bank also provides initial capital to set up RRB.
  • RRB operates in selective districts & doesn’t have all India presence.
  • The provisions of Priority Sector Lending (PSL) are applicable to RRB (75% of loans should be PSL).
  • According to the original RRB Act, paid up capital ( ownership) of RRBs was in the ratio i.e. Central Government: State Government: Sponsor Bank = 50: 35: 15
Regional Rural Banks (RRB)

Failure of RRBs

  • Due to excessive lending towards social banking & catering to highly weaker sections, these banks started to incur huge losses by the early 1980s. 
  • Private & Public banks too started to operate in rural areas, which resulted in low deposits in RRBs. As a result, RRBs had to depend on NABARD for credit.
  • Debt waivers to farmers & NPA also created a lot of problems.

Subsequently, following the suggestions of the Kelkar Committee, the government stopped opening new RRBs in 1987—by that time, their total number stood at 196.

Steps to revive

RRB Amendment Act, 2015  

  • Earlier shareholding requirements – Central : State : Sponsor Bank = 50:15:35 .
  • After Amendment, Centre, State & Sponsor Bank’s cumulative shareholding can reduce up to 51%.
State Union Sponsor 50% Bank OSBI Original Act Union + State + Sponsor Bank OSB 51% Others 35% civils edia.com RRB Amendment Act, 2015
  • In 2005, the amalgamation process of RRBs with their’ Parent Banks’ was initiated so these banks could become more viable (As of 2024, there are only 43 RRBs ).
  • RBI enabled the RRBs to avail the benefits through the Liquidity Adjustment Facility (LAF).
  • The obligation of concessional loans has been abolished & RRBs have started to charge commercial interest rates on lending.
  • Target client restrictions have been ended & RRBs can now serve anybody.
  • Dr KC Chakrabarty Committee has recommended that CAR/CRAR for RRBs should also be 9% & to achieve this, the government should recapitalize RRBs.

Note – Recently launched Priority Sector Lending Certificates (PSLC) will help them because RRBs do a lot of PSL.

2. Local Area Banks (LAB)

  • In 1996, Manmohan Singh (as Finance Minister) mooted to start Local Area Bank (LAB).
  • They are licensed under Banking Regulation Act but not included in the 2nd Schedule of the RBI Act.  
  • The vision was to increase financial inclusion.

Conditions

  • They can operate only in Rural & Semi-Urban Areas.
  • LAB can operate in a maximum of 3 geographically contiguous districts. 
  • LAB can open only 1 branch in an Urban / District city.
  • PSL norms apply to LABs as well. 40% of loans should go to Priority Sector.
  • They are not Scheduled Commercial Banks because their names are not mentioned in RBI Act. 

Problems with Local Area Banks

  • MSME loans given by LABs aren’t covered under the Credit Guarantee Scheme of the Government.
  • Farm loans aren’t covered under Interest Subvention Scheme.
  • State/Central PSUs/Institutes don’t open accounts in them.
  • Branch expansion is heavily restricted in rural & semi-urban areas.
  • They can’t get loans from RBI at Bank Rate /MSF.
  • They can’t get refinance from NABARD /SIDBI. 

Operating Banks

  • 10 Licenses were given at that time & only 2 are operating presently.
  • LABs were in the news in 2016 when applications for Small Financial Banks were called. Usha Thorat Committee allowed them to apply for Small Finance Banks & one out of them, i.e. Capital Local Area Bank based in Punjab got the license to open Small Finance Bank 
Local Area Banks (LAB)

3. Payment Banks

What are Payment Banks?

  • Payment Banks are a new stripped-down type of bank expected to reach customers mainly through mobiles rather than traditional bank branches.
  • Payment Banks were formed under the recommendations of the Nachiket Mor Committee. Consequently, in 2015, RBI granted ‘in-principle’ approval for payment banks to 11 entities. There are 5 in the market now.
 EstablishedHeadquarter
Airtel Payments Bank2017New Delhi
Fino Payments Bank2017Mumbai
India Post Payments Bank2018New Delhi
Jio Payments Bank2018Mumbai
NSDL Payments Bank2018Mumbai

Note: Out of the 11 bank entities which got in-principle approval, 3 surrendered their licenses without starting operations and 3 started their business but are defunct now

Surrendered (3)1. Cholamandalam Distribution Services Ltd 
2. Dilip Shantilal Shanghvi 
3. Tech Mahindra Ltd. 
Defunct1. Vodafone m-Pesa
2. PayTM Payments Bank
3. Aditya Birla Payments Bank

PayTM  Payments Bank was stopped by the RBI to take new customers and accepting deposits in 2024 due to non-compliance of regulatory norms. 

Characteristics of Payment Banks

1. Target Audience

  • Small Businessmen, Poor (domestic) Immigrant Workers and the Rural Population.

2. CRR

  • Banks have to keep Cash Reserve Ratio (CRR) just as Scheduled Commercial Banks.

3. Entry Capital

  • Payment Banks require ₹ 100 crores as entry capital/

4. Features

  • Payment Banks can hold up to ₹ 2 Lakh in Current or Saving account. 
  • But they cant involve in any credit risk, i.e. can’t give loans to others. However, they can invest in SLR-approved securities.
  • They must maintain the Capital Adequacy Ratio (CAR) of  15% (compared to ordinary Banks which are required to maintain a CAR of 9%).
  • They can issue debit cards and ATM cards usable on ATM networks of all banks. But they can’t issue credit cards.
  • They can offer transactions, transfers and remittances through a mobile.
  • Since Payment Banks can become Banking Correspondents of Universal Banks, the customer can use the same account as that of Universal Bank and take services of Payment Bank from that account. 
  • The Payment bank will enjoy all the rights and responsibilities of Scheduled Commercial Banks.
  • Payments Banks must use the word ‘Payments’ in their name to differentiate them from other banks.

Working of Payment Banks

Working of Payment Banks

Case Study of m-Pesa: Why India should get Payment Banks (case study)

  • M-Pesa is Kenya’s Payment bank. 
  • M = Mobile & Pesa = Money in Swahili . 
  • It provides banking services through mobile and works in the same way as Payment Banks. Nachiket Mor Committee recommended starting Payment Banks based on the success story of m-Pesa in Kenya.
Case Study of m-Pesa

Benefits of Payment Banks

  • Help in Financial Inclusion: It is uneconomical for traditional banks to open branches in every village, but mobile coverage is a promising low-cost platform.
  • Remittances at Zero Cost: Their main target is migrant labourers. It will tap India’s domestic remittance market.
  • Increase in the disposable income of poor migrant families: Since Remittances will happen at zero cost, it will increase disposable income in the hands of low-income migrant families.
  • These banks will help in the easy implementation of Direct Benefit Transfer.
  • They will help in moving India towards a less-cash society.  
  • They will create job opportunities in the form of Payment Bank’s Agents. 

Problems with Payment Banks

  • Low Revenue: Payment Banks can’t undertake any lending businesses and can only invest in SLR-approved securities.
  • Banks are already offering most services that payments banks can offer. Hence, offering a new and differentiated proposition will not be easy for Payment Banks. 
  • RBI has launched Unified Payment Interface (UPI), giving a blow to the business plans of Payment banks.
  • Regulatory Issues: PayTM Payments bank was closed as it did not comply with the regulatory norms.

As a result, after initial enthusiasm in applying for payment banks, companies like Tech Mahindra, Sanghvi’s, and Cholamandalam Investment have opted out.

Side Topic: Indian Post

Post office as Financial Intermediary

In September 2018, India Post Payment Bank was launched. 

  • All 1.55 Lakh Post Offices were linked to Payment Bank System.
  • 3 lakh Postmen and Grameen Dak Sewaks now provide on-the-door banking facilities.
  • India Post Payment Bank has all the features & benefits of Payment Banks like 1. Up to 2 lakh deposit 2. 4% interest Rate 3. Debit Card facility 4. Free withdrawals from own ATMs and Punjab National Bank’s ATMs and 5. No minimum balance (with the added benefit that they already have post office infrastructure).
  • They have also partnered with Bajaj Alliance Life Insurance (BALIC) to sell insurance policies. 
  • Till September 2023, more than 6 crore accounts have been opened across country including 96 lakh in Aspirational Districts. 

Post office as Financial Intermediary

  • Indian Post is the oldest & largest organization involved in resource mobilization in India.
  • It has a huge network of 1.55 lakh post offices, 3 lakh postmen & 5 lakh employees.
  • 90% of the post offices are present in Rural areas.  
  • Earlier, too, it provided a wide array of ‘financial services’ such as saving and other time deposit accounts, Public provident funds, Monthly Investment schemes, and National saving certificates. 
  • It comes to rescue the government when the banking system cannot deliver cash benefits such as under MGNREGA, Old age/disability Pension Schemes, etc. 
  • Post offices worldwide have gone through this transformation in many countries & experience was quite successful there. Most notable is Royal Post in the UK, which, apart from Banking services, also provides mobile and broadband services. The US is also considering such plans. 
  • It can free bigger commercial banks to concentrate on competitive commercial operations leaving social security works to be handled by Postal Bank. 
Indian Post

4. Small Finance Banks

  • The purpose of the small banks will be to provide a whole suite of basic banking products, such as deposits and supply of credit but in a limited area of operation (contiguous districts in a homogenous cluster of states or union territories).
  • These are modelled on Community Banks of USA. 
  • In Community Banks, Employees of banks know almost every family and therefore are well aware of their assets, credit history, financial position and business. As a result,  MSME Industry, Retail Businessmen and Farmers can take loans from them without any problem. 

Indian Parallels of Community Banks

  1. Old Private Banks like Catholic Syrian Bank of Kerala, Nainital Bank etc. 
  2. Local Area Banks 
  3. Regional Rural Banks
  4. Microfinance Institutions 

Unlike big PSBs (like SBI) and New Private Banks (like Axis, ICICI Bank), their employees know their customers very well.

Hence, Nachiket Mor Committee (2014) recommended the creation of Small Financial Banks based on the Community Banks of the USA. Their target customer base include unserved, underserved, small and marginal farmers along with MSMEs. Even Indian parallels can get an SFB license. At last, 10 contenders got provisional license. e.g., Capital Area Bank (Punjab), Au Financiers (Jaipur) etc.

Later 2 more licenses were issued

  1. Shivalik Small Finance Bank: Shivalik Mercantile Cooperative Bank became a Small Finance Bank, and it became the first Urban Cooperative to transition into a Small Finance Bank in 2021.
  2. Unity Small Finance Bank: Centrum Financial Services and PhonePe entered into banking by forming Unity Small Finance Bank in 2021.

Presently there are 11 Small Finance Banks

 Headquarters
Au SFBJaipur
Capital SFBJalandhar
ESAF SFBThrissur
Equitas SFBChennai
Jana SFBBangalore
North East SFBGuwahati
Suryoday SFBNavi Mumbai
Ujjivan SFBBangalore
Utkarsh SFBVaranasi
Shivalik SFBNoida
Unity SFBMumbai
Small Finance Banks

Prelims related information regarding Small Finance Banks 

  • They are licensed under Banking Regulation Act.
  • PSL requirement = 75% (40% category wise (as Universal Banks) + 35% into PSL with competitive edge).
  • They are Scheduled Banks under RBI Act.
  • CRR and SLR requirements are similar to existing Commercial Banks. 
  • CRAR/CAR requirements – 15% (ordinary Banks – 9%).
  • FDI – up to 74% allowed.
  • They can open bank branches with the condition that 25% of branches should be in rural unbanked areas.
  • The maximum loan size and investment limit exposure to single/group borrowers/issuers would be restricted to 15% of capital funds.
  • Loans and advances of up to ₹25 lakhs, primarily to micro-enterprises, should constitute at least 50 per cent of the loan portfolio.
  • They can evolve into Universal Banks after 5 years, subject to RBI’s discretion.

5. Wholesale Bank

It has not formed yet. RBI has proposed it in 2017. 

  1. Wholesale Bank will be regulated under the Banking Regulation Act.
  2. They can only accept deposits larger than Rs.10 crore from big investors. Apart from that, they will raise money by issuing bonds.
  3. It will not give a loan to a retail /common person. It will only lend in wholesale markets such as the infrastructure sector or corporates.
  4. PSL norms are applicable but at the wholesale level. They will finance big projects in Priority Sector and can sell extra PSL certificates to Scheduled Banks to fulfil their targets.
Wholesale Bank

Why do we need Wholesale Banks?

  • India needs huge investments in the Infrastructure Sector (₹40 trillion in the next decade). But there are issues.
    • The government is the biggest spender in the infrastructure sector (45% of total infrastructure spending). But government can’t invest more because of Fiscal Deficit problems.
    • The next biggest investor is banks. But they too cant invest more due to NPA Problem. 

To get more investment in infrastructure, the government plans to come up with Wholesale Banks.

  • The tenor of the infrastructural loans is very long, and therefore it does not incentivize institutions like Banks. Thus there is a need for separate infrastructure banks. Wholesale Banks will perform that work.
  • Right now, NBFCs are not under the supervision of RBI (and act somewhat like Shadow Banks) and are not covered under SARFAESI to recover their Bad Loans. It is not in the government’s interest to let them continue because they don’t have protection cover of CRR & SLR. By making Wholesale Banks, bigger NBFCs can be made to come under RBI’s regulatory supervision. 
  • Apart from that, they will help Banks to achieve their PSL Targets. They will invest huge amounts in PSL Projects and then issue their PSL Certificates which Banks can buy.  
Differential Banks

Merger and Consolidation of Public Sector Banks

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Last Updated: Jan 2025 (Merger and Consolidation of Public Sector Banks)

Merger and Consolidation of Public Sector Banks

This article deals with ‘Merger and Consolidation of Public Sector Banks.’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Bank Mergers

  • In 2016, it was decided in Gyan Sangam II that since Public Sector Banks aren’t performing well, there is a need to consolidate banks by merging small banks with the State Bank of India, Punjab National Bank, Bank of Baroda, Canara Bank etc. as Anchor Banks. 
  • The crux of the matter is the government is working on a consolidation of public sector banks to create 3-4 global-sized banks and reduce the number of state-owned banks to about 10-12. 

Mergers happened till now

  • 2017: SBI’s 5 Associated Banks & Bhartiya Mahila Bank merged with SBI.
  • 2019: Vijaya & Dena Bank merged with Bank of Baroda.   
  • 2019: Oriental Bank of Commerce and United Bank of India merged into Punjab National Bank.
  • 2019: Syndicate Bank merged with Canara Bank.
  • 2019: Andhra Bank and Corporation Bank merged with Union Bank of India.
  • 2019: Allahabad Bank merged with Indian Bank.
Merger and Consolidation of Public Sector Banks
Merger and Consolidation of Public Sector Banks

Points in favour of Merger of Banks

  • It will help in placing more Indian Banks in the top 100 banks of the world. It is sine quo non to have at least 6-8 top-100 banks of the world in India if we want to make India a financial hub of Asia and channelize global savings towards India to make India a $ 5 trillion economy. Currently, India has just one bank in the top 100 banks (SBI = 55 Rank), while China has 18. 
Number of top 100 banks in countries

India needs atleast 6-8 global banks in Top-100 to make India a $ 5 Trillion economy. (Economic Survey 2020)
  • Earlier State Bank of Saurashtra (2008) & Indore (2010) merger into SBI was successful. Hence, previous experience is pleasant. 
  • Larger banks provide financial stability and act as engines of growth in times of trouble. E.g. Chinese Banks in 2008.
  • It will lead to branch rationalization and reduce operating costs.
  • Larger Public Sector Banks can support the corporate sector better in overseas acquisitions as done by Chinese Banks.
  • To comply with BASEL III Norms, if big banks like consolidated SBI issue shares, they can fetch a good response. 
  • Enhanced geographical reach: For example, Vijaya Bank has strength in the South, while Bank of Baroda and Dena Bank had a stronger base in Western India. That would mean wider access for the proposed new entity and its customers. 
Merger of Banks

Points against Merger of Banks

  • Mergers eat up a lot of top management time. At a time when Public Sector Banks need razor focus to deal with the NPA menace, mergers will be very distracting.
  • Large banks aren’t necessarily efficient banks: The quest to create an Indian banking giant is an old one when the world looked in awe at the Japanese banking giants. But their big size emboldened them to do excessive lending and ultimately they had to be bailed out by taxpayers’ money.
  • The merged State Bank of India is likely to be five times larger than its nearest competitor and can stifle the competition.
  • Setback to corporate governance: The merger sends out a poor signal of a dominant shareholder (the government) dictating decisions that impact the minority shareholders.
  • Banks will lose their regional identities.
  • Political Implications: Kerala Legislative Assembly had passed the resolution that the State Bank of Travancore’s merger with SBI would negatively affect the state’s economic growth. 
  • Protests: Addressing the concerns of unions and shareholders will be challenging.
  • Harmonization of Technology: It is a big challenge as various banks are currently operating on different technology platforms.

Best way to Merge: Merge complementary banks. E.g., Bank of Baroda with Dena and Vijaya Bank so that layoffs aren’t large.

History of Banking System

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Last Updated: Jan 2025 (History of Banking System)

History of Banking System

This article deals with the ‘History of Banking System.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Financial Intermediaries

For the economy to function properly, savings must be channelled into investments. But there is a conflict here between savers and businesses/corporates. 

  1. Savers: Want instant access to their savings in case of unexpected expenditure.
  2. Businesses/Corporates: Want promise that they will not be forced to repay loans prematurely.

Banks can solve this problem by acting as an intermediary between savers and businesses (Ben Bernanke et al. )

Financial Intermediaries

Financial Intermediaries include Banks, Insurance Companies, Pension Funds, Mutual Funds etc.

Types of Financial Intermediaries

Banking System

Type of Banks in India
Type of Banks in India

Scheduled Commercial Banks

When RBI is satisfied that a bank has (Paid Up Capital + Reserves) of at least 5 Lakhs & it is not conducting business in a manner harmful to its depositors, such bank is listed in the 2nd Schedule of RBI Act, and it is known as a Scheduled Bank.

It is different from the Non-Scheduled Banks in the following ways

Scheduled Banks Non-Scheduled Banks
– Scheduled Banks are bound to maintain Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) as mandated by the RBI. They are not required to maintain SLR and CRR.
– They are eligible to borrow funds via Liquidity Adjustment Facility (Repo and Bank Rates). It depends on RBI’s discretion to borrow via this mechanism.
It can be subdivided into
1. Scheduled Commercial Banks, e.g. SBI, Axis, PNB, ICICI Bank etc.
2. Schedule Cooperative Banks like Haryana Rajya Sahakari Bank etc.
3. Schedule Payment Banks like PayTM Payment Bank, Fino Payments Bank etc.		Hundreds of Cooperative Banks are non-Schedule Banks.

Topic: History of the Banking System in India

History of the Banking System in India before Independence

  • Present Banking System was initially introduced in the Western World and was later introduced in India during the British Raj.
  • During British times, there were two types of Banks

1. British Banks

East India Company established Banks in 3 Presidencies.

Bengal 1806
Bombay 1840
Madras 1843
  • In 1921, these three merged to form the Imperial Bank of India. Later, it was nationalized and became SBI.
  • It provided services to British Army officers, Civil Servants & Judges.

2. Swadeshi Banks

  • These were set up by the Indians parallel to the British Banks. 
  • First Indian Bank to be opened was Allahabad Bank (1856). Later, other banks such as Bank of Baroda (backed by Gaekwads of Baroda), Punjab National Bank (role was played by Lala Lajpat Rai in its formation), Punjab & Sind Bank (by Bhai Vir Singh) etc. were established.
  • These banks targeted big merchants, particularly raw-material exporters.  

But neither of these helped in financial inclusion.

Birth of RBI

  • By the early 1930s, many banks were operating in India. They were registered under the Company Law, and regulations on this sector were not present. But the problem arose during The Great Depression (1929), which started in the USA. Due to this, the demand for Indian exports in the foreign market decreased, and Indian merchants began to default. 
  • Consequently, a large number of Indian banks collapsed.
  • To deal with such a situation and bring the banking sector under regulation, the British Indian government set up the Reserve Bank of India in 1934 under the recommendations of the Hilton Young Royal Commission. 

History after Independence

The Government of India took two important steps

Nationalisation of Banks

Nationalisation of Banks: SBI Case (1st Round )

1955 Imperial Bank was nationalized & renamed SBI. (At the same time, the Nationalization of Insurance Companies was also done)
1960 8 Banks were nationalised & made subsidiaries of the State Bank of India.
1963 Two subsidiary Banks were merged  (State Bank of Bikaner & State Bank of Jaipur), leading to the formation of the State Bank of Bikaner & Jaipur.
2008 State Bank of Saurashtra merged with Parent Bank.
2010 State Bank of Indore merged with Parent Bank.
Till recent times There were  5 subsidiaries of SBI
1. State Bank of Bikaner & Jaipur
2. State Bank of Hyderabad
3. State Bank of Mysore
4. State Bank of Patiala
5. State Bank of Travancore  
2017 All subsidiaries merged into Parent Bank
History of Banking System

Nationalisation of Banks:  Except SBI (2nd Round)

  • 1969: 14 Banks having deposits of more than ₹ 50 Crore were nationalized.
  • 1980: 6 more banks Nationalized, having deposits of more than ₹200 Crore.
Nationalised in 1969 Punjab National Bank, Canara Bank etc.
Nationalised in 1980 Punjab & Sind Bank, Vijaya Bank, Oriental Bank of Commerce etc.

Reasons of Nationalisation

  • To remove control & concentration of economic power in the hands of a few industrialists.
  • Due to misuse of funds by owners.
  • Due to the tendency of banks to ignore the needs of small-scale industrial sector & agriculture.
  • To remove the concentration of banking sector mostly in the Urban areas.

Objectives after Nationalisation

  • To open more banks in rural & semi-urban areas & to collect savings from these areas.
  • To provide credit facilities to areas defined as Priority Sector in the economy.



Has the Nationalisation of Private Banks benefitted India?

  • According to the Economic Survey (2020), banking resources to rural areas, agriculture, and priority sectors have increased due to the nationalisation of banks. For example, in the period between 1969-90
    • The number of Rural Bank branches increased ten-fold.
    • Credit to rural areas increased twenty-fold.
    • Agriculture Credit expanded forty-fold.
  • The US Banking System shows the inefficiencies of the Private Banking System during the successive financial scams, including the Subprime crisis of 2008, lending to subprime borrowers, bias against the people of colour etc. These things have not happened in India as the banks were nationalised.
  • But at the same time, Economic Survey (2020) doubts whether these benefits were entirely caused by nationalization as the period also saw various other events like green revolution, anti-poverty programmes (like the Integrated Rural Development Programme) and policies of RBI (such as RBI’s 4:1 formula).

Issues faced by Public Sector Banks due to Bank Nationalisation

  • Since the government was the majority shareholder of the banks, it started to give loans at populistic ‘Government Administered Interest Rates’, which decreased the banks’ profitability. 
  • Banks were forced to give loans to fund unviable projects based on political considerations, which increased the NPAs of Public Banks as the recovery of such loans was low. 
  • Public Sector Banks account for 92.9% of bank fraud cases. A large majority (90%) were related to advances, suggesting the poor quality of screening and monitoring processes for corporate lending adopted by Public Sector Banks.
  • PSBs perform poorly on Return-on-Assets (RoA), Return-on-Equity (RoE) etc., when compared with Private Banks. Public Sector Banks are having negative RoA presently. 

performance of Public Sector Banks
  • The politicization of Bank Boards happened with the government placing its favorites in the Board of Directors irrespective of their knowledge and talent. It reduced the professionalism in the banks.
  • Due to the above reasons, RBI feared that banks could collapse. Hence, it mandated a high Cash Reserve Ratio (CRR), reducing the funds at the disposal of banks for loan purposes. 
  • A large staff was hired in banks, even more than required, to create government jobs. It led to the unionization of staff and inefficient customer services. Frequent hartals of bank employees were observed in the period after nationalisation. 
NO OF BANK EMPLOYEES

PSB officers are subjected to extra scrutiny by the Central Vigilance Commission and CAG. Officers are wary of taking risks in lending or in renegotiating bad debt due to fears of harassment under the veil of vigilance investigations. 

Side Topic: Number of Public Sector Banks Today

  • Public Sector Banks = 12 ( on Jan 2025)

Old Private Banks

  • All the Big Private Banks were nationalized. But there were Small Private Banks whose deposits were less than limits and weren’t nationalized. These Banks are now called Old Private Banks. 
  • There are 12 such banks in India. 
  • These are Scheduled Banks and have to maintain Cash Reserve Ratio & Statutory Liquidity Ratio.
  • Examples: Catholic Syrian Bank, Dhanlaxmi Bank, Federal Bank, Jammu and Kashmir Bank etc.

Narsimham Committee and (Rise of ) New Private Sector Banks

After the 1980 nationalisation, Public Sector Banks had a 91% share in the national banking market which has reduced to 70%. The reduced stake has been absorbed by New Private Banks (NPBs), which came up in the early 1990s after liberalization. It brings us to the topic of New Private Banks.

Share of Private and Public Sector Banks

Private Sector Banks

The Balance of Payment crisis of 1991 finally forced the government to set up a Committee for Banking Sector Reforms under the former RBI Governor M Narsimham. He recommended following

  • Government should decrease its shareholding in Public Sector Banks. 
  • The banks’ resources came from the general public and were held by the banks in trust that they were to be deployed for the maximum benefit of the depositors. Even the government had no business to endanger the solvency, health and efficiency of the nationalised banks under the pretext of using bank’s resources for economic planning, social banking, poverty alleviation, etc.
  • RBI should decrease Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
  • Priority Sector Lending (PSL) given to agriculture and Small Scale Industries (SSIs) should be phased out gradually as they had already grown to a mature stage.  
  • Government should not dictate interest rates to Banks.
  • Liberalize the branch expansion policy. 
  • Allow entry of New Private Banks and New Foreign Banks.

This led to 3 Rounds of Banking Licences

1st Round (1993-95) 10 licenses were given to open the following banks. 
1. ICICI 
2. HDFC
3. Indus 
4. DCB 
5. UTI (later became Axis bank) 
6. IDBI (presently owned by LIC)
7. Global Trust Bank (later merged with Oriental Bank)  8-9-10: Bank of Punjab, Centurion Bank, and Times Bank were later merged into HDFC
2nd Round (2001-04)  2 licenses were given in the 2nd Round
1. Kotak Mahindra
2. Yes Bank   
3rd Round (2013) Bimal Jalan Committee made selections
1. Bandhan Bank (Originally, a Microfinance company based in West Bengal)  
2. IDFC (Originally, an infra finance NBFC based in Maharashtra).  

Side Topic: Number of Private Banks in India

  • 21 presently (these include both Old and New Private Banks).

On Tap System of Banking License

  • Earlier System: Start & Stop System
    • RBI issued notification and interested entities can apply at that time only..
    • Till now, 3 such rounds have happened
  • The new system proposed in 2016: On Tap System 
    • In this system, there will be no deadline for application. Hence, there is no need to wait for notification.
    • When an entity thinks it is fit to become a bank, it can approach RBI with the application. 
    • RBI has issued guidelines regarding this too.
  • In 2021, RBI gave Small Banking License to Unity Small Finance Bank through this route.
  • In 2023, the PRAVAAH Portal was started, where companies can apply for licenses from the RBI

The following company can apply for Bank License via the ‘On-Tap’ System

  • The company must have a minimum of 500 crores paid-up capital.
  • The company must have 10 years of record in the banking/finance sector.
  • Initially, it must be controlled by Indians (100% shareholding should be with Indians).
  • Applicant must be willing to open a minimum of 25% branches in rural areas.
  • They have to maintain CRR, SLR, PSL etc.
  • But large industrial houses and NBFCs can’t open banks via this route.  

Foreign Commercial Banks

  • In the Nehruvian Socialist Economy, there was disdain & apprehensions about Foreign Banks. Only a handful of them was allowed to open branches. But, Post-Narasimham Reforms, foreign banks approval policy was liberalized. 
  • In 1991, M Narsimham Committee recommended allowing Foreign Banks on a reciprocal basis. The government accepted this proposal.
  • There are 44 Foreign Banks in India
    1. AB Bank
    2. Abu Dhabi Commercial Bank
    3. American Express Banking
    4. ANZ Banking Group
    5. Bank of America
    6. Bank of Bahrain and Kuwait
    7. Barclays Bank
    8. BNP Paribas
    9. Citibank
    10. Commonwealth Bank of Australia
    11. CCRB
    12. Credit Agricole
    13. Credit Suisse
    14. DBS Bank
    15. Deutsche Bank
    16. Doha Bank
    17. FirstRand Bank
    18. Industrial and Commercial Bank of China
    19. Industrial Bank of Korea
    20. JP Morgan Chase Bank
    21. JSC VTB Bank
    22. KBC Bank
    23. KEB Hana Bank
    24. Krung Thai Bank
    25. Mashreq Bank
    26. Mizuho Bank
    27. National Bank of Australia
    28. National Bank of Abu Dhabi
    29. PT Bank
    30. Maybank Indonesia
    31. Sberbank
    32. SBM Bank
    33. Shinhan Bank
    34. Societe Generale
    35. Sonali Bank
    36. Standard Chartered Bank
    37. Sumitomo Mitsui Banking Corporation
    38. Bank of Nova Scotia
    39. Bank of Tokyo
    40. The Hongkong and Shanghai Bank
    41. Royal Bank of Scotland
    42. United Overseas Bank
    43. Westpac Bank
    44. Woori Bank
  • First, foreign banks have to open an Indian Subsidiary registered in India under the Companies Act. 

Core Banking Solution

  • Core Banking Solution (CBS) is the networking of branches, enabling customers to operate their accounts and avail banking services from any branch of the Bank on the CBS network, regardless of where he maintains his account. The customer is no more the customer of a Branch. He becomes the Bank’s Customer.
  • It has helped in converting Branch Banking to Branchless Banking. 

Entry of Business Houses in the Banking Sector

Procedure to open a new bank

  • Register the company with the Ministry of Corporate Affairs.
  • The company has to issue IPO in the share market after taking SEBI’s permission to arrange the capital.
  • Then, the company has to take permission from RBI through the ‘On Tap’ System.
  • After doing this, the company will initially get a Non-Scheduled Bank License. After some years, when RBI is confident that the bank has good health, RBI will upgrade the license of the Bank to Scheduled Commercial Bank.

Analysis: Should private houses be allowed to open banks

Arguments in favour

  1. More competition will lead to better services, higher interest rates and better customer services. 
  2. Existing banks have stressed balance sheets due to high NPAs. Hence, they have become over cautious while giving new loans. The entry of fresh banks will re-invigorate the lending process.
  3. It will help the ‘shadow banks’ such as IL&FS and DHFL to become banks and come under the proper supervision of RBI.

Based on the above arguments, PK Mohanty Committee, to review the corporate structure for Indian Private Sector Banks (2020), recommended allowing private houses’ entry into the banking sector.

Arguments against

  1. Connected Lending: In Connected lending, promoters of the bank lends loan at favourable terms to the companies owned by that group. The issue of connected lending was rampant in India from 1947 to 1958, which led to the failure of 361 banks in India during that phase.
  2. Circular Banking: It has the potential to lead to circular banking under which a bank controlled by Corporation A lends a loan at favourable terms to Corporation B and a bank controlled by Corporation B lends a loan at favourable terms to Corporation A. In the process, the interests of the depositors are jeopardized. 
  3. The higher competition will lead to excessive loan disbursement and misspelling of the banking products to gain new customers and retain the old customers. These types of practices led to Subprime Crisis in 2007-08. After the subprime crisis, most countries have become cautious to such ideas.
  4. History: Corporate houses were active in the banking sector till five decades ago, when the banks promoted by them were nationalized in the late sixties amid allegations of connected lending and misuse of depositors’ money.
  5. RBI cannot effectively regulate the existing banks as shown by various scams like Yes Bank-Rana Kapoor Scam, ICICI-Vodafone Loan Scam, Punjab National Bank-Nirav Modi Scam etc. Hence, it is not guaranteed that RBI will be able to regulate the new banks effectively.
  6. Large industrial houses face severe corporate governance issues, as epitomized by Ratan Tata- Cyrus Mistry and Narayan Murthy-Vishal Sikka controversy. In such a situation, allowing them to open banks is not advisable.
  7.  Banks controlled by big business houses can be misused for nefarious activities such as money laundering.
  8. It can create very powerful oligarchs with large economic power.
  9. Even regulators in developed countries don’t encourage the entry of business houses in the banking sector.

Considering the above discussion, the risks outweighs the benefits. Government can take steps to strengthen the corporate structure and health of the present banking sector.

This marks the end of the article on “History of Banking System.’

Forex Reserves of India

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Last Updated: Jan 2025 (Forex Reserves of India)

Forex Reserves of India

This article deals with ‘Forex Reserves of India .’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Current Status of Forex Reserves of India

  • Forex is the external assets that are readily available and controlled by the monetary authority for direct financing of external payment imbalances, for indirectly regulating the magnitude of such imbalances through exchange market intervention to affect the currency exchange rate and other purposes. 
  • In Oct 2024, India had a Forex Reserve of $700 billion,  enough to finance about 11.9 months of imports. In March 1991, it was reduced to just 2.5 months of import coverage (which forced the country to seek International Monetary Fund assistance). 
Forex Reserves of India

Ranking of Foreign Reserves with RBI

  1. Foreign Currency and Foreign Currency Assets
  2. Gold
  3. IMF’s SDR
  4. Reverse Tranche Position in the IMF

World Ranking of Forex Reserves ( India 6th and China topped with 3.2 Trillion Forex)

Rank Country Forex
1 China $ 3.2 trillion
2 Japan $1.2 trillion
3 Switzerland $812 billion
—- ——— ————-
6 India $700 billion (Oct 2024)
(Covering 11.9 months of imports)



In recent past, India has seen
rise in the Forex Reserves. The reasons behind the rise include

  1. Increase in Foreign Direct Investment and Foreign Portfolio Investment in India.
  2. Remittances sent by NRIs.

Reason for maintaining High Forex Reserves

  • It reduces the risk of external vulnerabilities such as high oil prices or Fed Tapering.
  • Exchange Rate Management: High Forex allows occasional RBI intervention to curb excessive volatility in the foreign exchange market.
  • It increases the investor’s confidence in the economy of the country.
  • It will help India to become a regional leader by signing currency swap agreements with other neighbours such as Sri Lanka, Bangladesh etc. 

Issues with maintaining more than required Forex

While reserves are imperative in both preventing crisis situations and mitigating their impact, there are issues with maintaining more than required Forex Reserves. The problems with maintaining more than required Forex reserves include

  1. Lost Opportunity Cost: Holding more than the required Forex Exchange reserve has opportunity cost because the stored money could be used for improving infrastructure and social services (like health and education)
  2. Increase borrowing cost: Borrowing in foreign currency has high borrowing cost and is vulnerable to volatility in the exchange rate

Is India’s Forex Reserves enough?

As evident from the graph above, India’s Forex reserves have reduced. But it should not be a cause of worry as India has enough Forex Reserves based on the following yardsticks.

#1 IMF’s Guidotti–Greenspan Rule

  • According to Guidotti-Greenspan Rule, the country should have enough Forex Reserves to cover the short-term external debt.
  • Indian Forex Reserves comfortably meets this rule. 

#2 RBI’s Tarapore Committee

  • According to Tarapore Committee, the country should have enough Forex Reserves to pay for 6 months’ imports.
  • Indian Forex Reserves comfortably meets this rule as well (Indian Forex Reserves can pay for more than 9 months’ imports). 

Side Topic: How did China reach the top foreign exchange reserve position?

The term used for this phenomenon is ‘China’s Mercantile Policy’. Under this policy, China refrains from imports from other countries, and at the same time, exports are encouraged. 

China restrains from imports in the following ways

IT SOEs (State Owned Enterprises) opaquely control the domestic market 
Pharma Inordinate delay in clearance
Food SPS agreements used to ban imports
Manufacturing Domestic products are too cheap

At the same time, Exports are promoted  by

  • Keeping Yuan undervalued 
  • SOE get cheap loans
  • Subsidies are provided on a large scale
  • Tech-piracy is neglected

Side Topic: Manipulators of Currency

  • US Treasury Department makes a list of countries which manipulate their currency.
  • 3 Conditions to include any country in this list
    1. A trade surplus of over $20 billion with the US.
    2. The current account surplus is 3% of the GDP with the rest of the world. 
    3. Persistent foreign exchange purchases of 2% plus of the GDP over 12 months.  
  • In 2018,  India was included in this list. But India was removed in 2019.
  • Countries which are included in this list include
    • China
    • Germany
    • Japan
    • South Korea
    • Switzerland