History of Banking

History of Banking
Banking
History of Banking
The name ‘bank’ is usually used in the sense of commercial bank.
The word ‘bank’ seems to have originated from the Germanic world ‘banck’
which means a joint stock fund or heap. It is possible that the word has also
been derived from the French word ‘banque’ and the Italian word ‘banco’.
The Italian word ‘banco’ refers to a bench at which the money changers or
mediaeval bankers used to change one kind of money into another and
transact their banking business. Thus, the early banking was associated with
the business of money changing.
The first public banking institution was The Bank of Venice, founded
in 1157. The Bank of Barcelona and the bank of Genoa were established in
1401 and 1407 respectively. These are the recognized forerunners of modern
commercial banks. Exchange banking was developed after the installation
of the Bank of Amsterdam in 1609 and Bank of Hamburg in 1690.
The credit for laying the foundation of modern banking in England
goes to the Lombards of Italy who had migrated to other European countries
and England. The bankers of Lombardy developed the money lending
business in England. The Bank of England was established in 1694. The
development of joint stock commercial banking started functioning in 1833.
The modern banking system actually developed only in the nineteenth century.
In India, the first modern bank ‘Bank of Bengal’ was established in 1806 in
the Bengal presidency.
Development of banking habits
Before the Industrial Revolution, the size of business units was very
small. After some years, there was a great increase in the size of the business
units. Therefore, joint stock forms of business organisations were established.
Such form of business organisation widened the circle of investors, by enabling
people with small means to become share holders of big industrial enterprises.
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Still, some people did not want to undertake any kind of risk by investing
their money. Hence, an institution was created to mobilize funds on terms
acceptable by the people. Such an institution is called ‘Bank’, whose business
is to mobilize capital. And hence, banks are connecting link between the
people, who have surplus money and the people who are in need of money.
In addition to this, banks undertake the risk arising out of the possible default
of the ultimate borrower.
The early stages of banks included three types of institutions
i) The merchant banker, who was primarily a trader. He accepted
customer’s money and kept it under safe custody.
ii) The money lender, who lent his surplus money to the needy persons
on deriving some interest payment.
iii) The gold smith, who accepted the valuables like gold and diamond
of the customers and kept it under his safe custody. It will be returned
to the customer on demand and interest will be collected for that.
Modern banks retain all the characteristics of above three types of
institutions. The advancement of society and economic thinking, specialization
and extended market resulting from Industrial revolution paved the way for
developing modern commercial banking system. The role of banks extended
from merely being institutions of ‘deposits and discounts’ to custodians of
national finance and trustees of the surplus balances of the public. The modern
banks have now become the lifeblood of our commercial and industrial
activities.
Definition of Banking
On account of multifarious activities of modern banks, the ‘Bank’ or
‘Banking’ has been defined by several economists as follows:
Dr.L. Herber and L. Hart define the banker, “as one who in the ordinary
course of business honours cheques drawn upon him by persons from and
for whom he receives money on current accounts”.
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Chamber’s Twentieth century Dictionary defines a bank as an,
“institution for the keeping, lending and exchanging etc. of money”.
According to Crowther, “The banker’s business is to take the debts
of other people to offer his own in exchange, and thereby create money”.
Prof. Kent defines a bank as, “an organisation whose principal
operations are concerned with the accumulation of the temporarily idle money
of the general public for the purpose of advancing to others for expenditure”.
It is evident from the above definitions that a bank is an institution
which accepts deposits from the public and in turn advances loans by creating
credit.
Role of Banks in economic development
Banks play a very useful and crucial role in the economic life of every
nation. They have control over a large part of the supply of money in
circulation, and they can influence the nature and character of production in
any country. In order to study the economic significance of banks, we have
to review the general and important functions of banks.
History of Banking
1. Removing the deficiency of capital formation
In any economy, economic development is not possible unless there is
an adequate degree of capital accumulation (or) formation. Deficiency of
capital formation is the result of low saving made by the community. The
serious capital deficiency in developing economies is reflected in small amount
of capital equipment per worker and the limited knowledge, training and
scientific advance. At this juncture, banks play a useful role. Banks stimulate
saving and investment to remove this deficiency. A sound banking system
mobilizes small savings of the community and makes them available for
investment in productive enterprises. The important implications of this activity
include

i) Banks mobilise deposits by offering attractive rates of interest and
thus convert savings into active capital. Otherwise that amount
would have remained idle.
ii) Banks distribute these savings through loans among productive
enterprises which are helpful in nation building.
iii) It facilitates the optimum utilization of the financial resources of the
community.
History of Banking
2) Provision of finance and credit
Banks are very important sources of finance and credit for industry
and trade. It is observed that credit is the lubricant of all commerce and
trade. Hence, banks become nerve centers of all trade activities and therefore
commerce and trade could function in the presence of sound banking system.
The banks cover foreign trade transactions also. Big banks also
undertake foreign exchange business. They help in concluding deferred
payments, arrangements between the domestic industrial undertakings and
foreign firms to enable the former import machinery and other essential
equipment.
3) Extension of the size of the market
Commercial bankers help commerce and industry in yet another way.
With the sound banking system, it is possible for commerce and industry for
extending their field of operation. Commercial banks act as an intermediary
between buyers and the sellers. Goods are supplied on bank guarantees,
making it viable for industry and commerce to cultivate and locate markets
for their products. The risks are undertaken by the bank. When the risks
have been set free by the banks, the industry can look forward to derive
economies of the large size of the market.
4) Act as an engine of balanced regional development
Commercial banks help in proper allocation of funds among different
regions of the economy. The banks operate primarily for profits. When the
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banks lend their funds for more productive uses, their profits will be
maximized. Introduction of branch banking makes it possible to choose
between different regions. A region with growth potential attracts more bank
funds. But in recent years, the approach of banks towards regional growth
has been undergoing a change. Banks help create infrastructure essential for
economic development. Thus banks are engines of balanced regional
development in the country.
5) Financing agriculture and allied activities
The commercial bank helps the farmers in extending credit for
agricultural development. Farmers require credit for various purposes like
making their produce, for the modernization and mechanization of their
agriculture, for providing irrigation facilities and for developing land.
The banks also extend their financial assistance in the areas of animal
husbanding, dairy farming, sheep breeding, poultry farming and horticulture.
6) For improving the standard of living of the people
The standard of living of the people is estimated on the basis of the
consumption pattern. The banks advance loans to consumers for the purchase
of consumer durables and other immovable property, which will raise the
standard of living of the people.
Stimulating human capital formation, facilitating monetary policy
formulation and developing entrepreneurs are some of the other roles played
by commercial banks in the economic life of every nation.
Commercial Banks
A commercial bank is an institution that operates for profit. The
traditional functions of a commercial bank relate to the acceptance of deposits
from the public and provision of credit to different sectors of the economy.
However, with the evolution of modern banking and growth of banking system
as an integral part of the national economy, there has been a perceptible
change in the attitude and outlook of the commercial banks. These banks
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have started providing a host of banking services to their customers.
Nevertheless, the basic character of commercial banking remains unchanged.
In the early days, commercial banks are organized as a joint stock company
to earn profit. They cater to the needs of short-term, medium term credit
and provide capital to businessmen and industrialists. In the recent days, the
banks lend long term funds to businessmen and industrialists.
Functions of Commercial Banks
The various functions performed by commercial banks can be
classified as follows:
History of Banking
1. Accepting or attracting deposits
Commercial banks accept deposits by mobilizing the savings of the
people. These deposits can be of three forms.
a) Savings deposits: It is a kind of safety vault for the people with
idle cash. These deposits are kept under savings account. Deposits in this
account earn interest at nominal rates and the banks are entitled to release
deposits on demand by the deposit holder. In practice, the bank imposes a
limit on the number and amount of withdrawals during a period. Cheque
facilities are also given to the deposit holder.
b) Demand deposits: Demand deposits are kept under current
account. The depositor can withdraw the money on demand. But, the account
holder should specify the amount and the number of withdrawals. Banks do
not pay any interest on these accounts. On the contrary, bank imposes service
charges on maintaining these accounts.
c) Fixed deposits: These are also known as time deposits. The amount
deposited cannot be withdrawn before the maturity period for which they
have contracted. These deposits carry interest at higher rates varying with
the length of the contract.
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2) Advancing of loans
Banks adopt several ways for granting loans and advances. These
operations take different forms.
a) Cash credit: The bank sanctions loans to individuals or firms against
some collateral security. The loan money is credited in the account of the
borrower and he can withdraw the amount as and when it is required. The
ceiling of the loan amount is determined by the bank on the basis of the stock
value of the borrower which in turn becomes Banker’s possession. The
borrower can withdraw the cash within or upto the credit limit. The bank
charges interest for the amount withdrawn only.
b) Provision of overdraft facilities
The respectable and reliable customers enjoy these facilities. The
customer can issue cheques and overdraw the money in times of need, even
if there is no adequate balance in his account. The customer will pay the
interest to the bank for the amount overdrawn.
c) Discounting bills of exchange
This operation is done through discounting of commercial papers,
promissory notes and bills of exchange, usually for three months. The banks
after deducting interest charges and collection charges from the face value of
the bills, give the balance amount to the customer. When the exchange bill
matures, the banks collect the payment from the party.
3) Creation of money or credit
Every loan sanctioned by the banker creates a deposit. Because,
when a bank sanctions loan to a customer, an account is opened in his name
and the loan amount is credited into his account. The borrower withdraws
money whenever the amount is required. The creation of such deposits leads
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to increase in the money stock of the economy and through its circulation
creates new money.
4) Other functions
Some of the other important functions performed by these banks
are as follows:
a) Transfer of funds
In the complexity of trade and commerce in the modern days, the
transfer of funds from one place to another becomes difficult. Banks help in
eliminating this difficulty through the use of various credit instruments like
cheques, bank drafts and pay orders, traveller cheques, etc. This process is
called ‘clearing’ and it is efficiently done by bank operations.
b) Agency functions
Commercial banks are increasingly acting as financial agents for their
clients. They make all sorts of payments on behalf of their clients like insurance
premium, pension claims, dividend claims or capital demands etc. Likewise,
they buy and sell gold, silver and securities on behalf of their clients.
c) General utility services
A commercial bank performs general utility services such as
i) providing safety lockers for the safer custody of valuables
of the customers.
ii) Issuing of letter of credit to the customers.
iii) Under-writing loans to be raised by public bodies and
corporations.
iv) Compiling statistics and information relating to trade,
commerce and industry.
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Thus, commercial banks render valuable services to the community.
Developed banking system ensures industrial and economic progress. It
constitutes the lifeblood of an advanced economic society. In developing
countries like India, commercial banking may be described as ‘development
banking’. It plays a critical developmental role in making their funds available
to the priority sectors, weaker sections and employment-oriented schemes.
Central Banks
The banking system of a country can work systematically in
coordinated manner, only if there is an apex institution to direct the activities
of the banks. Such apex institution is popularly known as ‘central bank’.
The central bank of the country is an autonomous institution, entrusted with
powers of control and supervision. It controls the monetary and banking
system of the country. After World War II, the International Monetary
conference held at Brussels in 1929 recommended the setting up of a central
bank in every country. The central bank of our country, known as Reserve
Bank of India was set up in 1935. The central bank of England called Bank
of England was established in 1694. It is known as the ‘mother of central
banks’, since it provides the fundamentals of the art of central banking.
The central bank of France called ‘Bank of France’ was founded in
1800. The USA established a central banking system in the form of Federal
Reserve Banks in 1914.
History of Banking
Definition of a central bank
A central bank has been defined in terms of its functions. The following
are some of the definitions given by economists.
According to Smith, “the primary definition of central banking is a
banking system in which a single bank has either complete control or a
residuary monopoly of note issue”.
H.A. Shaw defines a central bank, “as a bank which controls credit”.
In the words of Hawtrey “a central bank is that which is the lender of
the last resort”.
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According to Samuelson, “a central bank is a bank of bankers. Its
duty is to control the monetary base and through control of high-powered
money to control the community’s supply of money.
Distinction between central banks and commercial banks
The central bank is basically different from commercial banks in the
following respects.
1. The central bank is the apex institution of the monetary and banking
system of the country. A commercial bank is only a constituent
unit of the banking system and a subordinate to the central bank.
2. While the central bank possesses the monopoly of note-issue,
commercial banks do not have this right.
3. The central bank is not a profit making institution. Its aim is to
promote the general economic policy of the government. But, the
primary objective of commercial banks is to earn profit for their
shareholders.
4. The central bank maintains the foreign exchange reserves of the
country. The commercial banks only deal in foreign exchange under
the directions of the central bank.
5. The central bank is an organ of the government and acts as its
banker and the financial advisor, whereas commercial banks act
as advisors and bankers to the general public only.
Functions of Central bank
The main functions of a central bank are common all over the world.
But the scope and content of policy objectives may vary from country to
country and from period to period depending on the economic situations of
the respective country. Generally all the central banks aim at achieving
economic stability along with a high growth rate and a favourable external
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payment position through proper monetary management. The common
functions of central banks are discussed below.
1. Regulator of currency
The issue of paper money is the most important function of a central
bank. The central bank is the authority to issue currency for circulation,
which is a legal tender money. The issue department of the central bank has
the responsibility to issue notes and coins to the commercial banks. The
central bank regulates the credit and currency according to the economic
situation of the country. In the methods of note issue, the central bank is
required to keep a certain amount or a fixed proportion of gold and foreign
securities against the total notes issued. The Reserve Bank of India is required
to keep Rs.115 crore in gold and Rs.85 crore in foreign securities, but there
is no limit to the issue of notes.
Having the monopoly of note issue, central bank gains advantages as
i) Ensuring uniformity of the notes issued and a proper control over
the supply of money can be exercised.
ii) Bring stability in the monetary system and creates confidence among
the public.
iii) Government is able to earn profits from printing currencies.
2. Banker, Agent and Adviser to the Government
The central bank of the country acts as the banker, fiscal agent and
advisor to the government. As a banker, it keeps the deposits of the central
and state governments and makes payments on behalf of governments. It
buys and sells foreign currencies on behalf of the government. It keeps the
stock of gold of the country. As a fiscal agent, the bank makes short-term
loans to the government for a period not exceeding 90 days. It floats loans
and advances to the State governments and local bodies. It manages the
entire public debt on behalf of the government. As an adviser, the bank gives
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useful advice to the governments on important monetary and economic
problems like devaluation, foreign exchange policy and budgetary policy.
3. Custodian of cash Reserves of commercial banks
Commercial banks are required to keep a certain percentage of cash
reserves with the central bank. On the basis of these reserves, the central
bank transfers funds from one bank to another to facilitate the clearing of
cheques.
History of Banking
4. Custodian and Management of Foreign Exchange reserves
The central bank keeps and manages the foreign exchange reserves
of the country. It fixes the exchange rate of the domestic currency in terms of
foreign currencies. If there are any fluctuations in the foreign exchange rates,
it may have to buy and sell foreign currencies in order to minimize the instability
of exchange rates.
5. Lender of the last resort
By giving accommodation in the form of re-discounts and collateral
advances to commercial banks, bill brokers and their financial institutions,
the central bank acts as the lender of the last resort. The central bank lends
to such institutions in order to help them when they are faced with difficult
situations so as to save the financial structure of the country from collapse.
6. Clearing Function
The central bank acts as a ‘clearing house’ for other banks and mutual
obligations are settled through the clearing system. Since it holds cash reserves
of commercial banks, it is easier for the central bank to act as a ‘clearing
house’.
7. Controller of credit
The most important function of the central bank is to control the credit
creation power of commercial banks in order to control inflationary and
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deflationary pressures within the economy. For this purpose, the central bank
adopts Quantitative methods and Qualitative (selective) methods. Quantitative
methods aim at controlling the cost and quantity of credit by adopting i)
bank rate policy ii) open market operations iii) variations in reserve ratios of
commercial banks. Qualitative methods control the use and direction of credit.
It involves i) regulation of margin requirements ii) regulation of consumer
credit, iii) rationing of credit, iv) direct action by the central bank, and v)
moral suasion
Besides the above functions, the central bank performs many additional
functions. It has to study all problems relating to i) credit, ii) fluctuations in
price level iii) fluctuations in foreign exchange value. It has to collect monetary
and financial statistics, conduct research and provide information. It has to
look after the matters relating to IMF and the World Bank. All together, the
central bank is the financial and monetary guardian of the nation.
Methods of credit control employed by the central bank
Credit control is an important function of the central bank. Various
methods are employed by the central bank to control the creation of credit
by the commercial banks. The principal methods are classified under two
heads viz. Quantitative methods and Qualitative methods. Quantitative credit
control methods are used to expand or contract the total volume of credit in
the banking system. For example, the central bank of India believes that the
safe limit for bank credit is Rs.50, 000 crore. Suppose, at a particular time
the actual bank credit is Rs.75, 000 crore. Reserve Bank of India may now
use bank rate as a weapon to reduce the volume of credit by Rs.25,000
crore. As such the volume of bank credit is reduced in the country. On the
other hand, Qualitative credit control methods are used to control and regulate
the flow of credit into particular industries or businesses depending on the
economic priorities set by the government. Suppose RBI estimates that the
inflationary pressure in India is due to commercial banks’ loan to speculators
and hoarders who have managed to control the supply of inflation-sensitive
goods and thus have pushed up the price level. Now RBI may direct
commercial banks not to lend to speculators and hoarders. It is concluded
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from the above analysis that Quantitative controls are indirect, while Qualitative
controls are direct.
Quantitative or General Credit control methods
The important general methods of credit control are as follows:
1) Bank Rate (or) Discount Rate Policy
The rate of interest of every central bank is known as ‘Bank Rate’. It
is otherwise known as ‘discount rate’. At this rate the central bank rediscounts
bills of exchange and government securities held by the commercial banks.
When the cash reserves of the commercial banks tend to fall below the legal
minimum, the banks may obtain additional cash from the central bank either
by rediscounting bills with the central bank or by borrowing from the central
bank against eligible securities. The central bank charges interest rate for this
service. The central bank controls credit by making variations in the bank
rate. A rise in the bank rate makes borrowing costly from the central bank.
So commercial banks borrow less and in turn they raise their lending rates to
customers. This discourages business activity. Thereby there is contraction
of demand for goods and services and ultimately fall in the price level.
Therefore bank rate is raised to control inflation. In the opposite case, lowering
the bank rate offsets deflationary tendencies.
2) Open Market Operations
Direct buying and selling of securities, bills, bonds of government as
well as private financial institutions by the central bank, on its own initiative,
is called open market operations. In periods of inflationary situation, the
central bank will sell in the money market first class bills. Buyers of this bill
say commercial banks make payments to the central bank. It reduces the
size of the cash reserves held by the commercial bank with the central bank.
Some banks are forced to curtail lending. Thus, business activity based on
bank loans and which is responsible for boom conditions are curtailed. In
times of depression, the central bank will buy bills and securities from the
commercial banks. The central bank will pay cash to the commercial banks
for such purchases. Hence, the cash reserves of the commercial banks are
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increased. Thereby banks expand their loans resulting in the expansion of
investment, employment, production and prices. Thus central bank through
its open market operations influences business activity and economic
conditions of the country.
History of Banking
3. Variable Reserve Ratio
Every commercial bank is required by law to maintain a minimum
percentage of its time and demand deposits with the central Bank. The excess
money remains with the commercial bank over and above these minimum
reserves is known as the excess reserves. Commercial banks create credit
only based on these excess reserves. Central bank may bring changes in
reserve requirements. Consequently, it will affect the amount of reserves that
commercial bank must maintain as deposits with the central bank as well as
the amounts available for lending or investing. For instance, when the central
bank fixes the reserve requirement as 10 percent, a commercial bank will
have to maintain a cash reserve of Rs.100 for every deposit of Rs.1000 and
hence it can lend only upto Rs.900. To check inflation the central bank may
raise the cash reserve ratio from 10 percent to 15 percent. This will force the
commercial banks to deposit additional 5 percent by reducing their amount
available for lending. On the other hand, to check a deflation the central
bank may reduce the reserve ratio from 10 percent to 7 percent. This will
raise the excess cash with the commercial banks; consequently credit will be
expanded.
Qualitative or selective credit control
Qualitative methods of credit control mean the regulation and control
of the supply of credit among its possible users. The aim of such methods is
to channelise the flow of bank credit from speculative and other undesirable
purposes to socially desirable and economically useful uses. Important
selective credit controls are given below.
a) Margin Requirements
The aim of this method is to prevent excessive use of credit to purchase
securities by speculators. The central bank fixes minimum margin requirements
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on loans for purchasing securities. Suppose the central bank fixes a 30 percent
as margin requirements, then for Rs.1000 worth of security, commercial
bank may keep Rs.300 as margin and the remaining Rs.700 may be used
for lending. If the central bank wants to curb speculative activities, it will
raise the margin requirements. On the other hand, if it wants to expand credit,
it reduces the margin requirements.
b) Regulation of consumer credit
Under this instrument, the central bank regulates the use of bank credit
by consumers in order to buy durable consumer goods in instalments. To
achieve this, it adopts two devices i) Minimum down payment ii) Maximum
periods of repayment.
c) Rationing of Credit
Credit rationing is employed to control and regulate the purpose for
which credit is granted by the commercial banks. Credit rationing takes two
forms i) variable portfolio ceilings, wherein central bank fixes ceiling on the
aggregate portfolios of the commercial bank. They cannot advance loans
beyond this ceiling. ii) Variable capital assets ratio wherein the central bank
fixes in relation to the capital of a commercial bank to its total assets.
d) Direct Action
Direct action refers to ‘directives’ of the central bank to enforce the
commercial banks to follow a particular policy. The central bank gives
direction to commercial banks in respect of i) lending policies ii) the purpose
for which advances may be made iii) the margins to be maintained in respect
of secured loans.
e) Moral suasion
Moral suasion implies persuasion and request made by the central
bank to the commercial banks to follow the general monetary policy in the
context of the current economic situation.
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f) Publicity
The central bank publishes weekly or monthly or quarterly statements
of the assets and liabilities of the commercial banks for the information of the
public. It also publishes statistical data relating to money supply, prices,
production, employment and of capital and money market etc.
Nationalisation of Banks
History of Banking
The Indian banking system passed through a series of crises and
hence its growth was very slow during the first half of the 20th century. But
after Independence, the Indian banking system recorded rapid progress.
This was due to planned economic growth, increase in money supply, growth
of banking habit, setting up of the State Bank of India and its associate
banks in the 1950s, the control and guidance by the Reserve Bank of India
and above all nationalization of the 14 commercial banks in July 1969, and 6
more banks in 1980 by the Government.
Prior to nationalization, it was believed by some economists that Indian
commercial banking system did not play its role in the planned development
of the nation. The banking system was controlled by the leading industrialists
and business magnates. They used public funds to build up private industrial
empires. Small industrial and business units were consistently ignored.
Agricultural credit was never seriously considered. Therefore Government
of India took over 14 commercial banks in July 1969 and 6 other banks in
April 1980.
The commercial banking sector in India has within its fold the following
banks.
a) The State Bank of India
b) The seven associated banks of State Bank of India.
c) Twenty nationalized Banks.
d) Indian joint stock commercial banks
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e) Foreign banks functioning in India
f) Regional Rural Banks.
Performance of Nationalized Banks
The most important benefit of nationalization of commercial banks
was the achievement of homogeneity and strength as well as cohesion in the
banking structure of India, affording a better environment for effectively
implementing banking and monetary policies of the government.
The working of the commercial banks after nationalization show that
they have made a complete departure from the old conservative banking
practices and moving towards the objectives set forth in various fields of
their operations. They have made significant achievements in the sphere of
‘branch expansion’, deposit mobilization, production-oriented financing,
extension of credit to neglected sectors and creating new vistas in banking.