The bank is the most important financial intermediary in the economy as it connects surplus and deficit economic agents. A banking sector performs three Primary functions in an economy: The operation of the payment system, the mobilization of savings and the allocation of savings to investment projects.
Banking in India has existed in India since the Vedic period but due to informal system of banking, most of the bank dealing was based on mutual trust and dishonouring of the hundis (A Hundi is a financial instrument that developed in Medieval India for use in trade and credit transactions) was a rare event. First joint stock banking was introduced in India in early 18th century under which Bank of Bombay was established in 1720 by English house Agency. The first presidency bank with government shareholding was established in 1806 which undertook the tasks of issuing currency notes and discounting of treasury bills to provide monetary accommodation to the Government. Formal regulations were introduced in the mid-19th century with the enactment of the Companies Act in 1850 which was the first regulation covering banks. Banks were also allowed to be organised as private shareholding companies with limited liability whereby majority of shareholding was held by Europeans. However Indian owned private bank came into existence in 1865 with Establishment of Allahabad Bank then followed by many other banks such as Punjab National Bank and Bank of India. The individual borrowers were still juggling with the money lenders who charged extortionate rates of interest because these banks were only available to the industrial sector. Due to this, co-operative credit movement started, which addressed the need of lower income population and resulted in several urban cooperative banks and giving legal recognition to credit societies.
Fraudulent activities began rising such as activities by directors on one hand and gross mismanagement on account of management inexperience on the other, which resulted in Bank failures in India. There was a strong need of regulatory framework, even the establishment of Imperial Bank of India via amalgamation of three Presidency Banks had created a conflict of interest with the Imperial Bank acting as Central Bank and Banker to the Government as well as engaging in commercial banking activities. Finally an Act was passed in 1934 for the establishment of Reserve Bank of India with the dual objective of addressing the issue of bank failures and promoting reach of credit to the agricultural sector.
The Reserve Bank of India took over several responsibilities including
(a) Issuing currency notes and acting as banker to the Government
(b) Acting as lender of last resort for the banking system whereby it required banks to maintain cash reserves,
(c) Encouraging the co-operative credit movement to enhance the reach of agricultural credit.
(d) Supervisory role with the power to conduct audit and inspection to detect fraudulent activities
(e) Strengthening the banking regulatory framework by proposing new banking regulations to the Government.