8 Banking Sector Reforms in India

8/6/2019 8 Banking Sector Reforms in India

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Banking Sector Reforms in India

Dr Subhash Gupta


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Bank of Hindustan, set up in 1870, was the earliest IndianBank.

Banking in India on modern lines started with theestablishment of three presidency banks under Presidency

Bank's act 1876 i.e. Bank of Calcutta, Bank of Bombay andBank of Madras.

In 1921, all presidency banks were amalgamated to form theImperial Bank of India. Imperial bank carried out limitedcentral banking functions also prior to establishment of RBI.

Reserve Bank of India Act was passed in 1934 & ReserveBank of India (RBI) was constituted as an apex bank withoutmajor government ownership.

Banking Regulations Act was passed in 1949. Thisregulation brought Reserve Bank of India under governmentcontrol


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Indian Financial Sector: different phases

Three distinct periods: 1947-68, 1969-91, 1991 onward

1947-68: relatively liberal environment - the role of RBI

was to supervise and control the banks

1969-91: Bank nationalization and Financial repression

banking policies re-oriented to meet social objectives such

as the reduction in inequalities and the concentration of

economic power interest rate controls and directed credit

programs

1991 onward: financial sector liberalization


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Indian Financial Sector: Pre-Nationalization

RBI Act: scheduled commercial banks are required tomaintain a minimum cash reserve of 7% of their demandand time liabilities - SLR was 20% (cash, gold, govt.securities)

1962: RBI was empowered to vary the CRR between 3%and 15% - empowered to stipulate minimum lending ratesand ceilings rates on various types of advances

Problem of bank failures and compulsory merger of weak

banks with relatively stronger ones (no. of banks fell from566 in 1951 to 85 in 1969 due to mergers).


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Indian Financial Sector: Pre-Nationalization

1962: Deposit insurance scheme with the establishment

of the Deposit Insurance Corporation 1964: RBI directly regulated the interest on deposits

(prior to this, interest rates were governed by a voluntaryagreement among the important banks)

Certain disquieting features: (i) banking business waslargely confined to the urban areas (neglect of rural andsemi-urban areas) (ii) agriculture sector got only a verysmall share of total bank credit (iii) within industry, thelarge borrowers got the greatest share of credit

The pattern of credit disbursement was inconsistent withthe goal of achieving an equitable allocation of creditand the priorities set in the plans - bank nationalizationin 1969


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Indian Financial Sector: Bank nationalization

1969: 14 largest scheduled commercial banks

nationalized; 22 largest banks accounting for 86% ofdeposits had become public sector banks; 6 more banks

nationalized in 1980 bringing the share of public sector

banks deposits to 92%

Rural branch expansion to mobilize deposits andenhancement of agriculture credit

Priority sector lending (agriculture, small scale industries,

retail trade, transport operators etc); requirement was

33%, raised to 40% in 1979.

UTI and IDBI, IFCI and ICICI were set up with specific

objectives in mind


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A decade of change and evolution

Pre-reform

Extensiveregulation

Focus on

industrialsector

The 1990s Today

Indianeconomy

Financial

sector

..financial sector mirroring macro-economic

change

Liberalisation

Globalisation

Structuralchange services

Resilientindustry

Buoyant

servicessector

Highlysegmented

Public sectordominance

Opening upof varioussub-sectors

Privatesectorparticipation

Diversifiedfinancialgroups

Globallybenchmarked


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The banking sector today

Depth Countrywide coverage

Large number of players

Increasinglysophisticated financialmarkets

Technology

Increasing use of

technology in operations Poised to expand and

deepen technology usage

Diversification Emergence of integrated

players

Diversifying capitaldeployment

Leveraging synergies

Regulation

Robust regulatory systemaligned to internationalstandards

Efficient monetarymanagement


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Sector snapshot

Size Total assets of US$ 335 billion

Total deposits of US$ 279 billion

Number ofbanks

Over 290 scheduled banks

Public sector: 27

Private sector: new 9; old 24

Foreign: 37

Over 190 regional rural banks

Branch network

Over 66,000 branches Public sector: 46,000

Private sector: 5,500 Foreign: 190 Regional rural: 14,400


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A new orientation among banks

Sell products

Product research: whatwill sell?

Product sales and

profitability targets Product specialist

groups

Introduce newofferings every few

years/months Branch banking

Focus - customeracquisition

Meet customers needs

Customer research:what does the customerwant?

Customer segmentsales and profitabilitytargets

Customer owners

Customer specific new

offerings everyweek/day

Customer convenience

Deepen relationships

Traditional/ public sector New/ private sector


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Why Banking Sector Reforms High Regulated Sector

Prevalence of High Reserve Requirements

Interest Rate Controls

Large Allocations to Priority Sector

Poor Lending Strategies

Lack of Internal Risk Management

Low Yields on Government Securities

Waiver of Loans on Political Grounds Lack of Competition

High Cost of Operations

Poor Customer Service

Poor Loan Recovery

Weak Capital Position

Political Interference Lack of Institutional Autonomy

Lack of Accountability in Banks

Vague Reporting Formats

Technology Deficiency


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Reforms in Banking Sector

The first wave of financial liberalization took place in thesecond half of the 1980s, mainly taking the form of Introduction of Treasury Bills

Development of money markets

Partial Interest Rate Deregulation

In 1988, the Discount and Financial House of India wasestablished

In 1989, both commercial paper and certificates of depositwere introduced

Based on the 1985 report of the Chakravarty Committee,coupon rates on government bonds were gradually increasedto reflect demand and supply conditions

In 1988, the maximum (or ceiling) lending rate and ranges inminimum rates were unified and switched to a minimum-

lending rate (MLR) in 1988. As a result, banks were able toset interest rates more flexibly.

In 1989, the maximum interest rates on call money wereliberalised


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Second wave of Liberalisation started withNarsimham Committee Recommendations Reduction of the CRR and SLR

The CRR has declined gradually from 15% in 1991 to5.75% in November 2001 and to 5.5% in December 2001.

The SLR was reduced gradually from 38.5% in 1991 to25% in October 1997. The SLR has remained at this rateuntil today, while the legal upper limit has stayed at 40%throughout the period

Interest Rate Deregulation The Government started interest rate deregulation in 1992.

This led to a complete liberalization of all term deposit ratesand lending rates on advances in excess of Rs200,000.

The remaining interest rate controls are savings deposit ratesand lending rates up to Rs200,000.


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Reforms in Banking SectorReform of Priority SectorLending

Advances to the priority sectorsshould be reduced from 40% to 10%.

While the targets of 40% imposed ondomestic banks and 32% on foreignbanks have not changed during thereform period, the burden of thisdirected lending practice has beengradually reduced by (1) expandingthe definition of priority sector lending,and (2) liberalizing lending rates onadvances in excess of Rs200,000,


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Deregulation ofEntry Barriers and Branching RestrictionsEntry Deregulation

The RBI issued guidelines in 1993 governing the establishment ofnew private sector banks. The guidelines stated that a new bankneeded to

maintain minimum paid-up capital of Rs1 billion;

list its shares on stock exchanges; fulfill the priority sector lending requirement with modification allowed in the

composition of such lending for an initial period of three years;

set a ceiling of 1% of total voting rights held by an individual shareholder asstipulated by the Banking Regulation Act of 1949;

postpone setting up a subsidiary or mutual fund until at least three years afterits establishment, and

use modern infrastructural facilities to provide good customer service

In 1994, the Banking Regulation Act of 1949 was amended in order toraise the ceiling of voting rights of an individual shareholder in a privatebank from 1% to 10%.

The RBI approved six new private sector banks in 1994

The RBI granted an .in principle. approval to three local areabanks.


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Deregulation of Branch Restrictions

The RBI changed its licensing policy in 1992in order to provide banks with operationalautonomy to rationalize their branch networks.

Banks were allowed to shift their existingbranches within the same locality, open certaintypes of specialized branches, convert existing

nonviable rural branches into satellite offices,spin off business of a branch, and open extensioncounters and administrative units without priorapproval of the RBI.

The RBI allowed banks to open branches freely,provided that a bank met the capital adequacy

ratio of 8%; earned a net profit for threeconsecutive years, and had NPAs not exceeding15% of total outstanding loans. In 1998/99, oldand new foreign banks were permitted to open upto 12 branches a year, as against the earlierstipulation of eight branches.


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Adoption of Prudential Norms: The RBI issued guidelines in 1992/93 on

income recognition, asset classification, and

provisioning.

Restructuring of Public SectorBanks

Recapitalization

Debt Recovery and Bankruptcy

Partial Privatization Writing-Off of Bad Debts

Setting up of an Asset Reconstruction

Company

Reduction of Operational Costs


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Journey Ahead

reforms have not been a total success, for the followingreasons:

First, public sector banks still remain dominant. Inaddition, the profitability of nationalized banks has notimproved

Second, partial privatization has not significantlyimproved corporate governance, due to the ceiling ofindividual voting rights at 10%, the Governmentscontinued dominance as the largest shareholder, andthe absence of major reforms determining the boards ofdirectors.

Third, priority sector lending still remains a hindrance forthe full commercialization of banks.

Fourth, banks large-scale holdings of governmentsecurities lower banks incentives to improve their riskmanagement skills on lending activities

8 Banking Sector Reforms in India

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