7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 1/17
The Indian banking industry is measured as a flourishing and the secure
in the banking world. The country’s economy growth rate by over 9
percent since last several years and that has made it regarded as the next
economic power in the world. The paper deals with the banking sectorreforms and it has been discussed that India’s banking industry is a
mixture of public, private and foreign ownerships. The major dominance
of commercial banks can be easily found in Indian banking, although the
co-operative and regional rural banks have little business segment.
Further the paper has discussed an evaluation of banking sector reforms
and economic growth of the country since from the globalization and its
effects on Indian economy. Competition among financial intermediaries
gradually helped the interest rates to decline. Deregulation added to it.
The real interest rate was maintained. The borrowers did not pay high
price while depositors had incentives to save. It was something between
the nominal rate of interest and the expected rate of inflation. Finally the
paper deals with conclusion and inflation rates from the different years
and regulation of economy and finance of the country through
government policies and banking sector reforms.
Key Words: Banking Sector, Reforms, Economy, Inflation, Growth
Introduction:
The efficient, dynamic and effective banking sector plays a
decisive role in accelerating the rate of economic growth in any economy.
In the wake of contemporary economic changes in the world economy
and other domestic crises like adverse balance of payments problem,
increasing fiscal deficits our country too embarked upon economic reforms
(Ahulwalia M. S; 1993). The Government of India introduced economic
and financial sector reforms in 1991 and banking sector reforms were part
and parcel of financial sector reforms. These were initiated in 1991 to
make Indian banking sector more efficient, strong and dynamic.
The recommendations of the Narishiman Commission-I in 1991provided the blue print for the first generation reforms of the financial
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 2/17
sector, the period 1992-97 witnessed the laying of the foundations for
reforms in the banking system. This period saw the implementation of
prudential norms (relating to capital adequacy, income recognition, asset
classification and provisioning, exposure norms etc). The structuralchanges accomplished during the period provided foundation of further
reforms. Against such backdrop, the Report of the Narishiman
Committee- II in 1998 provided the road map of the second generation
reforms processes. Y.V. Reddy noted that the first generation reforms
were undertaken early in the reform cycle, and the reforms in the
financial sector were initiated in a well structured, sequenced and phased
manner with cautious and proper sequencing, mutually reinforcing
measures; complimentarily between forms in banking sector and changes
in fiscal, external and monetary policies, developing financial
infrastructure and developing markets. By way of visible impact, one
finds the presence of a diversified banking system. Another important
aspect is that apart from the growth of banks and commercial banks there
are various other financial intermediaries including mutual funds. NBFCs,
primary dealers housing financing companies etc., the roles played by the
commercial banks in promoting these institutions are equally significant.
Other important developments are:
1. Financial regulation through statutory pre-emotions (Bank rate,
deposit rate, Credit Reserve Ration, Statutory Liquidity ratio) has
been lowered while stepping up prudential regulations at the same
time.
2. Interest rates have been deregulated, allowing banks the freedom to
determine deposits and lending rates.
3. Steps have been initiated to strengthen public sector banks, through
increasing their autonomy recapitalization from the fiscal, several
banks capital base has been written off and some have even
returned capital to govt. Allowing new private sector banks and
more liberal entry of foreign banks has infused competition.
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 3/17
4. A set of prudential measures have been stipulated to impart greater
strength to the banking system and also, ensure their safety and
soundness with the objective of moving towards international
practices.5. Measures have also been taken to broaden the ownership base of
PSB; consequently, the private sector holding has gone up, ranging
from 23% to 43%.
6. The banking sector has also witnessed greater levels of transparency
and standards of disclosure.
7. As the banking system has liberalized and become increasingly
market oriented, the financial markets have been concurrently
developed ; while the conduct of monetary policy has been tailored
to take into account the realities of the changing environment
(switching to indirect instruments)
In the post liberalization-era, Reserve Bank of India (RBI) has
initiated quite a few measures to ensure safety and consistency of the
banking system in the country and at the same point in time to support
banks to play an effective role in accelerating the economic growth
process. One of the major objectives of Indian banking sector reforms
was to encourage operational self-sufficiency, flexibility and competition
in the system and to increase the banking standards in India to the
international best practices (Reddy Y. V.; 2002). Although the Indian
banks have contributed much in the Indian economy, certain weaknesses,
i.e. turn down in efficiency and erosion in profitability had developed in
the system, observance in view these conditions, the Committee on
Financial System (CFS) was lay down (Amit Kumar Dwivedi; D. Kumara
Charyulu; 2011).
India’s Pre-reform period
Since 1991, India has been engaged in banking sector reformsaimed at increasing the profitability and efficiency of the then 27 public-
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 4/17
sector banks that controlled about 90 per cent of all deposits, assets and
credit. The reforms were initiated in the middle of a “current account”
crisis that occurred in early 1991. The crisis was caused by poor
macroeconomic performance, characterized by a public deficit of 10 percent of GDP, a current account deficit of 3 per cent of GDP, an inflation
rate of 10 per cent, and growing domestic and foreign debt, and was
triggered by a temporary oil price boom following the Iraqi invasion of
Kuwait in 1990.
India’s financial sector had long been characterized as highly
regulated and financially repressed. The prevalence of reserve
requirements, interest rate controls, and allocation of financial resources
to priority sectors increased the degree of financial repression and
adversely affected the country’s financial resource mobilization and
allocation. After Independence in 1947, the government took the view
that loans extended by colonial banks were biased toward working capital
for trade and large firms (Joshi and Little 1996). Moreover, it was
perceived that banks should be utilized to assist India’s planned
development strategy by mobilizing financial resources to strategically
important sectors.
Banking Sector Reforms
As the real sector reforms began in 1992, the need was felt to
restructure the Indian banking industry. The reform measures
necessitated the deregulation of the financial sector, particularly the
banking sector. The initiation of the financial sector reforms brought
about a paradigm shift in the banking industry. In 1991, the RBI had
proposed to form the committee chaired by M. Narasimham, former RBI
Governor in order to review the Financial System viz. aspects relating to
the Structure, Organisations and Functioning of the financial system. The
Narasimham Committee report, submitted to the then finance minister,
Manmohan Singh, on the banking sector reforms highlighted theweaknesses in the Indian banking system and suggested reform
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 5/17
measures based on the Basle norms. The guidelines that were issued
subsequently laid the foundation for the reformation of Indian banking
sector.
The main recommendations of the Committee were: -
Banking Sector Reforms
• Reduction of Statutory Liquidity Ratio (SLR) to 25 per cent over a
period of five years
• Progressive reduction in Cash Reserve Ratio (CRR)
• Phasing out of directed credit programmes and redefinition of the
priority sector
• Stipulation of minimum capital adequacy ratio of 4 per cent to risk
weighted assets
• Adoption of uniform accounting practices in regard to income
recognition, asset classification and provisioning against bad and
doubtful debts
• Imparting transparency to bank balance sheets and making more
disclosures
• Setting up of special tribunals to speed up the process of recovery
of loans
• Setting up of Asset Reconstruction Funds (ARFs) to take over from
banks a portion of their bad and doubtful advances at a discount
• Restructuring of the banking system, so as to have 3 or 4 large
banks, which could become international in character, 8 to 10
national banks and local banks confined to specific regions. Rural
banks, including RRBs, confined to rural areas
• Abolition of branch licensing
• Liberalising the policy with regard to allowing foreign banks to open
offices in India
• Rationalisation of foreign operations of Indian banks• Giving freedom to individual banks to recruit officers
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 6/17
• Inspection by supervisory authorities based essentially on the
internal audit and inspection reports
• Ending duality of control over banking system by Banking Division
and RBI• A separate authority for supervision of banks and financial
institutions which would be a semi-autonomous body under RBI
• Revised procedure for selection of Chief Executives and Directors of
Boards of public sector banks
• Obtaining resources from the market on competitive terms by DFIs
• Speedy liberalisation of capital market
Economic Reforms of the Banking Sector in India
Indian banking sector has undergone major changes and reforms
during economic reforms. Though it was a part of overall economic
reforms, it has changed the very functioning of Indian banks. This reform
has not only influenced the productivity and efficiency of many of the
Indian Banks, but has left everlasting footprints on the working of the
banking sector in India. Let us get acquainted with some of the important
reforms in the banking sector in India below with a graph.
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 7/17
1. Reduced CRR and SLR : The Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR) are gradually reduced during the economic reforms
period in India. By Law in India the CRR remains between 3-15% of the
Net Demand and Time Liabilities. It is reduced from the earlier high level
of 15% plus incremental CRR of 10% to current 4% level. Similarly, the
SLR Is also reduced from early 38.5% to current minimum of 25% level.
This has left more loanable funds with commercial banks, solving the
liquidity problem.
2. Deregulation of Interest Rate: During the economics reforms
period, interest rates of commercial banks were deregulated. Banks now
enjoy freedom of fixing the lower and upper limit of interest on deposits.
Interest rate slabs are reduced from Rs.20 Lakhs to just Rs. 2 Lakhs.
Interest rates on the bank loans above Rs.2 lakhs are full decontrolled.
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 8/17
These measures have resulted in more freedom to commercial banks in
interest rate regime.
3. Fixing prudential Norms: In order to induce professionalism in its
operations, the RBI fixed prudential norms for commercial banks. Itincludes recognition of income sources. Classification of assets, provisions
for bad debts, maintaining international standards in accounting practices,
etc. It helped banks in reducing and restructuring Non-performing assets
(NPAs).
4. Introduction of CRAR : Capital to Risk Weighted Asset Ratio (CRAR)
was introduced in 1992. It resulted in an improvement in the capital
position of commercial banks, all most all the banks in India has reached
the Capital Adequacy Ratio (CAR) above the statutory level of 9%.
5. Operational Autonomy: During the reforms period commercial banks
enjoyed the operational freedom. If a bank satisfies the CAR then it gets
freedom in opening new branches, upgrading the extension counters,
closing down existing branches and they get liberal lending norms.
6. Banking Diversification: The Indian banking sector was well
diversified, during the economic reforms period. Many of the banks have
stared new services and new products. Some of them have established
subsidiaries in merchant banking, mutual funds, insurance, venture
capital, etc which has led to diversified sources of income of them.
7. New Generation Banks: During the reforms period many new
generation banks have successfully emerged on the financial horizon.
Banks such as ICICI Bank, HDFC Bank, UTI Bank have given a big
challenge to the public sector banks leading to a greater degree of
competition.
8. Improved Profitability and Efficiency: During the reform period,
the productivity and efficiency of many commercial banks has improved.
It has happened due to the reduced Non-performing loans, increased use
of technology, more computerization and some other relevant measures
adopted by the government.
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 9/17
Differential Rate Interest:
The differential Rate of Interest (DRI) is a leading programme
launched by the Government in April 1972 which makes it obligatory uponall the Public Sector Banks in India to lend I percent total leading of the
preceding year to the “The poorest among the poor” at an interest rates
of 4 percent paranom the total leading in 2005 – 06 was Rs. 351 crores,
period 1969-2000 gives the following: from 1969-1980, the ratio of
deposits in nationalized banks to deposits in private banks was
approximately 5 to 1; from 1980 to 1993, the ratio was approximately
11-1; post liberalization, the ratio has been falling, and in 2000 stood at
about 7.5 to 1.47 Thus, under the accounting that is most favorable to
public sector banks, they squeak by as less costly to the government than
private sector banks (the ratio of money spent bailing out public vs.
private banks would be 62 3 to 1, less than the deposits ratio). However,
using the estimate of 540 billion rupees total cost gives a 12-1 ratio,
which would imply that the public sector banks lost a greater portion of
their deposits to bad loans.
The Future of Banking Reform
Prior to the economic reforms, the financial sector of India was on
the crossroads. To improve the performance of the Indian commercial
banks, first phase of banking sector reforms were introduced in 1991 and
after its success; government gave much importance to the second phase
of the reforms in 1998. Uppal (2011) analyzes the ongoing banking sector
reforms and their efficacy with the help of some ratios and concludes the
efficacy of all the bank groups have increased but new private sector and
foreign banks have edge over our public sector bank. The efficient,
dynamic and effective banking sector plays a decisive role in accelerating
the rate of economic growth in any economy. In the wake of contemporary economic changes in the world economy and other
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 10/17
domestic crises like adverse balance of payments problem, increasing
fiscal deficits etc., our country too embarked upon economic reforms. The
govt. of India introduced economic and financial sector reforms in 1991
and banking sector reforms were part and parcel of financial sectorreforms. These were initiated in 1991 to make Indian banking sector
more efficient, strong and dynamic.
Rationale of Banking Sector Reforms
To cope up with the changing economic environment, banking
sector needs some dose to improve its performance. Since 1991, the
banking sector was faced with the problems such as tight control of RBI,
eroded productivity and efficiency of public sector banks, continuous
losses by public sector banks year after year, increasing NPAs,
deteriorated portfolio quality, poor customer service, obsolete work
technology and unable to meet competitive environment. Therefore,
Narasimham Committee was appointed in 1991 and it submitted its report
in November 1991, with detailed measures to improve the adverse
situation of the banking industry (Uppal; 2011. p. 69). The main motive
of the reforms was to improve the operational efficiency of the banks to
further enhance their productivity and profitability.
First Phase of Banking Sector Reforms
The first phase of banking sector reforms essentially focused on the
following:
1.) Reduction in SLR & CRR
2.) Deregulation of interest rates
3.) Transparent guidelines or norms for entry and exit of private sectorbanks
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 11/17
4.) Public sector banks allowed for direct access to capital markets
5.) Branch licensing policy has been liberalized
6.) Setting up of Debt Recovery Tribunals
7.) Asset classification and provisioning8.) Income recognition
9.) Asset Reconstruction Fund (ARF)
Second Phase of Banking Sector Reforms
In spite of the optimistic views about the growth of banking industry
in terms of branch expansion, deposit mobilization etc, several distortions
such as increasing NPAs and obsolete technology crept into the system,
mainly due to the global changes occurring in the world economy. In this
context, the government of India appointed second Narasimham
Committee under the chairmanship of Mr. M. Narasimham to review the
first phase of banking reforms and chart a programme for further reforms
necessary to strengthen India’s financial system so as to make it
internationally competitive. Uppal (2011. p. 70) the committee reviewed
the performance of the banks in light of first phase of banking sector
reforms and submitted its report with some more focus and new
recommendations. There were no new recommendations in the second
Narasimham Committee except the followings:
- Merger of strong units of banks
- Adaptation of the ‘narrow banking’ concept to rehabilitate
weak banks.
As the process of second banking sector reforms is going on since
1999, one may say that there is an improvement in the performance of
banks. However, there have been many changes and challenges now due
to the entry of our banks into the global market.
Third banking sector reforms and fresh outlook
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 12/17
Rethinking for financial sector reforms have to be accorded,
restructuring of the public sector banks in particular, to strengthen the
Indian financial system and make it able to meet the challenges of globalization. The on-going reform process and the agenda for third
reforms will focus mainly to make the banking sector reforms viable and
efficient so that it could contribute to enhance the competitiveness of the
real economy and face the challenges of an increasingly integrated global
financial architecture.
When we take this evidence together, where does it leave us? There
are obvious problems with the Indian banking sector, ranging from under-
lending to unsecured lending, which we have discussed at some length.
There is now a greater awareness of these problems in the Indian
government and a willingness to do something about them. One policy
option that is being discussed is privatization. The evidence from Cole,
discussed above, suggests that privatization would lead to an infusion of
dynamism in to the banking sector: private banks have been growing
faster than comparable public banks in terms of credit, deposits and
number of branches, including rural branches, though it should be noted
that in our empirical analysis, the comparison group of private banks were
the relatively small ”old” private banks.48 It is not clear that we can
extrapolate from this to what we could expect when the State Bank of
India, which is more than an order of magnitude greater in size than the
largest “old” private sector banks. The “new” private banks are bigger and
in some ways would have been a better group to compare with. However
while this group is also growing very fast, they have been favored by
regulators in some specific ways, which, combined with their relatively
short track record, makes the comparison difficult. Privatization will also
free the loan officers from the fear of the CVC and make them somewhat
more willing to lend aggressively where the prospects are good, though,
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 13/17
as will be discussed later, better regulation of public banks may also
achieve similar goals.
Historically, a crucial difference between public and private sector
banks has been their willingness to lend to the priority sector. The recentbroadening of the definition of priority sector has mechanically increased
the share of credit from both public and private sector banks that qualify
as priority sector. The share of priority sector lending from public sector
banks was 42.5 percent in 2003, up from 36.6 percent in 1995. Private
sector lending has shown a similar increase from its 1995 level of 30
percent. In 2003 it may have surpassed for the first time ever public
sector banks, with a share of net bank credit to the priority sector at 44.4
percent to the priority sector.
Still, there are substantial differences between the public and
private sector banks. Most notable is the consistent failure of private
sector banks to meet the agricultural lending sub-target, though they also
lend substantially less in rural areas. Our evidence suggests that
privatization will make it harder for the government to get the private
banks to comply with what it wants them to do. However it is not clear
that this reflects the greater sensitivity of the public banks to this
particular social goal. It could also be that credit to agriculture, being
particularly politically salient, is the one place where the nationalized
banks are subject to political pressures to make imprudent loans.
Finally, one potential disadvantage of privatization comes from
the risk of bank failure. In the past there have been cases where the
owner of the private bank stripped its assets, and declared that it cannot
honor its deposit liabilities. The government is, understandably, reluctant
to let banks fail, since one of the achievements of the last forty years has
been to persuade people that their money is safe in the banks. Therefore,
it has tended to take over the failed bank, with the resultant pressure on
the fiscal deficit. Of course, this is in part a result of poor regulation–theregulator should be able to spot a private bank that is stripping its assets.
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 14/17
Better enforced prudential regulations would considerably strengthen the
case for privatization.
On the other hand, public banks have also been failing–the problem
seems to be part corruption and part inertia/laziness on the part of thelenders. As we saw above, the cost of bailing out the public banks may
well be larger (appropriately scaled) than the total losses incurred from
every bank failure since 1969. Once again the fact that the “new” private
banks pose a problem: So far none of them have defaulted, but they are
also new, and as a result, have not yet had to deal with the slow decline
of once successful companies, which is one of the main sources of the
accumulation of bad debt on the books of the public banks. On balance,
we feel the evidence argues, albeit quite tentatively, for privatizing the
nationalized banks, combined with tighter prudential regulations. On the
other hand we see no obvious case for abandoning the “social” aspect of
banking. Indeed there is a natural complementarity between reinforcing
the priority sector regulations (for example, by insisting that private
banks lend more to agriculture) and privatization, since with a privatized
banking sector it is less likely that the directed loans will get redirected
based on political expediency.
However there is no reason to expect miracles from the privatized
banks. For a variety of reasons including financial stability, the natural
tendency of banks, public or private, the world over, is towards
consolidation and the formation of fewer, bigger banks. As banks become
larger, they almost inevitably become more bureaucratic, because most
lending decisions in big banks, by the very fact of the bank being big,
must be taken by people who have no direct financial stake in the loan.
Being bureaucratic means limiting the amount of discretion the loan
officers can exercise and using rules, rather human judgment wherever
possible, much as is currently done in Indian nationalized banks. Berger
et al. have argued in the context of the US that this leads bigger banks to
shy away from lending to the smaller firms.50 Our presumption is thatthis process of consolidation and an increased focus on lending to
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 15/17
corporate and other larger firms is what will happen in India, with or
without privatization, though in the short run, the entry of a number of
newly privatized banks should increase competition for clients, which
ought to help the smaller firms.In the end the key to banking reform may lie in the internal
bureaucratic reform of banks, both private and public. In part this is
already happening as many of the newer private banks (like HDFC, ICICI)
try to reach beyond their traditional clients in the housing, consumer
finance and blue-chip sectors. This will require a set of smaller step
reforms, designed to affect the incentives of bankers in private and public
banks. A first step would be to make lending rules more responsive to
current profits and projections of future profits. This may be a way to
both target better and guard against potential NPAs, largely because poor
profitability seems to be a good predictor of future default. It is clear
however that choosing the right way to include profits in the lending
decision will not be easy. On one side there is the danger that
unprofitable companies default. On the other side, there is the danger of
pushing a company into default by cutting its access to credit exactly
when it needs it the most, i.e. right after a shock to demand or costs has
pushed it into the red. Perhaps one way to balance these objectives would
be to create three categories of firms: (1) Profitable to highly profitable
firms. Within this category lending should respond to profitability, with
more profitable firms getting a higher limit, even if they look similar on
the other measures. (2) Marginally profitable to loss-making firms that
used to be highly profitable in the recent past but have been hit by a
temporary shock (e.g. an increase in the price of cotton because of crop
failures, etc.). For these firms the existing rules for lending might work
well. (3) Marginally profitable to loss-making firms that have been that
way for a long time or have just been hit by a permanent shock (e.g., the
removal of tariffs protecting firms producing in an industry in which the
Chinese have a huge cost advantage). For these firms, there should be anattempt to discontinue lending, based on some clearly worked out exit
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 16/17
strategy (it is important that the borrowers be offered enough of the pie
that they feel that they will be better off by exiting without defaulting on
the loans). Of course it is not always going to be easy to distinguish
permanent shocks from the temporary. In particular, what should wemake of the firm that claims that it has put in place strategies that help it
survive the shock of Chinese competition, but that they will only work in a
couple of years? The best rule may be to use the information in profits
and costs over several years, and the experience of the industry as a
whole.
CONCLUSION
It could be noted that there has been no banking crisis at the same
time, efficiency of banking system as a whole, measured by declining
spread has improved. This is not say that they have no challenges. There
are emerging challenges, which appear in the forms of consolidation;
recapitalization, prudential regulation weak banks, and non-performing
assets, legal framework etc needs urgent attention. The paper concludes
that, from a regulatory perspective, the recent developments in the
financial sector have led to an appreciation of the limitations of the
present segmental approach to financial regulation and favors adopting a
consolidated supervisory approach to financial regulation and supervision,
irrespective of its structural design.
In the post-era of IT Act, global environment is continuously
changing and providong new direction, dimensions and immense
opportunities for the banking industry. Keeping in mind all the changes,
RBI should appoint another committee to evaluate the on-going banking
sector reforms and suggest third phase of the banking sector reforms in
the light of above said recommendations. Need of the hour is to provide
some effective measures to guard the banks against financial fragilities
and vulnerability in an environment of growing financial integration,
competition and global challenges. The challenge for the banks is to
harmonize and coordinate with banks in other countries to reduce thescope for contagion and maintain financial stability. It is not possible to
7/29/2019 Banking Ssector Reforms
http://slidepdf.com/reader/full/banking-ssector-reforms 17/17
play the role of the Oracle of Delphi when a vast nation like India is
involved. However, a few trends are evident, and the coming decade
should be as interesting as the last one.
Top Related