Impact of Banking Sector Reforms In India

Table of Contents1.Introduction to Banking and Pre-reform era22.Necessity for Banking sector Reforms23.First Phase of Reforms(Narasimhan committee, 1991)3Recommendations of Narasimhan Committee3Banking reforms brought in by the Government and their impact34.Second phase of reforms (Narasimhan committee, 1998)5Recommendations of Narasimhan Committee5Banking reforms brought in by the Government and their impact65.Impact of Banking sector reforms8Productivity of Commercial Banks8Profitability of Commercial Banks9Asset Quality9Customer Services106.Impact on Corporate Sector:107.Conclusion and Recommendation128.References12

1. Introduction to Banking and Pre-reform era

A bank is an institution, which provides fundamental financial transactions such as accepting the deposits and providing loans. Basically, banks are a subset of the Financial Services Industry. After a series of reforms in the Indian banking industry, the Indian banks were able to compete with the modern banks of the world.

Banking in India originated in 18th century with the establishment of The General Bank of India and Bank of Hindustan in 1786. The East India Company then established three presidency banks in India namely The Bank of Bengal (1809), The Bank of Bombay (1840) and The Bank of Madras (1843). These three banks were amalgamated in 1921 to form The Imperial Bank of India (IBI) under the Imperial Bank of India Act, 1920 which is now The State Bank of India.Until 1935, all the banks were set up by individuals and/or industrial houses. Though consolidation in banking was building trust among investors yet a central regulatory and authority was much needed. The establishment of The Reserve Bank of India in 1935 brought an end to the quasi-central bank role of Imperial Bank of India and transformed it into a purely commercial bank over a period of time.Before reforms the Indian banking sector was characterised by high reserve requirements, low productivity/ efficiency in PSU banks, stringent regulations by RBI, quantitative restrictions on credit flows and an ever increasing Non Performing Assets, Inferior work technology and poor customer service. The Indian Banks were not in a position to handle the stiff competition from Foreign Banks. The private banks were not fulfilling the social and developing goals of banking.

2. Necessity for Banking sector Reforms

In 1991, India faced a severe macroeconomic crisis. This crisis opened the chinks in the armour of the Indian Banking Sector. The foreign exchange reserves were at a seemingly low level. The country faced the risk of defaulting with payments and the economic growth was at very low rate. This called for the government to bring measures on the paths of liberalization and globalization in the economy. A series of reforms had to be brought about in the Financial Sector. Between 1947 and 1990, there was a tremendous expansion of our banking system which played a major part in the development of the Financial Sector. However, by the end of 1990 it was felt that banking system wasnt as developed and robust as it should have been. Some of the Public Sector banks had become loss making entities with its high level of nonperforming Assets. The hidden NPAs had the potential to trigger a huge financial crisis. Compared to International Banks, Indian Banks were nowhere near with respect to capital adequacy and accounting standards etc. This served as a great threat to the progress of Indian economy.

3. First Phase of Reforms(Narasimhan committee, 1991)To overcome the 1991 financial crisis, the Government of India appointed a special committee headed by Shri. M. Narasimhan, ex-governor of the RBI to address the problem and to suggest corrective measures. The recommendations of this committee became the basis for the financial and banking sector reforms.Recommendations of Narasimhan Committee A new 4 tier hierarchy was to be established by the incorporation of a couple of large banks to be at the top level and a number of rural service providers to handle the activities pertaining to agriculture. The monitoring of the financial institutions and banks by separate entities that were set up by the RBI. Proposed phases of reduction in the SLR rate. A target level of 8% in terms of the Capital Adequacy Ratio. Elimination of the License raj. Full account disclosure and the correct organization of the banks assets and financial entities. Lower levels of regulation on Interest rates. Directing the lending activities of the IDBI to a separate corporate body. Banking reforms brought in by the Government and their impactSince 1991 the Narasimhan committee had recommended a series of measures which were incorporated by the Indian government

Lowering SLR and CRR

The reduction in the levels of SLR and CRR impacted the profits of the banks. The SLR was brought down to 25% from 38.5%. This helped in increased funding to the industry & Trading, agriculture. The Cash Reserve Ratio was reduced to 4.1% from the earlier rates of 15%. The primary reason behind the move was to liquidate the funds that were locked with the RBI.It is in use till date and serves as toll for regulating the monetary policy.

Prudential Norms

RBI had launched prudential norms for commercial banks. The primary motive behind this was the disclosure of the asset classification, bad debts provisioning, income to make that the financial records reflected the accurate data with respect to its financial position. It was necessary for the banks to ensure a 100% provisioning for all the NPAs which are at international standards. Capital Adequacy Norms

RBI had placed a slab for CAN at 8% and this was achieved the public sector banks by 1996.

Deregulation of Interest rates

The Narasimhan Committee proposed the interest rates to be decided by the market forces.

Scheduled Commercial banks were permitted to determine the fix the interest rates depending on the deposits taking into consideration the maximum ceiling rates & the minimum floor rates. The interest rates of termed domestic deposit was controlled. SBI along with the other players in the market had reduced the lending rates for advances that were more than 2 lakhs For the loans that were in excess of Rs. 2 lakhs the Interest rates were deregulated. The interest rates for the Co-operative banks for advances and deposits we reduced to a minimum level of 13%. Recovery of Debts

Recovery of debts due to Banks and Financial Institutions Act 1993 was passed by the government to facilitate the speeding up of the recovery of debts by the banks and financial institutions.6 special recovery tribunals and an Appellate Tribunal was set up in the city of Mumbai.

Competition from new private sector Banks

Banking was opened up to bring in private sector players and many private sector banks began operations. The new entrants were permitted to raise capital to the extent of up to 20% from the FIIs and about 40% from NRIs, which brought in high levels of competition. The new market players were armoured with the latest technology and services that had increased the expectations of the customers.

Phasing out of Direct Credit

The committee proposed the reduction in the credit target from 40% to 10% for the primary sectors. The task was however hectic for the government as those sectors involved powerful lobbies. Access to Capital Market

The Banking Companies Act was reviewed to enable the banks to raise capital through issues. This however came with a clause that the central governments stake of the paid up capital would not fall below 51%.

4. Second phase of reforms (Narasimhan committee, 1998)A committee was again appointed by the government of India, as a part of the second phase of reforms, to make the banking sector of the country stronger under the guidance of Mr. M. Narasimhan. The report/recommendations were submitted to the Government on April, 1998. The major focus and objective of the committee was to improve the principles of disclosure and the levels of transparency.Below are the recommendations and corresponding measures by government.Recommendations of Narasimhan Committee The committee suggested a resolute banking system entirely in the context of CAC (Capital Account Convertibility). The committee provided warning against the merging of small and weak banks with the strong players, as this might bring in a negative effect on the performance of stronger banks. The committee suggested that 2-3 large banks be given international positioning and global character. Capital inadequacy was tackled with new improved norms. It recommended the formation of an Asset Reconstruction Fund to take possession of bad debts of the banks and financial institutions. The committee suggested a Board for Financial Regulation and Supervision (BFRS) to organize the achievements of financial institutions and banks. To be at par with the current demands of the industry, there is an urgent need to evaluate and alter the provisions of the RBI Act, Banking Regulation Act, etc. By 2002,Net NPAs of all the banks to be reduced to 3%. The rearrangement of bank branches and staffs was emphasised. The committee was willing to continue with the licensing policy of new private banks. Foreign banks were permitted to set up their joint ventures and subsidiaries.Banking reforms brought in by the Government and their impactNew InstrumentsNew instruments were introduced to facilitate better risk management and greater flexibility. The new instruments were interest swaps, cross currency forward contracts, forward rate agreements, Liquidity Adjustment Facility(LAF) for meeting everyday liquidity mismatch.Risk ManagementBanks created dedicated committees to measure, monitor and track the various risks. These committees upgrade their skills and systems on a regular basis in order to sustain the risk management.Strengthening the technologyNew and advanced technology was introduced across banks to strengthen the payment and settlement systems through centralized fund management system, core banking solutions, electronic funds transfer, etc.Increased Foreign Direct Investment (FDI) LimitForeign Direct Investment(FDI) cap in private banks was raised to 74% from 49%.Increased inflow of CreditFlow of credit to priority sector was improved by giving more importance to Self Help and Micro Credit groups.

Adoption of Global StandardsRBI has introduced Risk Based Supervision of banks. The best international practices are being adopted in accounting systems, payment and settlement systems, corporate governance, etc.Information TechnologyOver the counter banking was replaced with the introduction of E-banking, telephonic banking etc. Focus was on the delivery of banking services through electronic medium.Management of NPAsNon-performing Assets had been the major cause of trouble for the Indian Banking Sector. The committee wanted a robust system to identify and classify NPAs. Asset Reconstruction Company or Asset Reconstruction Funds were created to take possession of the bad debt of banks. These recommendations led to the introduction of a new legislation which was subsequently implemented as the SARFAESAI(Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act), 2002 and came into effect from 21 June 2002.Mergers and AmalgamationIn May 2005,RBI issued procedures for merger and acquisition of private banks.Anti-Money Laundering guidelinesKYC(Know Your Customer) norms were reformed to prevent money laundering. Huge attention has been given to prevent money laundering in international financial relationships in recent times.Revamping the rural credit systemTo bridge the gap between demand and supply of agricultural credit.Managerial AutonomyFrom February 2005, public sector banks were given greater managerial autonomy to provide them equal opportunity to compete with private sector banks and international banks. This was achieved by Bringing recruitment process, training and remuneration policies of public sector banks in line with the private and international banks. Reducing GOI equity to 33% in nationalized banks.Customer ServiceRBI has introduced many new facilities such as Credit Cards, settlement of claims of deceased depositors, banking ombudsman etc. to improve the customer service.Base Rate System for fixing Interest RatesThe Benchmark Prime Lending Rate (BPLR) introduced in 2003, fell short of its purpose to bring transparency to lending rates. The main reason for this was that under the BPLR system, banks had the freedom to lend below BPLR. To overcome this failure of BPLR, RBI introduced the system of Base Rate. This new system is in use from July 2010.The base rate is nothing but the minimum interest rate for all loans.5. Impact of Banking sector reformsThe performance of both public and private sector banks improved in terms of profit per employee, productivity per employee, assets value etc.The improvement in the performance can be explained in the below 5 categories.

i. Productivity of Commercial Banksii. Profitability of Commercial Banksiii. Asset Qualityiv. Customer Services

Productivity of Commercial BanksAnalyses in terms of profit per employee, business per employee, and business per branch provides the improvement in the productivity of Commercial Banks.

Business per employeeThe business per employee for Public Sector Banks, Private Sector Banks and Foreign Banks are tabulated below, though the business per employee for Public sector banks is very low compared to New Private sector banks and foreign banks it had increased rapidly compared to others. A growth rate of 216% was witnessed in Public Sector Banks. By the year

Business per employee (in lakhs)YearPublic Sector BanksNew Private Sector BanksForeign Banks

1997-9888.5785.9529.4

2005-06324.1728.91012.8

2012-131274.7930.32173.3

Profit per employeeBetween the period 1997-98 and 2005-06, the profit per employee of Public sector banks had a increased by 314%, whereas the New private sector banks and Foreign banks had increased their profit by 350% and 489% respectively. The absolute value of profit per employee is tabulated,Profit per employee In lakhs)YearPublic Sector banksNew Private Sector BanksForeign Banks

1997-980.71.44.5

2005-062.96.326.5

2012-136.311.845.6

Business per BranchThe Business per Branch had an average growth rate 14% when our economic growth rate was 6.2% between 1999-2000 and 2004-05, During this period the Foreign banks had increased their business per branch by 109% followed by nationalised bank and new private sector banks with their business per branch increased by 97% and 44% respectively,

Business per Branch (in Lakhs)YearNationalized BanksNew Sector Private banksForeign Banks

1999-200021521498954800

2004-05424221656114768

Profitability of Commercial BanksProfitability of Commercial banks can be shown using below indicators.

a. Net/Spread interest marginNet/Spread interest rate is the difference between the interest income generated by bank to the interest paid by bank in relation to the amount of their assets. For public sector, private sector banks and foreign banks the spread interest margin was 2.9%, 2.1% and 3.6% respectively in 2000-01. In the year 2012-13 it was 2.78%, 3.24% and 3.89% for public, private and foreign banks respectively.

b. Return on Assets(ROA)The ROA of all banks has been risen after reforms. For public and private sector banks, it increased from 0.4%, 0.8%in 2000-01 to 0.88% and 1.22% in 2009-2010 and by the year 2012-13 it is 0.78% and 1.74% respectively. For foreign banks, the rise has been from 0.9% to 1.09% and 1.94% for the same period.

Asset QualityAsset quality of a bank in the terms of Non-performing Assets (NPA) have been increasedAverage NPA in %1997-20012009-2013

GNPA12.82.6

NNPA8.41.2

The NPA raised initially after reforms during early 1990s however it declined by mid 90s due to increased risk management, abundant liquidity condition, increased write off and increased restructuring.

Customer ServicesAfter the banking reforms, the Indian banks have begun to offer different kind of services to the clients/customers. Core Banking Solutions (CBS) has increased very fast. Under CBS, there are many services that has been provided to the customers/clients such as anywhere banking, everywhere access and quick and effecting fund transfer at reasonable cost. The number of branches implemented the CBS has increased from 79.4% in March 2009 to 90% at the end of March 2010.

6. Impact on Corporate Sector:

Corporate governanceCapital markets always had the prospective to implement discipline among the marketers andmanagement .However, it was the structural changes constituted by the financial reforms that unleashedthis power. Smaller stakeholders would be able to carry out the discipline of capitalmarkets by polling with their wallets. They have the powers vested on them to votein the primary market and to reject the subscription to new issues by a firm. They would also be able to trade their stocks in the secondary markets by decreasing thestock price.

DeregulationFinancial reforms not only helped in increasing the development visions, but they havealso made the markets more competitive. This forced companies to invest on a large scale continuously, to survive. The essential impact of the voting on companies is that the need to approach the market for the additional funds.

Disintermediation

The financial sector reforms made it vital for the firms to depend on the capital markets more for their needs of additional capital. As long as the companies were dependant on the direct credit, the ability to handle administrative and political process was all that mattered. This implied that the capital markets demanded performance.

Globalization

Globalization of the Indian Financial markets has showed the issuers, shareholders and intermediaries the higher standards of disclosures and corporate governance that succeed in more developed capital markets.

Tax reforms

The tax reforms together with deregulation and competition have made the market free from black money transaction. It is not often realized that when an organization makes profits in black money, it is cheating not only the government, but also the smaller investors. Profits made by black money do not enter the accounts of the organization at all, but will go into the pockets of the promoters.

Risk management

Unlike the stable interest rate before banking sector reforms during 1980s, interest rate are highly volatile post reform, which made the short term funding new projects very difficult to Corporates. Several companies that borrowed for acquisitions and expansion defaulted.Capital stricterAt the earlier stage after reform the corporates were increasing their debt to equity ratio due to the availability of the subsidized institution finance, the corporates were able to take more financial risks as there were less business risk in the protected economy before liberalisationCash flow discipline:The equity has no fixed service cost and the fluctuations in income every year dont have much impact as long as overall enough is earned to provide a decent return to the investor. On the other hand, the debt has a fixed repayment schedule and interest irrespective of the fluctuations. A company which enables the generation of enough cash flow to meet the requirement faces a painful reformation of liability. Bonds are rescheduled typically only as a part of insolvency proceeding or a BIFR reform.Group Structure:Indian business groups have been into serious self-assessment about their business portfolio and group structure. Under the guidance of many academicians, business groups which are involved in to an array of business are anticipating a move to a more intensive approach. Also, they are trying to create a structure of organizations which would enable the construction and execution of group wide corporate strategy.Working capital management:Numerous developments discussed above, reforms in the areas of credit assessment and delivery, interest deregulation, and transformation in the competitive structure have impacted the working capital management.In the cash credit system, the cast management has played key role. The companies should now decide on the optimum amount of cash they have to hold and should know about the ways to organise the cash, which corresponds to the decisions on maturity and credit risk liquidity.

7. Conclusion and Recommendation Since the reforms in the financial sector in 1991, there had been significant changes to Indias Banking sector. This paper tries to assess the impact of reforms in our economy. It is understood that the reforms have had a positive impact to an extent in terms of reducing the concentration of the banking sector and by improving performance. The empirical estimation also gave us an estimation which reveals that the reforms reduced profitability and decreased the efficiency of public-sector banks during the initial phase, However the decline overturned to accommodate a new environment Further reduction in the SLR rate could serve as a motivation for non-traditional activities and would make our banking sector resilient to adverse shocks. To maintain a steady growth of the economy it is imperative that the reforms continue to serve as a critical factor. The banking sectors response to the reforms has been significant and the sectors has adjusted well to the new environment

8. References1. www.ijmra.us/project%20doc/IJMT-234.pdf2. www.papers.ssrn.com/sol3/papers.cfm?abstract_id=18760523. www.wikipedia.com4. www.study-material4u.blogspot.in5. www.smsvaranasi.com