Banking Ssector Reforms

7/29/2019 Banking Ssector Reforms

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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



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.



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-



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



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



• 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.



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.



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.



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



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



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



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,



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.



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



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



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



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.

Documents

Banking Ssector Reforms