Banking Sector Reforms in India

Dr Subhash Gupta

 Bank of Hindustan, set up in 1870, was the earliest Indian Bank. Banking in India on modern lines started with the establishment of three presidency banks under Presidency Bank's act 1876 i.e. Bank of Calcutta, Bank of Bombay and Bank of Madras. In 1921, all presidency banks were amalgamated to form the Imperial Bank of India. Imperial bank carried out limited central banking functions also prior to establishment of RBI. Reserve Bank of India Act was passed in 1934 & Reserve Bank of India (RBI) was constituted as an apex bank without major government ownership. Banking Regulations Act was passed in 1949. This regulation brought Reserve Bank of India under government control

 In 1955, RBI acquired control of the Imperial Bank of India, which was renamed as State Bank of India. In 1959, SBI took over control of eight private banks floated in the erstwhile princely states, making them as its 100% subsidiaries. RBI was empowered in 1960, to force compulsory merger of weak banks with the strong ones. The total number of banks was thus reduced from 566 in 1951 to 85 in 1969. In July 1969, government nationalised 14 banks having deposits of Rs.50 crores & above. In 1980, government acquired 6 more banks with deposits of more than Rs.200 crores. The Narsimham Committee report suggested wide ranging reforms for the banking sector in 1992 to introduce internationally accepted banking practices The amendment of Banking Regulation Act in 1993 saw the entry of new private sector banks.

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

Indian Financial Sector: Pre-Nationalization

RBI Act: scheduled commercial banks are required to maintain a minimum cash reserve of 7% of their demand and 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 rates and 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 from 566 in 1951 to 85 in 1969 due to mergers).

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 voluntary agreement among the important banks) Certain disquieting features: (i) banking business was largely confined to the urban areas (neglect of rural and semi-urban areas) (ii) agriculture sector got only a very small share of total bank credit (iii) within industry, the large borrowers got the greatest share of credit The pattern of credit disbursement was inconsistent with the goal of achieving an equitable allocation of credit and the priorities set in the plans - bank nationalization in 1969

Indian Financial Sector: Bank nationalization

1969: 14 largest scheduled commercial banks nationalized; 22 largest banks accounting for 86% of deposits 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 and enhancement 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

A decade of change and evolution

Pre-reform

The 1990s

Today

Indian economy

Extensive regulation Focus on industrial sector Highly segmented Public sector dominance

Financial sector

Liberalisatio n Globalisation Structural change services Opening up of various sub-sectors Private sector participation

Resilient industry Buoyant services sector Diversified financial groups Globally benchmarke d

..financial sector mirroring macro-economic change

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The banking sector today

Depth

Diversification

Countrywide coverage Large number of players Increasingly sophisticated financial markets

Emergence of integrated players Diversifying capital deployment Leveraging synergies

Technology

Regulation

Increasing use of technology in operations Poised to expand and deepen technology usage

Robust regulatory system aligned to international standards Efficient monetary management

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Sector snapshot
Size

Total assets of US$ 335 billion Total deposits of US$ 279 billion

Number of banks

Over 290 scheduled banks Public sector: 27 Private sector: new 9; old 24 Foreign: 37 Over 190 regional rural banks Over 66,000 branches Public sector: 46,000 Private sector: 5,500 Foreign: 190 Regional rural: 14,400

Branch network

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A new orientation among banks

Traditional/ public sector

New/ private sector

Sell products Product research: what will sell? Product sales and profitability targets Product specialist groups Introduce new offerings every few years/months Branch banking Focus - customer acquisition

Meet customers needs Customer research: what does the customer want? Customer segment sales and profitability targets Customer owners Customer specific new offerings every week/day Customer convenience Deepen relationships
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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

Reforms in Banking Sector The first wave of financial liberalization took place in the second 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 was established In 1989, both commercial paper and certificates of deposit were introduced Based on the 1985 report of the Chakravarty Committee, coupon rates on government bonds were gradually increased to reflect demand and supply conditions In 1988, the maximum (or ceiling) lending rate and ranges in minimum rates were unified and switched to a minimumlending rate (MLR) in 1988. As a result, banks were able to set interest rates more flexibly. In 1989, the maximum interest rates on call money were liberalised

Reforms in Banking Sector Second wave of Liberalisation started with Narsimham Committee Recommendations
Reduction of the CRR and SLR
The CRR has declined gradually from 15% in 1991 to 5.75% in November 2001 and to 5.5% in December 2001. The SLR was reduced gradually from 38.5% in 1991 to 25% in October 1997. The SLR has remained at this rate until 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 rates and lending rates on advances in excess of Rs200,000. The remaining interest rate controls are savings deposit rates and lending rates up to Rs200,000.

Reforms in Banking Sector

Reform of Priority Sector Lending
Advances to the priority sectors should be reduced from 40% to 10%. While the targets of 40% imposed on domestic banks and 32% on foreign banks have not changed during the reform period, the burden of this directed lending practice has been gradually reduced by (1) expanding the definition of priority sector lending, and (2) liberalizing lending rates on advances in excess of Rs200,000,

Reforms in Banking Sector Deregulation of Entry Barriers and Branching Restrictions

Entry Deregulation The RBI issued guidelines in 1993 governing the establishment of new private sector banks. The guidelines stated that a new bank needed 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 as stipulated by the Banking Regulation Act of 1949; postpone setting up a subsidiary or mutual fund until at least three years after its establishment, and use modern infrastructural facilities to provide good customer service

In 1994, the Banking Regulation Act of 1949 was amended in order to raise the ceiling of voting rights of an individual shareholder in a private bank from 1% to 10%. The RBI approved six new private sector banks in 1994 The RBI granted an .in principle. approval to three local area banks.

Deregulation of Branch Restrictions

The RBI changed its licensing policy in 1992 in order to provide banks with operational autonomy to rationalize their branch networks. Banks were allowed to shift their existing branches within the same locality, open certain types of specialized branches, convert existing nonviable rural branches into satellite offices, spin off business of a branch, and open extension counters and administrative units without prior approval 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 three consecutive years, and had NPAs not exceeding 15% of total outstanding loans. In 1998/99, old and new foreign banks were permitted to open up to 12 branches a year, as against the earlier stipulation of eight branches.

 Adoption of Prudential Norms:

The RBI issued guidelines in 1992/93 on income recognition, asset classification, and provisioning.

Restructuring of Public Sector Banks

Recapitalization Debt Recovery and Bankruptcy Partial Privatization Writing-Off of Bad Debts Setting up of an Asset Reconstruction Company Reduction of Operational Costs

Journey Ahead reforms have not been a total success, for the following reasons: First, public sector banks still remain dominant. In addition, the profitability of nationalized banks has not improved Second, partial privatization has not significantly improved corporate governance, due to the ceiling of individual voting rights at 10%, the Governments continued dominance as the largest shareholder, and the absence of major reforms determining the boards of directors. Third, priority sector lending still remains a hindrance for the full commercialization of banks. Fourth, banks large-scale holdings of government securities lower banks incentives to improve their risk management skills on lending activities