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The Transition of Indian Banking and its current challenges

Name A V S Srikanth Batch : PGDIM (second year MBA) College : NITIE. E mail Id ;, Ph : 8108355229,

Recent economic literature is replete with establishing the positive and direct linkage between financial inclusion and economic growth. In the Indian context, where both financial inclusion and economic growth have become focal points of governance, the association assumes special significance given that a large proportion of the population continues to exist outside of formal financial system. Any growth vision or any long term economic planning can ill afford to ignore such an economic inequity. Commercial banks, among the primary carriers of financial development to the excluded, have been assigned the task of financial inclusion. However they are likely to falter in meeting this onerous duty, or might end up harming their balance sheet while trying to achieve the targets. The reason is simple; they are held back by regulations that date back to the pre reforms era. Such a regulatory framework suited the predominant economic model but it doesn’t fit the current Indian context. In the following article effort has been made to capture the changes in the Indian banking system in the past decade or so.

Proliferation of bank branches
Over the past few decades, the Indian banking industry has evolved from being the development agent of a centrally – planned economy to becoming a free market intermediary, but still bound by the remains of the legacy regulatory framework. Earlier the focus was on expanding the banking infrastructure with the objective of garnering deposits to fund the government development expenditure. The bank performance was often focused on the growth in the deposits, with profit numbers being somewhat ignored

However proliferation of bank branches in the ‘70s and ‘80s did help increase the volume of the bank deposits. Bank branches shot up from 8,262 in 1969 to 89,622 till June 26 2011.during the same period aggregate deposits increased from slightly over Rs.4,388 crore to Rs 52,07,969 at the end of march 2011.

Along side this focus on deposit generation, the overall structure of the banking system was directed at leveraging a fledging formal financial system to meeting lofty social objectives, including economic development and poverty alleviation. Cross subsidization, excessive regulation of the lending rates, credit rationing to industry and lack of regulatory rigor impacted the viability of the banking sector, leading to pile up of nonperforming assets. With the advent of the reforms and tightening of prudential regulations, Indian banks have today become stronger and resilient.

Gross NPAs
Gross NPA’s during the 1990s stood at 23 % of total advances. Post economic reforms, gross NPAs have over the years have decreased to below 3 %. This has, undoubtedly helped banks stand on par with their global counter parts.

%ge of gross NPA to total advances
%ge of gross NPA to the total advances





Source: RBI




But it is an irony that despite the explosion in the bank branches and deposits garnered, percentage of the population untouched by the formal financial system still remains quite large. Half of Indian population exists outside the sweep of the formal financial system. RBI governor D. Subba rao said: “out of the 6,00,000 habitations in the country , less than 30,000 have a commercial bank branch. Just about 40 % of the populations across the country have bank accounts, and this ratio is much lower in north east.

Financial Inclusion
In developed countries such as the US and the UK around 91 % of the population has access to formal banking channels and in Germany and Sweden it accounting to 97 % The goal of financial inclusion in India has been left entirely to the banking industry. The reason behind the slow progress of financial inclusion in India can be found, to some extent, in the structural impediments facing the banking industry, no matter what the nature of the economic regime. It also highlights the fact that financial inclusion, as a social and economic phenomenon is being pushed top- down with banks displaying a visible reluctance. The overall design of the strategy and the structural issues that afflict commercial banks need to be addressed before the dream of financial inclusion can become Reality. The comparison of Rural and urban banks is given below

Bank branches
Opening of the bank branches in remote and uneconomical areas involve significant costs which the banking industry alone has to bear. The present administrative mechanism, which makes compulsory for commercial banks to open 25 % if their branches in the unbanked areas is not viable. Branches in such areas are bound to suffer from poor business and thus impact profitability of the banks. Out of a total of 5165 new branches opened in 2011, only 21.86% are rural branches. Such high level of banking access requires concerted efforts and a goal at national policy level which has been widely absent. Since bank account is the first step towards financial inclusion. It is necessary to give priority not only at the national policy level but also create the systems, processes and infrastructure that will help banks lower their cost of achieving financial inclusion. Pushing ahead on financial inclusion without actually improving the real economy in terms of connectivity, infrastructure, income opportunities or other social indicator is unlikely to result in any meaningful inclusion. There needs to be a policy framework to improve banking in the areas which are less profitable.

Source: RBI

One of the solutions to improve the spread of banking system to the remote areas is to probably compensate banks in lieu of the social measures they undertake. The telecom policy compensated state-run operators for providing services to rural and remote areas. Such a framework can be tweaked for the banking industry to improve the reach of basic banking services easily to masses. Business strategy that banks will have the freedom to opt for, instead of the mandatory fiat today. Business correspondents The RBI, conscious of the costs involved in the expansion of the brick and mortar rural network did come up with some solutions such as business correspondents (BC). The RBI, to its credit also kept tweaking the scheme to make it more acceptable and broadened its scope to allow for greater number of player’s .However, the scheme still hasn’t met with the kind of success anticipated. It is a work in progress and additionally it still needs to address host of issues relating to business correspondents like regulatory oversight, accounting grey areas, security of the BC representatives, integrating the BC technology interface with the host bank’s technology platform and the costs associated with all of this.

Cash reserve ratio and other regulatory obligations

But the main problem lies elsewhere. The following skew applies to every bank in India. For every Rs.100 of fresh deposits raised, banks have to keep aside Rs.6 as a cash reserve ratio (CRR) with RBI, on which they earn no interest income. Banks now have to deploy Rs.94 at commercial rates in such a way as to ensure the depositor earns interest on his Rs.100. But, banks have to invest another Rs.24 in government securities -- as statutory liquidity ratio (SLR) – which offer the lowest interest rate among all interest – bearing asset categories. So, now banks have to earn enough interest income from the remaining Rs.70. From the remaining Rs.70, a good 40 %( Rs 28) has to be allocated to priority sectors (banks have to lend 40 % of the previous year’s credit achievement for the priority sector) Although only a small portion of priority sector lending today involves concessional rates. There are two associated problems. For one, direct lending at 40 % is quite large in today’s economic environment. More importantly, since a large portion of these loans is in nature of small ticket transactions, these are huge administrative and transactions costs in involved. At the end of this rather uneconomic model, banks are finally left with Rs.42 to do proper commercial banking and earn enough interest income to enable it to pay the depositor interest on his Rs.100, distribute some profit to share holders and plough back the balance profit to capital for future expansion. This model is counter intuitive to not only funding the future course of growth, expansion planning and improving the bank’s competitive advantage, but also pursuing financial inclusion. Therefore having pushed banks to market based system , matching measures are also required that address banks’ need for growth and profitability.CRR should pay and interest to banks and SLR should be brought down to levels comparable with elsewhere in the world. SLR is as low as 10 % in U.S. There’s a scope for relaxing SLR coupled with prudent regulations can certainly lead to growth if the banking industry.


Therefore, a misshapen policy framework seems to be of the main hindrances to banks achieving the financial inclusion. Banks are undoubtedly the prime catalysts for economic growth in any economy. But without an enabling economic environment the targets will remain a fond dream. References  Rural Credit in 20th Century India An Overview of History and Perspectives : Mihir Shah, Ranga Rao  Indian Banking Industry: Challenges And Opportunities : Dr. Krishna A. Goyal  Banking statistics : RBI   