CHAPTER I

Introduction

“Considering the growing erosion in the efficiency and profitability of the banking sector, the
government decided to restructure the banking sector in order to infuse greater competition and
efficiency in their workings and to increase their profitability.

Accordingly, the Government of India appointed a nine member committee headed by M.

Narasimham, the former Governor of RBI on August 14, 1991. The committee was appointed to
review the working of the commercial banks and other financial institutions of the country and to
suggest measures to remodel these institutions for raising their efficiency.

The Narasimham Committee submitted its report in November, 1991 and the report was placed
before the parliament on December 17, 1991. In its report the Narasimham Committee has
acknowledged the success of the public sector banks in respect of branch expansion, deposit
mobilization in household sector, priority sector lending and removal of regional disparities in
banking. But during this post-nationalization period, the banking sector suffered a serious
erosion in its productivity, efficiency and profitability.

Two most important factors responsible for this situation, as reported by the committee, include
directed investment and directed credit programmes. The Committee argued that the abnormally
high statutory liquidity ratio (SLR-38.5 per cent) and cash reserve ratio (CRR-15 per cent)
enforced on the bankers a kind of tax on the banking system and diverted a good amount of
banking fund for unproductive purposes.

For the uninitiated, SLR stands for Statutory Liquidity Ratio. This term is used by bankers and
indicates the minimum percentage of deposits that the bank has to maintain in form of gold, cash
or other approved securities. Thus, we can say that it is ratio of cash and some other approved to
liabilities (deposits) It regulates the credit growth in India. The current SLR rate stands at 18.5%.

And CRR means Cash Reserve Ratio. Banks in India are required to hold a certain proportion of
their deposits in the form of cash. However, actually Banks don’t hold these as cash with
themselves, but deposit such case with Reserve Bank of India (RBI) / currency chests, which is
considered as equivalent to holding cash with themselves.. This minimum ratio (that is the part
of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash
Reserve Ratio. Thus, when a bank’s deposits increase by Rs100, and if the cash reserve ratio is
9%, the banks will have to hold additional Rs 9 with RBI and Bank will be able to use only Rs
91 for investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower
is the amount that banks will be able to use for lending and investment. This power of RBI to
reduce the lendable amount by increasing the CRR makes it an instrument in the hands of a
central bank through which it can control the amount that banks lend. Thus, it is a tool used by
RBI to control liquidity in the banking system. The current CRR rate is 3%.

CRR, in the form of “reserve requirement tax” has reduced the potential income of the banks and
thus reduced the profitability of the bankers. Moreover, the Narasimham Committee report
mentioned that the system of directed credit operation in the form of subsidised credit flow to
under-banked and priority areas, IRDP lending, loan mela etc. has disturbed the sound banking
practices. The Committee mentioned, “The intended socially oriented credit in the process,
degenerated into irresponsible lending.”

The Committee further mentioned that about 20 per cent of agricultural and small industrial
credit is in the form of “infected” and “contaminated” portfolio. The Committee also mentioned
that the operational expenditure of these banks has increased significantly due to phenomenal
increase in branch banking, lack of proper supervision, rapid growth of staff and accelerated
promotion, improper role of trade unions and higher unit cost administering loan to the priority
sectors.

The Narasimham Committee’s recommendations for reforming the banking system are based on
the sole rational criteria, i.e. the resources of the banks should be deployed in a most rational
manner so that it can provide maximum benefit to its depositors. Thus the holding of funds of the
banks by the government at low rate of interest for financing its” consumption expenditure
(paying salary of the employees) defrauded the depositors.
CHAPTER II

Problems identified by the Committee in the banking sector

The Narasimham “Committee firstly wanted to define what are the essential problems plaguing
the banking sector causing its delay in growth, and then give recommendations accordingly.
Here are some of the main problems identified by the committee as of 1991:

Directed Investment Programme

The committee objected to the system of maintaining high liquid assets by commercial banks in
the form of cash, gold and unencumbered government securities. It is also known as the statutory
liquidity Ratio (SLR). In those days, in India, the SLR was as high as 38.5 percent. According to
the M. Narasimham's Committee it was one of the reasons for the poor profitability of banks.
Similarly, the Cash Reserve Ratio- (CRR) was as high as 15 percent. Taken together, banks
needed to maintain 53.5 percent of their resources idle with the RBI.

Directed Credit Programme

Since nationalization the government has encouraged the lending to agriculture and small-scale
industries at a confessional rate of interest. It is known as the directed credit programme. The
committee opined that these sectors have matured and thus do not need such financial support.
This directed credit programme was successful from the government's point of view but it
affected commercial banks in a bad manner. Basically it deteriorated the quality of loan, resulted
in a shift from the security oriented loan to purpose oriented. Banks were given a huge target of
priority sector lending, etc. ultimately leading to profit erosion of banks.
Interest Rate Structure

The committee found that the interest rate structure and rate of interest in India are highly
regulated and controlled by the government. They also found that government used bank funds at
a cheap rate under the SLR. At the same time the government advocated the philosophy of
subsidized lending to certain sectors. The committee felt that there was no need for interest
subsidy. It made banks handicapped in terms of building main strength and expanding credit
supply.

Additionally, the Committee also suggested that the determination of interest rate should be on
grounds of market forces. It further suggested minimizing the slabs of interest.

Along with these major problem areas M. Narasimham’s Committee also found various
inconsistencies regarding the banking system in India. Inorder to remove” them and make it
more vibrant and efficient, it has given the following recommendations.
CHAPTER III

RECOMMENDATIONS OF THE COMMMITTEE

The Narsimham Committee “was set up in order to study the problems of the Indian financial
system and to suggest some recommendations for improvement in the efficiency and
productivity of the financial institution. The committee has given the following major
recommendations:-

Granting Autonomy

The committee recommended that the public sector banks should be free and autonomous. In
order to pursue competitiveness and efficiency, banks must enjoy autonomy so that they can
reform the work culture and banking technology upgradation will thus be easy.

Reduction in the SLR and CRR

The committee recommended the reduction of the higher proportion of the Statutory Liquidity
Ratio 'SLR' and the Cash Reserve Ratio 'CRR'. Both of these ratios were very high at that time.
The SLR then was 38.5% and CRR was 15%. This high amount of SLR and CRR meant locking
the bank resources for government uses. It was hindrance in the productivity of the bank thus the
committee recommended their gradual reduction. SLR was recommended to reduce from 38.5%
to 25% and CRR from 15% to 3 to 5%.

Phasing out of Directed Credit Programme

The committee acknowledged the role of these programs in extending the reach of banking
system to the neglected sectors of the economy. However, it also called for re-examination of the
present relevance of these programs, especially for those sectors which had become self-
sufficient.

Accordingly, the committee proposed that the directed credit committees should be phased out. It
also called for a re-defining of the priority sector.

Deregulation of Interest Rate

The committee felt that the prevailing structure of administered rates was highly complex and
rigid and called for deregulating it so that it reflects the emerging market conditions. However, it
warned against instant deregulation and suggested that the rates be brought in line with the
market rates gradually over a period of time. Hence the committee recommended eliminating
government controls on interest rate and phasing out the concessional interest rates for the
priority sector.

Structural Reorganizations of the Banking sector

The committee recommended that the actual numbers of public sector banks need to be reduced.
Three to four big banks including SBI should be developed as international banks. Eight to Ten
Banks having nationwide presence should concentrate on the national and universal banking
services. Local banks should concentrate on region specific banking. Regarding the RRBs
(Regional Rural Banks), it recommended that they should focus on agriculture and rural
financing. They recommended that the government should assure that henceforth there won't be
any nationalization and private and foreign banks should be allowed liberal entry in India.

Establishment of the ARF(Asset Reconstruction Tribunal)

The proportion of bad debts and Non-performing asset (NPA) of the public sector Banks and
Development Financial Institute was very alarming in those days. The committee recommended
the establishment of an Asset Reconstruction Fund (ARF). This fund will take over the
proportion of the bad and doubtful debts from the banks and financial institutes. It would help
banks to get rid of bad debts.

Removal of dual control

Back in those days banks were under the dual control of the Reserve Bank of India (RBI) and the
Banking Division of the Ministry of Finance (Government of India). The committee
recommended the stepping of this system. It considered and recommended that the RBI should
be the only main agency to regulate banking in India.

Create private banks

Banking sector was dominated by PSBs during post nationalization era. This had led to
deterioration in service, poor financial performance and a sense of complacency in banking
industry. Such a state of near monopoly seems to have led to lack of innovation, scarcity of
customer oriented products and approach.

The spirit of reforms was to allow the competition and increase the efficiency. There had been
increasing recognition of the need to introduce greater competition in banking by allowing the
entry of private sector banks. The Reserve Bank has accordingly formulated guidelines for the
establishment of new banks in the private sector.

Adopt prudential norms

Identifying the causes for the deterioration in the financial health of the banking system over
time, the Narasimham Committee recommended various remedial measures which included inter
aha capital adequacy norms, prudential norms for income recognition and provisioning for bad
debts. The Committee recommended that classification of assets of banks should be done on the
basis of objective criteria which would ensure a uniform and consistent application of the norms,
that a policy of income recognition should be objective and based on record of recovery rather
than on any subjective considerations, and that provisioning should be made” on the basis of
classification of assets into different categories.
CHAPTER IV

Conclusion/Implementation of the recommendations

Many of the recommendations of the committee were acceded to by the government. The SLR ,
“

which was around 38.5% in 1991-1992 was brought down to some 28% in five years. The CRR
was also brought down from 14% to 10% by 1997.

 The RBI introduced the CRAR or Capital to Risk Weighted Asset ratio in 1992 for the
soundness of the banking industry. RBI also included new prudential reforms for
classification of assets and provisioning of the non-performing assets.

 Some strong banks (such as SBI) were allowed to seek access to capital markets. The
banks which were relatively weaker, were recapitalized by the government via budgetary
support. More private banks were allowed. More freedom was given to banks to open
branches. The RBI’s supervision system was strengthened. Rapid computerization of the
banks was adopted. RBI started helping the commercial banks to improve the quality of
”

their performance.

The government also enacted Recovery of Debts Due to Banks and Financial Institutions
(RDDBFI) Act, 1993 Debt Recovery Tribunals with an Appellate Tribunal at Mumbai for
quicker recovery of bad debts. In 1995, Banking Ombudsman scheme was launched with an
objective to provide quicker solutions to customers’ complaints.