Indian Financial System

The Indian financial system comprises a set of financial institutions, financial markets and
financial infrastructure. The financial institutions mainly consist of commercial and co-operative
banks, regional rural banks (RRBs), all-India financial institutions (AIFIs) and non-banking
financial companies (NBFCs). The banking sector which forms the bedrock of the Indian
financial system, falls under the regulatory ambit of the Reserve Bank of India under the
provisions of the Banking Regulation Act, 1949 and the Reserve Bank of India Act, 1934. The
Reserve Bank also regulates select AIFIs. Consequent upon amendments to the Reserve Bank of
India (Amendment) Act in 1997, a comprehensive regulatory framework in respect of NBFCs
was put in place in January 1997.

The financial market in India comprises the money market, the Government securities market,
the foreign exchange market and the capital market. A holistic approach has been adopted in
India towards designing and development of a modern, robust, efficient, secure and integrated
payment and settlement system. The Reserve Bank set up the Institute for Development and
Research in Banking Technology (IDRBT) in 1996, which is an autonomous centre for
technology capacity building for banks and providing core IT services.

Financial Institutions

Scheduled commercial banks (SCBs) occupy a predominant position in the financial system
accounting for around three fourths of the total assets in the financial system. While the public
sector banks (PSBs), consisting of eight banks in the State Bank group and 19 nationalized
banks, constitute almost three fourths of the total assets of SCBs, the private sector banks, 30 in
number, 2 constitute less than one-fifth of the total assets. The 33 foreign banks operating in
India account for about 6-7 per cent of the assets of SCBs. The 196 RRBs play a critical role in
extending credit to the poorer sections of the rural society. The ownership of RRBs jointly vests
with the Central Government, the State Governments and the sponsor banks. The co-operative
banking system, with two broad segments of urban and rural co-operatives, forms an integral part
of the Indian financial system. While the urban co-operative banking system has a single tier
comprising the Primary Co-operative Banks (commonly known as ʹurban co-operative banks –
UCBs), the rural co-operative credit system is divided into long-term and short-term co-operative
credit institutions which have a multi-tier structure.

The term-lending institutions are mostly Government-owned and have been the traditional
providers of long-term project loans. Non-Banking Financial Companies (NBFCs) encompass an
extremely heterogeneous group of intermediaries and provide a gamut of financial services.
Primary Dealers (PDs) in the Government securities market constitutes a systemically important
segment of the NBFCs. At present, there are a total of 17 PDs playing active role in the
Government securities market. A majority of them are promoted by banks. Apart from this, India
has a well-established and vibrant insurance sector within the financial system. The Insurance
Regulatory and Development Agency (IRDA) have been established to regulate and supervise
the insurance sector.

Pre-reforms Phase

Until the early 1990s, the role of the financial system in India was primarily restricted to the
function of channeling resources from the surplus to deficit sectors. Whereas the financial system
performed this role reasonably well, its operations came to be marked by some serious
deficiencies over the years. The banking sector suffered from lack of competition, low capital
base, low productivity and high intermediation cost. After the nationalization of large banks in
1969 and 1980, the Government-owned banks dominated the banking sector. The role of
technology was minimal and the quality of service was not given adequate importance. Banks
also did not follow proper risk management systems and the prudential standards were weak. All
these resulted in poor asset quality and low profitability. Among non-banking financial
intermediaries, development finance institutions (DFIs) operated in an over-protected
environment with most of the funding coming from assured sources at concessional terms. In the
insurance sector, there was little competition. The mutual fund industry also suffered from lack
of competition and was dominated for long by one institution, viz., the Unit Trust of India. Non-
banking financial companies (NBFCs) grew rapidly, but there was no regulation of their asset
side. Financial markets were characterized by control over pricing of financial assets, barriers to
entry, high transaction costs and restrictions on movement of funds/participants between the
market segments. This apart from inhibiting the development of the markets also affected their
efficiency.

Financial Sector Reforms in India

It was in this backdrop that wide-ranging financial sector reforms in India were introduced as an
integral part of the economic reforms initiated in the early 1990s with a view to improving the
macroeconomic performance of the economy. The reforms in the financial sector focused on
creating efficient and stable financial institutions and markets. The approach to financial sector
reforms in India were one of gradual and non-disruptive progress through a consultative process.
The Reserve Bank has been consistently working towards setting an enabling regulatory
framework with prompt and effective supervision, development of technological and institutional
infrastructure, as well as changing the interface with the market participants through a
consultative process. Persistent efforts have been made towards adoption of international
bench marks as appropriate to Indian conditions. While certain changes in the legal infrastructure
are yet to be effected, the developments so far have brought the Indian financial system closer to
global standards.

The reform of the interest regime constitutes an integral part of the financial sector reform. With
the onset of financial sector reforms, the interest rate regime has been largely deregulated with a
view towards better price discovery and efficient resource allocation. Initially, steps were taken
to develop the domestic money market and freeing of the money market rates. The interest rates
offered on Government securities were progressively raised so that the Government borrowing
could be carried out at market-related rates. In respect of banks, a major effort was undertaken to
simplify the administered structure of interest rates. Banks now have sufficient flexibility to
decide their deposit and lending rate structures and manage their assets and liabilities
accordingly. At present, apart from savings account and NRE deposit on the deposit side and
export credit and small loans on the lending side; all other interest rates are deregulated.

Indian banking system operated for a long time with high reserve requirements both in the form
of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). This was a consequence of
the high fiscal deficit and a high degree of monetization of fiscal deficit. The efforts in the recent
period have been to lower both the CRR and SLR. The statutory minimum of 25 per cent for
SLR has already been reached, and while the Reserve Bank continues to pursue its medium-term
objective of reducing the CRR to the statutory minimum level of 3.0 per cent, the CRR of SCBs
is currently placed at 5.0 per cent of NDTL.

As part of the reforms programme, due attention has been given to diversification of ownership
leading to greater market accountability and improved efficiency. Initially, there was infusion of
capital by the Government in public sector banks, which was followed by expanding the capital
base with equity participation by the private investors. This was followed by a reduction in the
Government shareholding in public sector banks to 51 per cent. Consequently, the share of the
public sector banks in the aggregate assets of the banking sector have come down from 90 per
cent in 1991 to around 75 per cent in 2004. With a view to enhancing efficiency and productivity
through competition, guidelines were laid down for establishment of new banks in the private
sector and the foreign banks have been allowed more liberal entry. Since 1993, twelve new
private sector banks have been set up. As a major step towards enhancing competition in the
banking sector, foreign direct investment in the private sector banks is now allowed up to
74 per cent, subject to conformity with the guidelines issued from time to time.

Financial Markets

A major objective of reforms in the financial sector was to develop various segments of the
financial market as also eliminate segmentation across various markets in order to smoothen the
process of transmission of impulses across markets, easing the liquidity management process and
making resource allocation process more efficient across the economy. The strategy adopted for
meeting these objectives involved removal of restrictions on pricing of assets, building the
institutional structure and technological infrastructure, introduction of new instruments, and fine-
tuning of the market microstructure. The 1990s saw the significant development of various
segments of the financial market. At the short end of the spectrum, the money market saw the
emergence of a number of new instruments such as CP and CDs and derivative products
including FRAs and IRS. Repo operations, which were introduced in the early 1990s and later
refined into a Liquidity Adjustment Facility, allows the Reserve Bank to modulate liquidity and
transmit interest rate signals to the market on a daily basis. The process of financial market
development was buttressed by the evolution of an active government securities market after the
Government borrowing programme was put through the auction process in 1992-93. The
development of a market for Government paper enabled the Reserve Bank to modulate the
monetization of the fiscal deficit. The foreign exchange market deepened with the opening up of
the economy and the institution of a market-based exchange rate regime in the early 1990s.
Although there were occasional episodes of volatility in the foreign exchange market, these were
swiftly controlled by appropriate policy measures. The capital market also underwent some
metamorphic changes during the 1990s. The development of the financial markets was well
supported by deregulation of balance sheet restrictions in respect of financial institutions,
allowing them to operate across markets. This resulted in increased integration among the
various segments of the financial markets.

Indian Banking System

Years ago, an account holder had to wait for hours at the bank counter for withdrawing his own
money or getting a draft. But today, he has a choice. Gone are those days when the most efficient
bank transferred money from one branch to other in two days or more. Now it is simple as
messaging or ordering a pizza. Money has become the order of the day. The first bank in India
was established in 1786. From 1786 till today, the journey of Indian Banking System can be
segregated into three distinct phases

 Early phase from 1786 to 1969 of Indian Banks

 Nationalization of Indian Banks and up to 1991 prior to Indian banking sector reforms
 New phase of Indian Banking System with the advent of Indian Financial and Banking
Sector Reforms after 1991.

Phase I

The General Bank of India was set up in the year 1786. The subsequent banks were Bank of
Hindustan and Bengal Bank. The East India Company established Bank of Bengal (1809), Bank
of Bombay (1840) and Bank of Madras (1843) as independent units and called it as Presidency
Banks. These three banks amalgamated in 1920 and Imperial Bank of India was established
which operated as private shareholders banks, mostly European shareholders.

In 1865, Allahabad Bank was established and was established and first time exclusively by
Indians, Punjab National Bank Ltd. was set up in 1984 with headquarters at Lahore. Bank of
India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore
were set up between 1906 and 1913. Reserve Bank of India came in 1935.

The first phase of the growth was very slow and banks also experienced periodic failures
between 1913 and 1948. There were approximately 1100 banks, mostly banks. The Government
of India came up with The Banking Companies Act, 1949 which was later changed to Banking
Regulation Act as per amending Act of 1965 (Act No. 23 of 1965), to streamline the functioning
and activities of commercial banks. Reserve Bank of India was vested with extensive powers for
the supervision of banking in India as the Central Banking Authority.

During the first phase, public had lesser confidence in the banks. As an aftermath deposit
mobilization was slow. Abreast of it the savings bank facility provided by the Postal department
was comparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after independence. In 1955,
it nationalized Imperial Bank of India with extensive banking facilities on a large scale especially
in rural and semi-urban areas. It formed State Bank of India to act as the principle agent of RBI
and to handle banking transactions of the Union and State Governments all over the country.

Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on 19 th July,
1969, major process of nationalization was carried out. During the reign of Indira Gandhi, Prime
Minister of India, 14 major commercial banks in the country was nationalized.

Second phase of nationalization Indian Banking Sector Reform was carried out in 1980 with
seven more banks. This pace brought 80% of the banking segment in India under Government
ownership.

The following are the steps taken by the Government of India to regulate Banking Institutions in
the country:

 1949: Enactment of Banking Regulation Act.

 1955: Nationalization of State Bank of India.
 1959: Nationalization of SBI subsidiaries.
 1961: Insurance cover extended to deposits.
 1969: Nationalization of 14 major banks.
  1971: Creation of credit guarantee corporation.
 1980: Nationalization of seven banks with deposits over 200 crore.

After the nationalization of banks, the branches of the public sector bank India rose to
approximately 80% in deposits and advances took a huge jump by 11,000%. Banking in the
sunshine of Government ownership gave the public implicit faith and immense confidence about
the sustainability of these institutions.

Phase III

The third phase is in the introduction of many products and facilities in the banking sector in its
reforms measure. In 1991, under the chairmanship of M Narasimham, a committee was set up by
his name which worked for the liberalization of banking practices.

The entire country was flooded with entry of foreign banks and their ATM stations. More
emphasis was given on satisfactory services to customers. The phase also introduced other types
of banking viz Phone banking and net banking. The entire banking sector became more
convenient and swift. Time was given more importance than money.

The financial system of India has shown a great amount of pliability. It is sheltered from any
crisis triggered by any external macroeconomics shock as other East Asian Countries suffered.
This is all due to a flexible exchange rate regime, the foreign reserves are high, the capital
account is not yet fully convertible, and banks and their customers have limited foreign exchange
exposure.

Indian Banking Sector as of 2010

For the past three decades India’s banking system has several outstanding achievements to its
credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or
cosmopolitans in India. In fact, Indian banking system has reached even to remote corners of the
country. This is one of the main reasons of India’s growth process. The government’s regular
policy for Indian bank since 1969 has paid rich dividends with the nationalization of 14 major
private banks of India.
The banking system of India should not only be hassle free but it should be able to meet new
challenges posed by the technology and any other external and internal factors.

The interplay between policy and regulatory interventions and management strategies will
determine the performance of Indian banking over the next few years. Legislative actions will
shape the regulatory stance through six key elements: industry structure and sector consolidation;
freedom to deploy capital; regulatory coverage; corporate governance; labor reforms and human
capital development; and support for creating industry utilities and service bureaus. Management
success will be determined on three fronts: fundamentally upgrading organizational capability to
stay in tune with the changing market; adopting value creating M&A as an avenue for growth;
and continually innovating to develop new business models to access untapped opportunities.

To improve the performance of this sector, the policy makers should focus on:

 To shape a superior industry structure in a phased manner through “managed

consolidation” and by enabling capital availability. This would create 3-4 global sized
banks controlling 35-45 % of the market in India; 6-8 national banks controlling 20-25 %
of the market; 4-6 foreign banks with 15-20 % share in the market.
 Creating a unified regulator, distinct from the central bank of the country, in a phased
manner to overcome supervisory difficulties and reduce compliance costs.
 Improve corporate governance primarily by increasing board independence and
accountability.
 Enable labor reforms, focusing on enriching human capital, to help public sector and old
private banks become competitive.
The extent to which Indian policy makers and bank managements develop and execute such a
clear and complementary agenda to tackle emerging discontinuities will lay the foundations for a
high-performing sector in 2010.