Introduction to Banking Sector Reforms in India

The banking sector reforms in India were started as a follow up measures of the economic liberalization and financial sector reforms in the country. The banking sector being the life line of the economy was treated with utmost importance in the financial sector reforms. The reforms were aimed at to make the Indian banking industry more competitive, versatile, efficient, productive, to follow international accounting standard and to free from the government's control. The reforms in the banking industry started in the early 1990s have been continued till now. The paper makes an effort to first gather the major reforms measures and policies regarding the banking industry by the govt. of India and the Central Bank of India (i.,e. Reserve Bank of India) during the last fifteen years. Secondly, the paper will try to study the major impacts of those reforms upon the banking industry. A positive responds is seen in the field of enhancing the role of market forces, regarding prudential regulations norms, introduction of CAMELS supervisory rating system, reduction of NPAs and regarding the up gradation of technology. But at the same time the reform has failed to bring up a banking system which is at par with the international level and still the Indian banking sector is mainly controlled by the govt. as public sector banks being the leader in all the spheres of the banking network in the country. 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 have 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. 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

more computerization and some other relevant measures adopted by the government.20 Lakhs to just Rs. Banking Diversification : The Indian banking sector was well diversified. insurance. Operational Autonomy : During the reforms period commercial banks enjoyed the operational freedom. 3. 6.freedom of fixing the lower and upper limit of interest on deposits. These are some of the import reforms regarding the banking sector in India. the RBI fixed prudential norms for commercial banks. 8. provisions for bad debts. 2 Lakhs. the productivity and efficiency of many commercial banks has improved. Many of the banks have stared new services and new products. Interest rate slabs are reduced from Rs. It resulted in an improvement in the capital position of commercial banks. etc which has led to diversified sources of income of them. Interest rates on the bank loans above Rs. upgrading the extension counters. HDFC Bank. Classification of assets. With these reforms. Improved Profitability and Efficiency : During the reform period. Banks such as ICICI Bank. It has happened due to the reduced Non-performing loans. These measures have resulted in more freedom to commercial banks in interest rate regime. It includes recognition of income sources. Some of them have established subsidiaries in merchant banking. New Generation Banks : During the reforms period many new generation banks have successfully emerged on the financial horizon. Fixing prudential Norms : In order to induce professionalism in its operations. increased use of technology. 4. 7. during the economic reforms period. maintaining international standards in accounting practices. closing down existing branches and they get liberal lending norms. Introduction of CRAR : Capital to Risk Weighted Asset Ratio (CRAR) was introduced in 1992. mutual funds. etc. If a bank satisfies the CAR then it gets freedom in opening new branches. venture capital. UTI Bank have given a big challenge to the public sector banks leading to a greater degree of competition. all most all the banks in India has reached the Capital Adequacy Ratio (CAR) above the statutory level of 9%. It helped banks in reducing and restructuring Non-performing assets (NPAs). Indian banks especially the public sector banks have proved that they are no .2 lakhs are full decontrolled. 5.

and was triggered by a temporary oil price boom following the Iraqi invasion of Kuwait in 1990. a current account deficit of 3 per cent of GDP. finance fiscal deficits. Prior to the reforms. 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. but savings were successfully mobilized in part because relatively low inflation kept negative real interest rates at a mild level and in part because the number of branches was encouraged to expand rapidly. The crisis was caused by poor macroeconomic performance. characterized by a public deficit of 10 per cent of GDP. Nevertheless. many banks remained unprofitable. assets and credit. The prevalence of reserve requirements. interest rate controls. an inflation rate of 10 per cent. and unsound poor lending strategy and lack of internal risk management under owing to their government ownership. India’s financial sector had long been characterized as highly regulated and financially repressed. These nationalized banks were then increasingly used to Although non-nationalized private banks and foreign banks were allowed to coexist with public-sector banks at that time. India’s pre-reform period and financial reform Since 1991. the number of banks increased slightly. and growing domestic and foreign debt. The reforms were initiated in the middle of a “current account” crisis that occurred in early 1991.longer inefficient compared with their foreign counterparts as far as productivity is concerned. quantitative loan targets were imposed on these banks to expand their networks in rural areas and they were directed to extend credit to priority sectors. all large private banks were nationalized in two stages: the first in 1969 and the second in 1980. 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). Subsequently. their activities remained negligible. After Independence in 1947. Joshi and Little (1996) have reported that the average return on . Moreover. their activities were highly restricted through entry regulations and strict branch licensing policies. Reflecting these views. it was perceived that banks should be utilized to assist India’s planned development strategy by mobilizing financial resources to strategically important sectors. India has been engaged in banking sector reforms aimed at increasing the profitability and efficiency of the then 27 public-sector banks that controlled about 90 per cent of all deposits. In the period 1969-1991. inefficient. Thus.

and (e) lack of competition. These factors not only reduced incentives to operate properly. only 15 public-sector banks achieved a net profit. (c) directed and concessional lending.e. The important achievements in the following fields is discussed under serparate heads:        Financial markets Regulators The banking system Non-banking finance companies The capital market Mutual funds Overall approach to reforms . (b) low interest rates charged on government bonds (as compared with those on commercial advances).15 per cent. Financial and Banking Sector Reforms The last decade witnessed the maturity of India's financial markets. even these indicators are likely to have exaggerated the banks’ true performance. The major factors that contributed to deteriorating bank performance included (a) too stringent regulatory requirements (i. (d) administered interest rates. but also undermined regulators’ incentives to prevent banks from taking risks via incentive-compatible prudential regulations and protect depositors with a well-designed deposit insurance system. Further.assets in the second half of the 1980s was only about 0. it will put newly established private banks as well as foreign banks in an extremely disadvantageous position. every governments of India took major steps in reforming the financial sector of the country. While government involvement in the financial sector can be justified at the initial stage of economic development.. Given that global accounting standards were not applied.5 per cent of assets. Further. a cash reserve requirement [CRR]2 and statutory liquidity requirement [SLR] that required banks to hold a certain amount of government and eligible securities). the prolonged presence of excessively large public-sector banks often results in inefficient resource allocation and concentration of power in a few banks. in 1992/93. once entry deregulation takes place. Since 1991. while capital and reserves averaged about 1. non-performing assets (NPAs) of 27 public-sector banks amounted to 24 per cent of total credit. and half of the public-sector banks faced negative net worth.

The RBI has given licences to new private sector banks as part of the liberalisation process. With the openings in the insurance sector for these institutions. Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development Authority (IRDA) became important institutions. Deregulation added to it. Financial Markets In the last decade. Opinions are also there that there should be a super-regulator for the financial services sector instead of multiplicity of regulators. retail trade. Regulators The Finance Ministry continuously formulated major policies in the field of financial sector of the country. The real interest rate was maintained. The banking system Almost 80% of the business are still controlled by Public Sector Banks (PSBs). they started making debt in the market. They grew rapidly in commercial banking and asset management business.   Deregulation of banking system Capital market developments Consolidation imperative Now let us discuss each segment seperately. in order to . The PSBs will play an important role in the industry due to its number of branches and foreign banks facing the constrait of limited number of branches. The RBI has also been granting licences to industrial houses. 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. PSBs are still dominating the commercial banking system. The Reserve Bank of India (RBI) has become more independant. Many banks are successfully running in the retail and consumer segments but are yet to deliver services to industrial finance. Private Sector Institutions played an important role. Shares of the leading PSBs are already listed on the stock exchanges. Competition among financial intermediaries gradually helped the interest rates to decline. The Government accepted the important role of regulators. small business and agricultural finance. Hence.

After bringing some order to the equity market. the requirement of minimum net owned funds.2 crores. Non-banking finance companies In the case of new NBFCs seeking registration with the RBI. only an estimated two lakh persons actively trade in stocks. Expectations are that India will be an attractive emerging market with tremendous potential. Long-term debt market: The development of a long-term debt market is crucial to the financing of infrastructure. strengthening of existing instruments and setting up of the Discount and Finance House of India (DFHI).edged market occupies an important position in the financial set. However. Stamp duty is being withdrawn at the time of dematerialisation of debt instruments in order to encourage paperless trading.up. Unfortunately. Several measures have been initiated and include new money market instruments. has been raised to Rs. The Securities Trading Corporation of India (STCI). . the SEBI has now decided to concentrate on the development of the debt market. the onus is on the Government to encourage the PSBs to be run on professional lines. the gilt. The RBI has introduced a liquidity adjustment facility (LAF) in which liquidity is injected through reverse repo auctions and liquidity is sucked out through repo auctions. There has been a dramatic improvement in the country's stock market trading infrastructure during the last few years. Until recently. On account of the substantial issue of government debt. Primary dealers bid for these securities and also trade in them. The DFHI is the principal agency for developing a secondary market for money market instruments and Government of India treasury bills. The capital market The number of shareholders in India is estimated at 25 million. which started operations in June 1994 has a mandate to develop the secondary market in government securities. The RBI conducts its sales of dated securities and treasury bills through its open market operations (OMO) window.achieve an efficient banking system. The secondary market was underdeveloped and lacked liquidity. the money market in India was narrow and circumscribed by tight regulations over interest rates and participants.

The entry of foreign players has assisted in the introduction of international practices and systems. which has led to retail investors deserting the stock markets. An indication of the strength of the reformed Indian financial system can be seen from the way . It is too early to conclude whether the erstwhile public sector monopolies will successfully be able to face up to the competition posed by the new players. 1996 and amendments thereto. mutual funds started becoming popular. Mutual funds The mutual funds industry is now regulated under the SEBI (Mutual Funds) Regulations. both Indian and foreign players. The biggest shock to the mutual fund industry during recent times was the insecurity generated in the minds of investors regarding the US 64 scheme. They are introducing new products. With the issuance of SEBI guidelines. Overall approach to reforms The last ten years have seen major improvements in the working of various financial market participants. of course. Foreign companies can only enter joint ventures with Indian companies. The insurance industry is the latest to be thrown open to competition from the private sector including foreign players. The foreign owned AMCs are the ones which are now setting the pace for the industry. setting new standards of customer service. The new players will need to bring in innovative products as well as fresh ideas on marketing and distribution. the industry had a framework for the establishment of many more players. The government and the regulatory authorities have followed a step-bystep approach. in order to improve the low per capita insurance coverage. Good regulation will. On the whole. be essential. not a big bang one. but it can be expected that the customer will gain from improved service. but its share is going down. With the growth in the securities markets and tax advantages granted for investment in mutual fund units. an active corporate debt market and a developed derivatives market). Technology developments have improved customer service.70. with participation restricted to 26 per cent of equity. improving disclosure standards and experimenting with new types of distribution. the cumulative effect of the developments since 1991 has been quite encouraging.during recent times the stock markets have been constrained by some unsavoury developments.000 crores. Some gaps however remain (for example: lack of an inter-bank interest rate benchmark. The Unit Trust of India remains easily the biggest mutual fund controlling a corpus of nearly Rs.

The fate of the Fiscal Responsibility Bill remains unknown and high fiscal deficits continue. and special recovery tribunals set up to facilitate quicker recovery of loan arrears. Government pre-emption of banks' resources through statutory liquidity ratio (SLR) and cash reserve ratio (CRR) brought down in steps. punishment has to follow crime. frauds cannot be totally prevented. PSBs were encouraged to approach the public for raising resources. which is often not the case in India. In the case of financial institutions. even with the best of regulation. Banks asked to set up asset liability management (ALM) systems. The National Stock . financial stability cannot be ensured. the political and legal structures hve to ensure that borrowers repay on time the loans they have taken.India was not affected by the Southeast Asian crisis. provisioning for delinquent loans and for capital adequacy. The phenomenon of rich industrialists and bankrupt companies continues. Capital market developments The Capital Issues (Control) Act. Without fiscal control. New private sector banks allowed to promote and encourage competition. 1993 was passed. Further. Indian companies were permitted to access international capital markets through euro issues. substantial capital were provided by the Government to PSBs. asset classification. Some tough decisions still need to be taken. the capital market regulator was established in 1992. In order to reach the stipulated capital adequacy norms. Derivative products such as forward rate agreements (FRAs) and interest rate swaps (IRSs) introduced. market and operational risks. However. However. office of the Controller of Capital Issues were abolished and the initial share pricing were decontrolled. SEBI. Foreign institutional investors (FIIs) were allowed to invest in Indian capital markets after registration with the SEBI. RBI guidelines issued for risk management systems in banks encompassing credit. Bank lending norms liberalised and a loan system to ensure better control over credit introduced. repealed. Recovery of debts due to banks and the Financial Institutions Act. financial liberalisation alone will not ensure stable economic growth. A credit information bureau being established to identify bad risks. 1947. Deregulation of banking system Prudential norms were introduced for income recognition. Interest rates on the deposits and lending sides almost entirely were deregulated.

with nationwide stock trading and electronic display. A system of rolling settlements introduced. clearing and settlement facilities was established. In India the banks are in huge quantity. subject to conditions. 1999 issued for regulating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Companies were required to disclose all material facts and specific risk factors associated with their projects while making public issues. Private mutual funds permitted The Depositories Act had given a legal framework for the establishment of depositories to record ownership deals in book entry form. Steps were taken to improve corporate governance based on the report of a committee. Buy back of shares allowed The SEBI started insisting on greater corporate disclosures. Several local stock exchanges changed over from floor based trading to screen based trading. Companies given the freedom to issue dematerialised shares in any denomination. there is no need for 27 PSBs with branches all over India. SEBI reconstituted governing boards of the stock exchanges. and made rules for making client or broker relationship more transparent which included separation of client and broker accounts. The practice of making preferential allotment of shares at prices unrelated to the prevailing market prices stopped and fresh guidelines were issued by SEBI. 100 were abolished. First. Consolidation imperative Another aspect of the financial sector reforms in India is the consolidation of existing institutions which is especially applicable to the commercial banks. SEBI issued detailed employee stock option scheme and employee stock purchase scheme for listed companies. underwriting by the issuer were made optional. Dematerialisation of stocks encouraged paperless trading.Exchange (NSE). 10 and Rs. introduced capital adequacy norms for brokers. The SEBI (Credit Rating Agencies) Regulations. Standard denomination for equity shares of Rs. A number of . To reduce the cost of issue. SEBI empowered to register and regulate venture capital funds. Derivatives trading starts with index options and futures.

and most other public sector players are already exiting the mutual fund business. However.them can be merged. No one expected so many employees to take voluntary retirement from PSBs. Various forms of bancassurance are being introduced. but the business being comparatively new for the private players. the Life Insurance Corporation of India is a behemoth. In the case of insurance. as there is a great deal of synergy among these businesses. it will take some time. and anyway play only a niche role. Private sector banks will be self consolidated while co-operative and rural banks will be encouraged for consolidation. This phenomenon is expected to grow rapidly in the coming years. the new buzzword internationally. but the situation is different now.these were related to administered structure of interest rates. Where mergers may not be possible. even though it has not always been a success till date. Contours of Banking Reforms in India First. There are a number of small mutual fund players in the private sector. Both banks and insurance companies have started entering the asset management business. and the coming decade should be as interesting as the last one. reform measures were initiated and sequenced to create an enabling environment for banks to overcome the external constraints . which at one time were much sought after jobs. and credit allocation to certain sectors. even though facing difficult times. We finally come to convergence in the financial sector. . The UTI is yet again a big institution. It is not possible to play the role of the Oracle of Delphi when a vast nation like India is involved. In India organisations such as IDBI. Hi-tech and the need to meet increasing consumer needs is encouraging convergence. a few trends are evident. with the RBI having already come out with detailed guidelines for entry of banks into insurance. The pensions market is expected to open up fresh opportunities for insurance companies and mutual funds. The LIC has bought into Corporation Bank in order to spread its insurance distribution network. alliances between organisations may be effective. ICICI. The merger of Punjab National Bank and New Bank of India was a difficult one. while the four public sector general insurance companies will probably move towards consolidation with a bit of nudging. HDFC and SBI are already trying to offer various services to the customer under one umbrella. high levels of pre-emption in the form of reserve requirements.

infusion of funds by the Government into the public sector banks for the purpose of recapitalisation amounted. financial opening and. above all. administered interest rates still prevail in small savings schemes of the Government. Even after accounting for the reduction in the Government's shareholding on account of losses set off. Third. The interest rates in the banking system have been largely deregulated except for certain specific classes. to less than one per cent of India's GDP. small loans up to Rs. The share of wholly Government-owned public sector banks (i. The need for continuance of these prescriptions as well as those relating to priority sector lending have been flagged for wider debate in the latest annual policy of the RBI. market behaviour. Diversification of ownership has led to greater market accountability and improved efficiency. a figure much lower than that for many other countries.e.. which has imparted greater efficiency to resource allocation.2 lakh and export credit. Guidelines have been laid down for establishment of new banks in the private sector and the foreign banks have been allowed . there was infusion of capital by the Government in public sector banks. one of the major objectives of banking sector reforms has been to enhance efficiency and productivity through competition. The process has been gradual and predicated upon the institution of prudential regulation for the banking system. the underlying macroeconomic conditions. Second. where no diversification of ownership has taken place) sharply declined from about 90 per cent to 10 per cent of aggregate assets of all scheduled commercial banks during the same period. initially. the current market value of the share capital of the Government in public sector banks has increased manifold and as such what was perceived to be a bail-out of public sector banks by Government seems to be turning out to be a profitable investment for the Government. Since the initiation of reforms. non-resident Indian (NRI) deposits. on a cumulative basis.The share of the public sector banks in the aggregate assets of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in 2004. as regards the policy environment of public ownership. However. As part of the reforms programme. these are: savings deposit accounts. which was followed by expanding the capital base with equity participation by the private investors. it must be recognised that the lion's share of financial intermediation was accounted for by the public sector during the pre-reform period.Sequencing of interest rate deregulation has been an important component of the reform process.

twelve new private sector banks have been set up. the level of competition was gradually increased within the banking system while simultaneously introducing international best practices in prudential regulation supervision tailored to Indian requirements. 2006). Permission for foreign investment in the financial sector through foreign direct investment (FDI) as well as portfolio investment. foreign direct investment in the private sector banks is now allowed up to 74 per cent. securities. Roadmap for foreign banks and guidelines for mergers and amalgamation of private sector banks with other banks and NBFCs. As already mentioned. Some of the measures undertaken in this regard are as follows- Competition Enhancing Measures  Allowing operational autonomy and reduction of public ownership in public sector banks by raising capital from equity market up to 49 percent of paid up capital. Secondly. Since 1993. disbanding of administered interest rates and enhanced transparency and disclosure norms to facilitate market discipline. As a major step towards enhancing competition in the banking sector. Measures enhancing role of market forces  Reduction in pre-emption through reserve requirement. .more liberal entry. subject to conformity with the guidelines issued from time to time. active steps were initiated to improve the institutional arrangements like legal and technological frameworks (Mohan. an element of private shareholding in public sector banks has been injected by enabling a reduction in the Government shareholding in public sector banks to 51 per cent. first.    Transparent norms for entry of Indian private sector banks. special emphasis was placed on building up the risk management capabilities of Indian banks while measures were initiated to ensure flexibility. market determined pricing for govt. foreign banks and joint venture banks. Types of reform measures for the banking sector The banking sector reforms started in the early 1990s essentially followed a two pronged approach. operational autonomy and competition in the banking sector. In particular.

 Introduction of capital charge for market risk. income recognition and provisioning. etc. asset reconstruction companies. application of market to market principle for investment portfolio limits on deployment of fund in sensitive activities. guidelines for ownership and governance. 2002 and its subsequent amendment to ensure creditor rights. assignment of risk weights to various asset classes. Supervisory measures  Establishment of Board of Financial Supervision as the apex supervisory authority for commercial banks. Measures to strengthen risk management though recognition of different component of risk.  Setting up of Clearing Corporation of India Limited (CCIL) to act as a counter party for facilitating payment and settlement system relating to fixed income securities and money market instruments. Institutional and legal measures  Setting up of debt recovery tribunals.  Promulgation of Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act. higher graded provisioning for NPAs. Significant advancement in dematerialization and markets for securitized assets are being developed. etc. for quick recovery of debts. . corporate debt reconstructing mechanism.  Introduction of auction-based repos and reverse repos for short term liquidity management. financial institutions and non-banking financial companies. accounting. facilitation of improved payments and settlement mechanism. Prudential measures   Introduction of international best practices norms on capital to risk asset ratio (CRAR) requirement. securitization and debt restructuring mechanism norms. risk concentration. norms of connected lending.  Introduction and roadmap for implementation of Basel II by 31 March 2007. Lok-Adalat (people’s court). settlement advisory committees.

increased internal control through strengthening of internal audit. Though the branch expansion of the SCBs has slowed down during the post 1991 era but population per bank branch has not changed much and the figure is hovering around 15. Therefore.   Move towards risk based supervision. securities and Real Time Gross Settlement System (RTGS). Impacts of reforms upon the banking industry The Indian banking industry had made sufficient progress during the reforms period. fit and proper test for directors. Technology related measures  Setting up of INFINET as the communication backbone for the financial sector. Recasting of the role of statutory auditors. Strengthening corporate governance. strengthening of off-site surveillance through control returns. enhance due diligence on important shareholders. introduction of Negotiated Dealing System (NDS) for screen based trading in govt. . consolidated supervision of conglomerates. banking sector has maintained the gains in terms of branch network in the phase of social banking during the reform period.000 per branch. The progress of the industry can be judged in terms of branch expansion and growth of credit and deposits.

80/  39073.7003 -./ 2.-.38 3 90728 41 -7.804184.947 .:/9478   3.33 3/:897.0974:.4384/.47547.3.05.0  03..90/ 8:507.3-..30/ 90 .80/ 97. ../334.3 -7.333/:897 %03/.3.943 -..3/ 90 1:70 8 4.70/9 .073 .8 840/ /43 /:73 90 5489  07.3/ /054898  %4: 90 -7.8 2.0395747088/:739070147285074/  %0574708841903/:897.3.893 41 90  740  41 89.943 41 049.3/#0.O 4.33 80.8 349 .8 90 .073.0  %0.70.90/20.43974 974:8970390334139073.0 43 25479.3. 80.80/ 8:507.30/ 2:.. .943 507 -.  . 05.843 41 ..74:3/   507 -7.908 89703903341411 8908:7.:/9  O $97039033  .%207488$09902039$8902 #%$  25.3843.3.34470.3/5745079089147/70.3 $8902 $  147 8.3-0:/0/39072841-7.:7908.434207.947  3974/:./08:11..90  4.  %0701470  -.7/8 78 -.0 /:0 /03.422:3..3.9 80.8:708 O $0993 :5 41 % .39 8.704/078 19.98417014728:54390-.33/:73907014725074/  .43974709:738  O #0. -:9 545:.9:947  .90/ 0.3843 41 90 $8 .3.3.843  .-430 147 90 13.