Liberalization of Indian Banking and Regulation
Finance is a key component that drives the economy's overall expansion. Finance is essential to
the functioning of the economy. A well system makes a direct contribution to the economy's
growth in terms of knit financial 4w. Financial institutions, financial instruments, and financial
markets must all operate well in order for the financial system to be efficient.
India's banking sector has risen gradually in size (in terms of total deposits) over the decades
with an average annual growth rate of 18%. There are around 100 commercial banks operating
in the country, with 30 of them being state-owned, 30 being private sector banks, and the
remaining 40 being foreign banks. Although state-owned banks continue to dominate (they
account for over 80% of deposits and assets), new private sector banks have emerged, as well
as the entry of numerous new international banks, in the years after deregulation. As a result,
India's concentration ratio is significantly lower than that of other rising economies (Demirgüç-
Kunt and Levine 2001). Between 1991-1992 and 2000-2001, the Herfindahl index (a measure of
concentration) for advances and assets dropped by over 28% and around 20%, respectively,
indicating that competition has increased (Koeva 2003).
The ICICI Bank, a private bank, has grown to become India's second largest bank within a
decade of its founding. In comparison to most Asian countries, India's banking system has done
a better job of handling its nonperforming loans (NPL) problem. Although there is some worry
about "ever-greening" loans to avoid being classified as NPLs, the Indian banking system's
"healthy" position is due in part to its high standards in selecting borrowers (many enterprises
grumbled about the stringent rules and lack of sufficient funding). In terms of profitability,
Indian banks have outperformed the banking sector in other Asian economies, with returns on
bank assets exceeding those of other Asian economies. Prior to the 1990s, the financial sector
was characterised by segmented and underdeveloped financial markets, a scarcity of
instruments, and a complex structure of interest rates arising from economic and social
concerns about providing directed and concessional credit to specific sectors, resulting in "cross
subsidisation" among borrowers. Regulation of both deposit and lending rates to sustain
banking sector spreads not only distorted the interest rate mechanism, but also harmed the
viability and profitability of banks and equity.
The recent takeoff of India has been one of the key economic developments of this decade,
with growth rates averaging over 8% for the last four years, a stock market that has more than
tripled in as many years, and a rising inflow of international investment. In 2006, India's overall
equity issuance increased by 22% to $19.2 billion. Merger and acquisition volume reached a
new high of $27.8 billion, up 38%, thanks to a 371 percent increase in outbound acquisitions,
which surpassed incoming deal volumes for the first time. Debt issuance hit an all-time high of
$13.7 billion, up 28% from a year ago.
According to the Bank of New York, Indian corporations were among the world's most active
issuers of depositary receipts in the first half of 2006, accounting for one in every three new
issues internationally. As a result, the concerns and challenges that India faces in the first
decade of the new millennium are vastly different from those that it has faced for decades after
independence. Liberalization and globalisation have given the foreign currency markets a new
lease on life while also posing new problems.
Commodity trading, particularly commodity futures trading, has essentially built from the
ground up to achieve scale and attention. The banking industry has transitioned from a system
of tight restrictions and government intervention to one that is more market-driven. New
private banks have established a major presence in the country, as have a number of foreign
institutions. Microfinance has grown in importance in India's financial system over the years,
expanding its scope and delivering much-needed financial services to millions of poor Indian
households.
History of Banking:
Banking is an ancient business in India with some of oldest references in the writings of Manu.
Bankers played an important role during the Mogul period. During the early part of the East
India Company era, agency houses were involved in banking. Modern banking (i.e. in the form
of joint-stock companies) may be said to have had its beginnings in India as far back as in 1786,
with the establishment of the General Bank of India. Three Presidency Banks were established
in Bengal, Bombay and Madras in the early 19th century. These banks functioned
independently for about a century before they were merged into the newly formed Imperial
Bank of India in 1921. The Imperial Bank was the forerunner of the present State Bank of India.
The latter was established under the State Bank of India Act of 1955 and took over the Imperial
Bank.
The Swadeshi movement witnessed the birth of several indigenous banks including the Punjab
National Bank, Bank of Baroda and Canara Bank. In 1935, the Reserve Bank of India was
established under the Reserve Bank of India Act as the central bank of India. In spite of all these
developments, independent India inherited a rather weak banking and financial system marked
by a multitude of small and unstable private banks whose failures frequently robbed their
middle-class depositors of their life’s savings. After independence, the Reserve Bank of India
was nationalized in 1949 and given wide powers in the area of bank supervision through the
Banking Companies Act (later renamed Banking Regulations Act). The nationalization of the
Imperial bank through the formation of the State Bank of India and the subsequent acquisition
of the state owned banks in eight princely states by the State Bank of India in 1959 made the
government the dominant player in the banking industry. In keeping with the increasingly
socialistic leanings of the Indian government, 14 major private banks, each with deposits
exceeding Rs. 50 crores, were nationalized in 1969. This raised the proportion of scheduled
bank branches in government control from 31% to about 84%. In 1980, six more private banks
each with deposits exceeding Rs 200 crores , were privatized further raising the proportion of
government controlled bank branches to about 90%. As in other areas of economic policy-
making, the emphasis on government control began to weaken and even reverse in the mid-80s
and liberalization set in firmly in the early 90’s. The poor performance of the public sector
banks, which accounted for about 90% of all commercial banking, was rapidly becoming an area
of concern. The continuous escalation in non-performing assets (NPAs) in the portfolio of banks
posed a significant threat to the very stability of the financial system. Banking reforms,
therefore, became an integral part of the liberalization agenda.
The first Narasimham Committee set the stage for financial and bank reforms in India. Interest
rates, previously fixed by the Reserve Bank of India, were liberalized in the 90’s and directed
lending through the use of instruments of the Statutory Liquidity Ratio was reduced. While
several committees have looked into the ailments of commercial banking in India, but major
work has been done according to the Narasimham committee reports.
- the Narasimham committee I (1992) and II (1998)
Liberalization
Liberalization (or liberalization) refers to a relaxation of previous government restrictions,
usually in areas of social or economic policy. In some contexts this process or concept is often,
but not always, referred to as deregulation. In the arena of social policy it may refer to a
relaxation of laws restricting. Most often, the term is used to refer to economic liberalization,
especially trade liberalization or capital market liberalization.
Liberalization in Indian Banking Sector-
Liberalization in Indian banking sector was begun since 1992, following the Narasimham
Committee Report (December 1991). The 1991 report of the Narasimham Committee served as
the basis for the initial banking sector reforms . In the following years, reforms covered the
areas of interest rate deregulation, directed credit rules, statutory pre-emptions and entry
deregulation for both domestic and foreign banks. The objective of banking sector reforms was
in line with the overall goals of the 1991 economic reforms of opening the economy, giving a
greater role to markets in setting prices and allocating resources, and increasing the role of the
private sector. The Narsimhan Committee was first set up in 1991 under the chairmanship of
Mr. M. Narasimham who was 13th governor of RBI. Only a few of its recommendations became
banking reforms of India and others were not at all considered. Because of this a second
committee was again set up in 1998.As far as recommendations regarding bank restructuring,
management freedom, strengthening the regulation are concerned, the RBI has to play a major
role. If the major recommendations of this committee are accepted, it will prove to be fruitful in
making Indian banks more profitable and efficient.
Problems Identified By The Narasimham Committee
1. Directed Investment Program : 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.
2. Directed Credit Program : 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.
3. 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.
4. Additional Suggestions : 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.
Narasimham Committee Report I - 1991
The Narasimham 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:-
1. Reduction in the SLR (Statutory Liquidity Ratio) and CRR(Cash Reserve Ratio) : 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%.
2. Phasing out Directed Credit Programme : In India, since nationalization, directed credit
programmes were adopted by the government. The committee recommended phasing out of
this Programme. This programme compelled banks to earmark then financial resources for the
needy and poor sectors at confessional rates of interest. It was reducing the profitability of
banks and thus the committee recommended the stopping of this programme.
3. Interest Rate Determination : The committee felt that the interest rates in India are
regulated and controlled by the authorities. The determination of the interest rate should be on
the grounds of market forces such as the demand for and the supply of fund. Hence the
committee recommended eliminating government controls on interest rate and phasing out the
concessional interest rates for the priority sector.
4. 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.
5. Establishment of the ARF 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.
6. Removal of Dual control : 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.
7. Banking 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.
Some of these recommendations were later accepted by the Government of India and became
banking reforms.
Narasimham Committee Report II - 1998
In 1998 the government appointed yet another committee under the chairmanship of Mr.
Narasimham. It is better known as the Banking Sector Committee. It was told to review the
banking reform progress and design a programme for further strengthening the financial
system of India. The committee focused on various areas such as capital adequacy, bank
mergers, bank legislation, etc.
It submitted its report to the Government in April 1998 with the following recommendations.
1. Strengthening Banks in India: The committee considered the stronger banking system in the
context of the Current Account Convertibility (CAC). It thought that Indian banks must be
capable of handling problems regarding domestic liquidity and exchange rate management in
the light of CAC. Thus, it recommended the merger of strong banks which will have 'multiplier
effect' on the industry.
2. Narrow Banking: Those days many public sector banks were facing a problem of the Non-
performing assets (NPAs). Some of them had NPAs were as high as 20 percent of their assets.
Thus for successful rehabilitation of these banks it recommended 'Narrow Banking Concept'
where weak banks will be allowed to place their funds only in short term and risk free assets.
3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian banking
system the committee recommended that the Government should raise the prescribed capital
adequacy norms. This will further improve their absorption capacity also. Currently the capital
adequacy ration for Indian banks is at 9 percent.
4. Bank ownership: As it had earlier mentioned the freedom for banks in its working and bank
autonomy, it felt that the government control over the banks in the form of management and
ownership and bank autonomy does not go hand in hand and thus it recommended a review of
functions of boards and enabled them to adopt professional corporate strategy.
5. Review of banking laws: The committee considered that there was an urgent need for
reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking
Regulation Act, State Bank of India Act, Bank Nationalisation Act, etc. This upgradation will bring
them in line with the present needs of the banking sector in India.
Apart from these major recommendations, the committee has also recommended faster
computerization, technology upgradation, training of staff, depoliticizing of banks,
professionalism in banking, reviewing bank recruitment, etc.
Changes due to the recommendations made by the Narasimham committee are-
1. Statutory pre-emptions: The degree of financial repression in the Indian banking sector was
significantly reduced with the lowering of the CRR and SLR, which were regarded as one of the
main causes of the low profitability and high interest rate spreads in the banking system. During
the 1960s and 1970s the CRR was around 5%, but until 1991 it increased to its maximum legal
limit of 15%.The reduction of the CRR and SLR resulted in increase flexibility for banks in
determining both the volume and terms of lending.
2. Priority sector lending: Besides the high level of statutory pre-emptions, the priority sector
advances were identified as one of the major reasons for the below average profitability of
Indian banks. The Narasimham Committee therefore recommended a reduction from 40% to
10%. However, this recommendation has not been implemented and the targets of 40% of net
bank credit for domestic banks and 32% for foreign banks have remained the same.
3. Interest rate liberalization: Prior to the reforms, interest rates were a tool of cross-
subsidization between different sectors of the economy. To achieve this objective, the interest
rate structure had grown increasingly complex with both lending and deposit rates set by the
RBI. The deregulation of interest rates was a major component of the banking sector reforms
that aimed at promoting financial savings and growth of the organized financial system. The
lending rate for loans in excess of Rs200,000 that account for over90% of total advances was
abolished in October 1994. Banks were at the same time required to announce a prime lending
rate (PLR) which according to RBI guidelines had to take the cost of funds and transaction costs
into account.
4. Entry barriers: Before the start of the 1991 reforms, there was little effective competition in
the Indian banking system for at least two reasons. First, the detailed prescriptions of the RBI
concerning for example the setting of interest rates left the banks with limited degrees of
freedom to differentiate themselves in the marketplace. Second, India had strict entry
restrictions for new banks, which effectively shielded the incumbents from
competition.Through the lowering of entry barriers, competition has significantly increased
since the beginning of the1990s. Seven new private banks entered the market between 1994
and 2000. In addition, over 20 foreign banks started operations in India since 1994. By March
2004, the new private sector banks and the foreign banks had a combined share of almost 20%
of total assets. Deregulating entry requirements and setting up new bank operations has
benefited the Indian banking system from improved technology, specialized skills, better risk
management practices and greater portfolio diversification..
5. Prudential norms: The report of the Narasimham Committee was the basis for the
strengthening of prudential norms and the supervisory framework. Starting with the guidelines
on income recognition, asset classification, provisioning and capital adequacy the RBI issued in
1992/93, there have been continuous efforts to enhance the transparency and accountability of
the banking sector. The improvements of the prudential and supervisory framework were
accompanied by a paradigm shift from micro-regulation of the banking sector to a strategy of
macro-management .
6. Public Sector Banks : At the end of the 1980s, operational and allocative inefficiencies caused
by the distorted market mechanism led to a deterioration of Public Sector Banks' profitability.
Enhancing the profitability of PSBs became necessary to ensure the stability of the financial
system. The restructuring measures for PSBs were threefold and included recapitalization, debt
recovery and partial privatization.
Despite the suggestion of the Narasimham Committee to rationalize PSBs, the Government of
India decided against liquidation, which would have involved significant losses accruing to
either the government or depositors. It opted instead to maintain and improve operations to
allow banks to create a good starting basis before a possible privatization.
Conclusion
Nevertheless, more than a decade since the beginning of economic reforms, the banking sector
is still struggling under the burden of considerable NPAs and the poor performance of public
sector banks continues to be a major issue. Liberalization has, however, had a predictable effect
in the distribution of scheduled commercial banking in India. The reforms era growth in banking
have focused on the more profitable urban and metro areas of the country. Between 1969 and
1991 for instance, the share of the rural branches increased from about 22% to over 58%. In
2004, the corresponding figure stood at a much lower 46%. The number of rural bank branches
actually declined from the 1991 figure of over 35,000 branches by about 3000 branches.
Between 1969 and 1991 the share of urban and metro branches fell from over 37% to less than
23%. In the years since it has crawled back up to over 31%.
Since India has decided to move toward a more market-based system, it is now important for
policy makers to create the conditions for the well-functioning of a market based banking
system. Among the necessary tasks are the building and strengthening of the necessary
institutions like oversight bodies, accounting standards and regulations as well as the further
restructuring and privatization of PSBs. If India continues on its current path of banking sector
liberalization, it should be in a position to further strengthen its banking system, which will be
vital to support its economic growth in the years to come.
Thus Liberalisation has proved to be a great boon to the banking system as the structural
changes which have been implemented due to the liberalisation has transformed the Indian
banking system and moreover the recommendations of various committees has led to further
strengthening banking system. Thus liberalisation has made banking from class banking to mass
banking.
