Banking I. IntroductionIndian banking industry, the backbone of the country’s economy, has alwaysPlayed a key role in prevention the economic catastrophe from reaching terribleVolume in the country. It has achieved enormous appreciation for its strength,Particularly in the wake of the worldwide economic disasters, which pressed itsWorldwide counterparts to the edge of fall down. If we compare the business of topthree banks in total assets and in terms of return on assets, the Indian bankingsystem is among the healthier performers in the world. This sector istremendously competitive and recorded as growing in the right trend (RamMohan, 2008). Indian banking industry has increased its total assets more thanfive times between March 2000 and March 2010, i.e., US$250 billion to more thanUS$1.3 trillion. This industry recorded CAGR growth of 18 percent as compared tocountry’s average GDP growth of 7.2 percent during the same period. Thecommercial banking assets to GDP ratio has increased to nearly 100 percentwhile the ratio of bank’s business to GDP has recorded nearly twofold, from 68percent to 135 percent. The overall development has been lucrative withenhancement in banking industry efficiency and productivity. It should beunderlined here is financial turmoil which hit the western economies in 2008 andthe distress effect widened to the majority of the other countries but Indianbanking system survived with the distress and showed the stable performance.Indian banks have remained flexible even throughout the height of the sub-primecatastrophe and the subsequent financial turmoil.The Indian banking industry is measured as a flourishing and the secure in thebanking world. The country’s economy growth rate by over 9 percent since lastseveral years and that has made it regarded as the next economic power in theworld. Our banking industry is a mixture of public, private and foreign ownerships.The major dominance of commercial banks can be easily found in Indian banking,although the co-operative and regional rural banks have little business segment.Banking in India broadly falls under two categories: (a) Commercialbanks and (b) Co-operative banks. Commercial banks are the major players as far asindustry and trade sectors are concerned whereas co-operative banks cater to the needs ofrural economy particularly agriculture sector. Commercial banks fall under two distinctcategories, namely, Scheduled commercial banks and non-scheduled Commercial banks.Scheduled commercial banks means the banks which are listed in the Second Scheduleof RBI Act, 1934. Under section 42 (1) of the Act, scheduled commercial banks areexpected to maintain cash balance to a minimum of three per cent of their net demandand time liabilities, The cash reserve ratio is subject to upward / downward revision byRBI. The scheduled commercial banks enjoy certain special privileges like availingfinancial assistance under section 17 of the RBI Act. Non-scheduled Commercial banksare not listed and they do not have any large network. As of now only, one nonscheduledbank is functioning in India as compared to 16 nos on the eve of bank nationalisation.Banks in IndiaIn India, banks are segregated in different groups. Each group has its own benefits and limitations in operations. Each has its owndedicated target market. A few of them work in the rural sector only while others in both rural as well as urban. Many banks arecatering in cities only. Some banks are of Indian origin and some are foreign players.Banks in India can be classified into: • Public Sector Banks • Private Sector Banks • Cooperative Banks • Regional Rural Banks • Foreign BanksOne aspect to be noted is the increasing number of foreign banks in India. The RBI has shown certain interest to involve more foreignbanks. This step has paved the way for a few more foreign banks to start business in India.
Reserve Bank of India (RBI)The central bank of the country is the Reserve Bank of India (RBI). It was established in April 1935 with a share capital of Rs 5 croreon the basis of the recommendations of the Hilton Young Commission. The share capital was divided into fully paid shares of Rs 100each, which was entirely owned by private shareholders in the beginning. The government held shares of nominal value of Rs220,000.The RBI commenced operation on April 1, 1935, under the Reserve Bank of India Act, 1934. The Act (II of 1934) provides thestatutory basis of the functioning of the Bank. The Bank was constituted to meet the following requirements: • Regulate the issue of currency notes • Maintain reserves with a view to securing monetary stability • Operate the credit and currency system of the country to its advantage5.2 Progress of Banking in IndiaThe progress of Commercial banking in India can be categorised underthe following four distinct phases: Phase I (1 860-1 946 ); Phase I1 (1 947-1968 ); Phase111 (1969-1 990); Phase IV (1991- till date). Banking Sector Reforms As the real sector reforms began in 1992, the need was felt to restructure the Indian banking industry.The reform measures necessitated the deregulation of the financial sector, particularly the banking sector.The initiation of the financial sector reforms brought about a paradigm shift in the banking industry. In1991, the RBI had proposed to form the committee chaired by M. Narasimham, former RBI Governor inorder to review the Financial System viz. aspects relating to the Structure, Organizations and Functioningof the financial system. The Narasimham Committee report, submitted to the then finance minister,Manmohan Singh, on the banking sector reforms highlighted the weaknesses in the Indian banking systemand suggested reform measures based on the Basle norms. The guidelines that were issued subsequentlylaid the foundation for the reformation of Indian banking sector.Economic Reforms of the Banking Sector in India Indianbanking sector has undergone major changes and reforms during economic reforms. Though it was a partof overall economic reforms, it has changed the very functioning of Indian banks. This reform has not onlyinfluenced the productivity and efficiency of many of the Indian Banks, but has left everlasting footprintson the working of the banking sector in India. Let us get acquainted with some of the important reformsin the banking sector in India below with a graph. 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 CRRremains between 3-15% of the Net Demand and Time Liabilities. It is reduced from the earlier high levelof 15% plus incremental CRR of 10% to current 4% level. Similarly, the SLR Is also reduced from early38.5% 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, interestrates of commercial banks were deregulated. Banks now enjoy freedom of fixing the lower and upper limitof interest on deposits. Interest rate slabs are reduced from Rs.20 Lakhs to just Rs. 2 Lakhs. Interest
rates on the bank loans above Rs.2 lakhs are full decontrolled. These measures have resulted in morefreedom to commercial banks in interest rate regime.3. Fixing prudential Norms: In order to induce professionalism in its operations, the RBIfixed prudential norms for commercial banks. It includes recognition of income sources. Classification ofassets, provisions for bad debts, maintaining international standards in accounting practices, etc. It helpedbanks in reducing and restructuring Non-performing assets (NPAs).4. Introduction of CRAR: Capital to Risk Weighted Asset Ratio (CRAR) was introduced in1992. It resulted in an improvement in the capital position of commercial banks, all most all the banks inIndia has reached the Capital Adequacy Ratio (CAR) above the statutory level of 9%.5. Operational Autonomy: During the reforms period commercial banks enjoyed theoperational freedom. If a bank satisfies the CAR then it gets freedom in opening new branches, upgradingthe extension counters, closing down existing branches and they get liberal lending norms.6. Banking Diversification: The Indian banking sector was well diversified, during theeconomic reforms period. Many of the banks have stared new services and new products. Some of themhave established subsidiaries in merchant banking, mutual funds, insurance, venture capital, etc whichhas led to diversified sources of income of them.7. New Generation Banks: During the reforms period many new generation banks havesuccessfully emerged on the financial horizon. Banks such as ICICI Bank, HDFC Bank, UTI Bank havegiven a big challenge to the public sector banks leading to a greater degree of competition.8. Improved Profitability and Efficiency: During the reform period, theproductivity and efficiency of many commercial banks has improved. It has happened due to the reducedNon-performing loans, increased use of technology, more computerization and some other relevantmeasures adopted by the government.Differential Rate Interest:The differential Rate of Interest (DRI) is a leading programme launched by the Government in April 1972which makes it obligatory upon all the Public Sector Banks in India to lend I percent total leading of thepreceding year to the “The poorest among the poor” at an interest rates of 4 percent paranom the totalleading in 2005 – 06 was Rs. 351 crores, period 1969-2000 gives the following: from 1969-1980, the ratioof deposits in nationalized banks to deposits in private banks was approximately 5 to 1; from 1980 to1993, the ratio was approximately 11-1; post liberalization, the ratio has been falling, and in 2000 stoodat about 7.5 to 1.47 Thus, under the accounting that is most favorable to public sector banks, they squeakby as less costly to the government than private sector banks (the ratio of money spent bailing out publicvs. private banks would be 62 3 to 1, less than the deposits ratio). However, using the estimate of 540billion rupees total cost gives a 12-1 ratio, which would imply that the public sector banks lost a greaterportion of their deposits to bad loans.The Future of Banking Reform Prior to the economic reforms, the financial sector of India was on the crossroads. To improve theperformance of the Indian commercial banks, first phase of banking sector reforms were introduced in1991 and after its success; government gave much importance to the second phase of the reforms in1998. Uppal (2011) analyzes the ongoing banking sector reforms and their efficacy with the help of someratios and concludes the efficacy of all the bank groups have increased but new private sector and foreign
banks have edge over our public sector bank. The efficient, dynamic and effective banking sector plays adecisive role in accelerating the rate of economic growth in any economy. In the wake of contemporaryeconomic changes in the world economy and other domestic crises like adverse balance of paymentsproblem, increasing fiscal deficits etc., our country too embarked upon economic reforms. The govt. ofIndia introduced economic and financial sector reforms in 1991 and banking sector reforms were part andparcel of financial sector reforms. These were initiated in 1991 to make Indian banking sector moreefficient, strong and dynamic.Rationale of Banking Sector Reforms To cope up with the changing economic environment, banking sector needs some dose to improve itsperformance. Since 1991, the banking sector was faced with the problems such as tight control of RBI,eroded productivity and efficiency of public sector banks, continuous losses by public sector banks yearafter year, increasing NPAs, deteriorated portfolio quality, poor customer service, obsolete worktechnology and unable to meet competitive environment. Therefore, Narasimham Committee wasappointed in 1991 and it submitted its report in November 1991, with detailed measures to improve theadverse situation of the banking industry (Uppal; 2011. p. 69). The main motive of the reforms was toimprove the operational efficiency of the banks to further enhance their productivity and profitability.First Phase of Banking Sector Reforms The first phase of banking sector reforms essentially focused on the following: 1.) Reduction in SLR & CRR2.) Deregulation of interest rates3.) Transparent guidelines or norms for entry and exit of private sector banks4.) Public sector banks allowed for direct access to capital markets5.) Branch licensing policy has been liberalized6.) Setting up of Debt Recovery Tribunals7.) Asset classification and provisioning8.) Income recognition9.) Asset Reconstruction Fund (ARF) Second Phase of Banking Sector Reforms In spite of the optimistic views about the growth of banking industry in terms of branch expansion,deposit mobilization etc, several distortions such as increasing NPAs and obsolete technology crept intothe system, mainly due to the global changes occurring in the world economy. In this context, thegovernment of India appointed second Narasimham Committee under the chairmanship of Mr. M.Narasimham to review the first phase of banking reforms and chart a programme for further reformsnecessary to strengthen India’s financial system so as to make it internationally competitive. Uppal (2011.p. 70) the committee reviewed the performance of the banks in light of first phase of banking sectorreforms and submitted its report with some more focus and new recommendations. There were no newrecommendations in the second Narasimham Committee except the followings: - Merger of strong units of banks - Adaptation of the ‘narrow banking’ concept to rehabilitate weak banks. As the process of second banking sector reforms is going on since 1999, one may say that thereis an improvement in the performance of banks. However, there have been many changes and challengesnow due to the entry of our banks into the global market.
Third banking sector reforms and fresh outlook Rethinking for financial sector reforms have to be accorded, restructuring of the public sector banks inparticular, to strengthen the Indian financial system and make it able to meet the challenges ofglobalization. The on-going reform process and the agenda for third reforms will focus mainly to make thebanking sector reforms viable and efficient so that it could contribute to enhance the competitiveness ofthe real economy and face the challenges of an increasingly integrated global financial architecture. When we take this evidence together, where does it leave us? There are obvious problems with theIndian banking sector, ranging from under-lending to unsecured lending, which we have discussed atsome length. There is now a greater awareness of these problems in the Indian government and awillingness to do something about them. One policy option that is being discussed is privatization. Theevidence from Cole, discussed above, suggests that privatization would lead to an infusion of dynamism into the banking sector: private banks have been growing faster than comparable public banks in terms ofcredit, deposits and number of branches, including rural branches, though it should be noted that in ourempirical analysis, the comparison group of private banks were the relatively small ”old” private banks.48It is not clear that we can extrapolate from this to what we could expect when the State Bank of India,which is more than an order of magnitude greater in size than the largest “old” private sector banks. The“new” private banks are bigger and in some ways would have been a better group to compare with.However while this group is also growing very fast, they have been favored by regulators in some specificways, which, combined with their relatively short track record, makes the comparison difficult.Privatization will also free the loan officers from the fear of the CVC and make them somewhat morewilling to lend aggressively where the prospects are good, though, as will be discussed later, betterregulation of public banks may also achieve similar goals. Historically, a crucial difference between public and private sector banks has been theirwillingness to lend to the priority sector. The recent broadening of the definition of priority sector hasmechanically increased the share of credit from both public and private sector banks that qualify aspriority sector. The share of priority sector lending from public sector banks was 42.5 percent in 2003, upfrom 36.6 percent in 1995. Private sector lending has shown a similar increase from its 1995 level of 30percent. In 2003 it may have surpassed for the first time ever public sector banks, with a share of netbank credit to the priority sector at 44.4 percent to the priority sector. Still, there are substantial differences between the public and private sector banks. Most notableis the consistent failure of private sector banks to meet the agricultural lending sub-target, though theyalso lend substantially less in rural areas. Our evidence suggests that privatization will make it harder forthe government to get the private banks to comply with what it wants them to do. However it is not clearthat this reflects the greater sensitivity of the public banks to this particular social goal. It could also bethat credit to agriculture, being particularly politically salient, is the one place where the nationalizedbanks are subject to political pressures to make imprudent loans. Finally, one potential disadvantage of privatization comes from the risk of bank failure. In thepast there have been cases where the owner of the private bank stripped its assets, and declared that itcannot honor its deposit liabilities. The government is, understandably, reluctant to let banks fail, sinceone of the achievements of the last forty years has been to persuade people that their money is safe inthe banks. Therefore, it has tended to take over the failed bank, with the resultant pressure on the fiscaldeficit. Of course, this is in part a result of poor regulation–the regulator should be able to spot a private
bank that is stripping its assets. Better enforced prudential regulations would considerably strengthen thecase for privatization. On the other hand, public banks have also been failing–the problem seems to be part corruptionand part inertia/laziness on the part of the lenders. As we saw above, the cost of bailing out the publicbanks may well be larger (appropriately scaled) than the total losses incurred from every bank failuresince 1969. Once again the fact that the “new” private banks pose a problem: So far none of them havedefaulted, but they are also new, and as a result, have not yet had to deal with the slow decline of oncesuccessful companies, which is one of the main sources of the accumulation of bad debt on the books ofthe public banks. On balance, we feel the evidence argues, albeit quite tentatively, for privatizing thenationalized banks, combined with tighter prudential regulations. On the other hand we see no obviouscase for abandoning the “social” aspect of banking. Indeed there is a natural complementarity betweenreinforcing the priority sector regulations (for example, by insisting that private banks lend more toagriculture) and privatization, since with a privatized banking sector it is less likely that the directed loanswill get redirected based on political expediency. However there is no reason to expect miracles from the privatized banks. For a variety of reasonsincluding financial stability, the natural tendency of banks, public or private, the world over, is towardsconsolidation and the formation of fewer, bigger banks. As banks become larger, they almost inevitablybecome more bureaucratic, because most lending decisions in big banks, by the very fact of the bankbeing big, must be taken by people who have no direct financial stake in the loan. Being bureaucraticmeans limiting the amount of discretion the loan officers can exercise and using rules, rather humanjudgment wherever possible, much as is currently done in Indian nationalized banks. Berger et al. haveargued in the context of the US that this leads bigger banks to shy away from lending to the smallerfirms.50 Our presumption is that this process of consolidation and an increased focus on lending tocorporate and other larger firms is what will happen in India, with or without privatization, though in theshort run, the entry of a number of newly privatized banks should increase competition for clients, whichought to help the smaller firms. In the end the key to banking reform may lie in the internal bureaucratic reform of banks, bothprivate and public. In part this is already happening as many of the newer private banks (like HDFC,ICICI) try to reach beyond their traditional clients in the housing, consumer finance and blue-chip sectors.This will require a set of smaller step reforms, designed to affect the incentives of bankers in private andpublic banks. A first step would be to make lending rules more responsive to current profits andprojections of future profits. This may be a way to both target better and guard against potential NPAs,largely because poor profitability seems to be a good predictor of future default. It is clear however thatchoosing the right way to include profits in the lending decision will not be easy. On one side there is thedanger that unprofitable companies default. On the other side, there is the danger of pushing a companyinto default by cutting its access to credit exactly when it needs it the most, i.e. right after a shock todemand or costs has pushed it into the red. Perhaps one way to balance these objectives would be tocreate three categories of firms: (1) Profitable to highly profitable firms. Within this category lending should respond toprofitability, with more profitable firms getting a higher limit, even if they look similar on the othermeasures.(2) Marginally profitable to loss-making firms that used to be highly profitable in the recent past but havebeen hit by a temporary shock (e.g. an increase in the price of cotton because of crop failures, etc.). Forthese firms the existing rules for lending might work well. (3) Marginally profitable to loss-making firmsthat have been that way for a long time or have just been hit by a permanent shock (e.g., the removal oftariffs protecting firms producing in an industry in which the Chinese have a huge cost advantage). For
these firms, there should be an attempt to discontinue lending, based on some clearly worked out exitstrategy (it is important that the borrowers be offered enough of the pie that they feel that they will bebetter off by exiting without defaulting on the loans). Of course it is not always going to be easy todistinguish permanent shocks from the temporary. In particular, what should we make of the firm thatclaims that it has put in place strategies that help it survive the shock of Chinese competition, but thatthey will only work in a couple of years? The best rule may be to use the information in profits and costsover several years, and the experience of the industry as a wholeCONCLUSIONSince the banking reforms of 1991, there have been significant favorable changes in India’s highly regulated banking sector. Thisproject has assessed the impact of the reforms by examining several hypotheses. It concludes that the banking reforms have had amoderately positive impact on reducing the concentration of the banking sector (at the lower end) and improving performance.Allowing banks to engage in non-traditional activities has contributed to improved profitability and cost and earnings efficiency of thewhole banking sector, including public-sector banks. By contrast, investment in government securities has lowered the profitabilityand cost efficiency of the whole banking sector, including public-sector banks. Lending to priority sectors and the public-sector hasnot had a negative effect on profitability and cost efficiency, contrary to our expectations. Further, foreign banks (and private domestic banks insome cases)have generally performed better than other banks in terms of profitability and income efficiency. This suggests thatownership matters and foreign entry has a positive impact on banking sector restructuring. .