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History and Development of Banks in India

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INTRODUCTION:

The banking industry in India seems to be unaffected from the global financial crises which started from U.S in the last quarter of 2008. Despite the fallout and nationalization of banks across developed economies, banks in India seems to be on the strong fundamental base and seems to be well insulated from the financial turbulence emerging from the western economies. The Indian banking industry is well placed as compare to their banking industries western counterparts which are depending upon government bailout and stimulus packages. The strong economic growth in the past, low defaulter ratio, absence of complex financial products, regular intervention by central bank, proactive adjustment of monetary policy and so called close banking culture has favored the banking industry in India in recent global financial turmoil. Although there will no impact on the Indian banking system similar to that in west but the banks in India will adopt for more of defensive approach in credit disbursal in coming period. In order to safe guard their interest, banks will follow stringent norms for credit disbursal. There will be more focus on analyzing borrower financial health .

A nation with 1 billion plus, India is the fastest growing country in terms of population and soon to overtake China as world's largest populated country. The discerning impact on the over-stretched limited resources explains why India always tends to be deficient in infrastructure and opportunity. The largest economy of the world often frustrated researchers, as there was no single predictable pattern of the market; the multiplicity of government regulations and widespread government ownership had always kept investors away from exploring the vast Indian market. However, with India being liberalised today, banking intermediation has been playing a crucial role in economic development through its credit channel. Foreign banks have entered the soil but that has not yet posed a threat to the vast network of public sector banks that still conduct 92% of banking business in India.

Banking in India has undergone a major revamp. It has come a long way since its creation which dates back to the British era. The present banking systems has come into place after many transformations from the Older systems. Against this background the present chapter deals with the evolution of the Indian Banking systems, the various reforms that has been made to make banks more effective, the role of private and foreign sector banks and last the challenges the Indian banks faces in the New Millennium .

The banking system is central to a nation's economy. Banks are special as they not only accept and deploy large amounts of uncollateralised public funds in a fiduciary capacity, but also leverage such funds through credit creation. In India, prior to nationalisation, banking was restricted mainly to the urban areas and neglected in the rural and semi-urban areas. Large industries and big business houses enjoyed major portion of the credit facilities. Agriculture, small-scale industries and exports did not receive the deserved attention. Therefore, inspired by a larger social purpose, 14 major banks were nationalised in 1969 and six more in 1980. Since then the banking system in India has played a pivotal role in the Indian economy, acting as an instrument of social and economic change. The rationale behind bank nationalisation has been succinctly put forth by eminent bankers:

'Many bank failures and crises over two centuries, and the damage they did under laissez faire conditions; the needs of planned growth and equitable distribution of credit, which in privately owned banks was concentrated mainly on the controlling industrial houses and influential borrowers; the needs of growing small scale industry and farming regarding finance, equipment and inputs; from all these there emerged an inexorable demand for banking legislation, some government control and a central banking authority, adding up, in the final analysis, to social control and nationalisation' (Tandon, 1989).

Post nationalisation, the Indian banking system registered tremendous growth in volume. Despite the undeniable and multifold gains of bank nationalization, it may be noted that the important financial institutions were all state owned and were subject to central direction and control. Banks enjoyed little autonomy as both lending and deposit rates were controlled until the end of the 1980s. Although nationalisation of banks helped in the spread of banking to the rural and hitherto uncovered areas, the monopoly granted to the public sector and lack of competition led to overall inefficiency and low productivity. By 1991, the country's financial system was saddled with an inefficient and financially unsound banking sector. Some of the reasons for this were (i) high reserve requirements, (ii) administered interest rates, (iii) directed credit and (iv) lack of competition (v) political interference and corruption. As recommended by the Narasimham Committee Report (1991) several reform measures were introduced which included reduction of reserve requirements, de-regulation of interest rates, introduction of prudential norms, strengthening of bank supervision and improving the competitiveness of the system, particularly by allowing entry of private sector banks. With a view to adopting the Basel Committee (1988) framework on capital adequacy norms, the Reserve Bank introduced a risk-weighted asset ratio system for banks in India as a capital adequacy measure in 1992. Banks were asked to maintain risk-weighted capital adequacy ratio initially at the lower level of 4 per cent, which was gradually increased to 9 per cent. Banks were also directed to identify problem loans on their balance sheets and make provisions for bad loans and bring down the burgeoning problem of non-performing assets. The period 1992-97 laid the foundations for reform in the banking system (Rangarajan, 1998). The second Narasimham Committee Report (1998) focussed on issues like strengthening of the banking system, upgrading of technology and human resource development. The report laid emphasis on two aspects of banking regulation, viz., capital adequacy and asset classification and resolution of NPA-related problems.

Commercial banks in India are expected to start implementing Basel II norms with effect from March 31, 2007. They are expected to adopt the standardised approach for credit risk and the basic indicator approach for operational risk initially. After adequate skills are developed, both at the banks and at the supervisory levels, some banks may be allowed to migrate to the internal rating based (IRB) approach (Reddy 2005).

At present, banks in India are venturing into non-traditional areas and generating income through diversified activities other than the core banking activities. Strategic mergers and acquisitions are being explored and implemented. With this, the banking sector is currently on the threshold of an exciting phase. Against this backdrop, this paper endeavours to study the important banking indicators for the last 25-year period from 1981 to 2005. These indicators have been broadly grouped into different categories, viz., (i) number of banks and offices (ii) deposits and credit (iii) investments (iv) capital to risk-weighted assets ratio (CRAR) (v) non performing assets (NPAs) (vi) Income composition (vii) Expenditure composition (viii) return on assets (ROAs) and (ix) some select ratios. Accordingly, the paper discusses these banking indicators in nine sections in the same order as listed above. The paper concludes in section X by drawing important inferences from the trends of these different banking parameters.

The number of offices of all scheduled commercial banks almost doubledfrom 29,677 in 1980 to 55,537 in 2005. This rapid increase in the number of bank offices is observed in the case of all the bank groups. However, the number of banks in the case of foreign bank group and domestic private sector bank group decreased from 42 in 2000 to 31 in 2005 and from 33 in 2000 to 29 in 2005, respectively. This fall in the number of banks is reflective of the consolidation process and, in particular, the mergers and acquisitions that are the order of the banking system at present (Table 1).

BANKING IN THE OLDER DAYS

Banking is believed to be a part of Indian society from as early as Vedic age; transition from mere money lending to banking must have happened before Manu, the great Hindu jurist, who had devoted a large section of his work to "deposits" and "advances" and also formulated rules for calculating interest on both 1. During the Mogul period indigenous bankers (rich individuals or families) helped foreign trades and commerce by lending money to the business. It was during the East Indian period when agency houses started managing the banking business.

The first Joint Stock bank India saw came in 1786 named the General Bank of India followed by the Bank of Hindustan and the Bengal Bank. Only the Bank of Hindustan continued to be in the show until 1906 while the other two disappeared in the meantime. East India Company established three banks in first half of 19th century: the Bank of Bengal in 1809, the Bank of Bombay in 1840, and the Bank of Madras in 1843. Eventually these three banks (which used to be referred to as Presidency Banks) were made independent units and they really did well for almost a century. In 1920, these three were amalgamated and a new Imperial Bank of India was established in 1921. Reserve Bank of India Act was passed in 1934 and finally in 1935, the Central Bank was created and christened as Reserve Bank of India. Imperial Bank was undertaken as State Bank of India after passing the State Bank of India Act in 1955. During the last phase of freedom fighting (Swadeshi Movement) few banks with purely Indian management were established like Punjab National bank (PNB), Bank of India (BoI) Ltd, Canara Bank Ltd, Indian Bank Ltd, the Bank of Baroda Ltd, the Central Bank of India Ltd, etc.July 19, 1969 was an important day in the history of Indian banking industry. Fourteen major banks of the country were nationalised and on April 15, 1980 six more commercial private banks were taken over by the Indian government.

In the wake of liberalisation that started in the last decade a few foreign banks entered the foray of commercial banks. To date there are around 40 banks of foreign origin that are operating in the market, like ABN AMRO Bank, ANZ Grindlays Bank, American Express Bank, HSBC Bank, Barclays Bank and Citibank groups to name a few major of them.

HISTORY OF INDIAN BANKS:

We can identify three distinct phases in the history of Indian Banking.

  1. Early phase from 1786 to 1969
  2. Nationalisation of Banks and up to 1991 prior to banking sector Reforms
  3. New phase of Indian Banking with the advent of Financial & Banking Sector Reforms after 1991.

The first phase is from 1786 to 1969, the early phase up to the nationalisation of the fourteen largest of Indian scheduled banks. It was also the traditional or conservative phase of Indian Banking. The advent of banking system of India started with the establishment of the first joint stock bank, The General Bank of India in the year 1786. After this first bank, Bank of Hindustan and Bengal Bank came to existence. In the mid of 19th century, East India Company established three banks The Bank of Bengal in 1809, The Bank of Bombay in 1840, and bank of Madras in 1843. These banks were independent units and called Presidency banks. These three banks were amalgamated in 1920 and a new bank, Imperial Bank of India was established. All these institutions started as private shareholders banks and the shareholders were mostly Europeans. The Allahabad Bank was established in 1865. The next bank to be set up was the Punjab National Bank Ltd., which was established with its headquarters at Lahore in 1894 for the first time exclusively by Indians. Most of the Indian commercial banks, however, owe their origin to the 20th century. Bank of India, Central Bank of India, Bank of Baroda, the Canara Bank, the Indian Bank, and the Bank of Mysore were established between 1906 and 1913. The last major commercial bank to be set up in this phase was the United Commercial Bank in 1943. Earlier the establishment of Reserve Bank of India in 1935 as the central bank of the country was an important step in the development of commercial banking in India.

The history of joint stock banking in this first phase was characterised by slow growth and periodic failures. There were as many as one thousand one hundred banks, mostly small banks, failed during the period from 1913 to 1948. The Government of India concerned by the frequent bank failures in the country causing miseries to innumerable small depositors and others enacted The Banking Companies Act, 1949. The title of the Act was changed as "Banking Regulation Act 1949", as per amending Act of 1965 (Act No.23 of 1965). The Act is the first regulatory step undertaken by the Government to streamline the functioning and activities of commercial banks in India. Reserve Bank of India as the Central Banking Authority of the country was vested with extensive powers for banking supervision. Salient features of the Act are discussed in a separate page/article

At the time of Independence of the country in 1947, the banking sector in India was relatively small and extremely weak. The banks were largely confined to urban areas, extending loans primarily to trading sector dealing with agricultural produce. There were a large number of commercial banks, but banking services were not available at rural and semi-urban areas. Such services were not extended to different sectors of the economy like agriculture, small industries, professionals and self-employed entrepreneurs, artisans, retail traders etc.

DRAW BACK OF INDIAN BANKING SYSTEM BEFORE NATIONALISATION

Commercial banks, as they were privately owned, on regional or sectarian basis resulted in development of banking on ethnic and provincial basis with parochial outlook. These Institutions did not play their due role in the planned development of the country. Deposit mobilisation was slow. Public had less confidence in the banks on account of frequent bank failures. The savings bank facility provided by the Postal department was viewed a comparatively safer field of investment of savings by the public. Even the deficient savings thus mobilised by commercial banks were not channeled for the development of the economy of the country. Funds were largely given to traders, who hoarded agricultural produce after harvest, creating an artificial scarcity, to make a good fortune in selling them at a later period, when prices were soaring. The Reserve Bank of India had to step in at these occasions to introduce selective credit controls on several commodities to remedy this situation. Such controls were imposed on advances against Rice, Paddy, Wheat, Other foodgrains (like jowar, millets, ragi etc.) pulses, oilseeds etc.

When the country attained independence Indian Banking was exclusively in the private sector. In addition to the Imperial Bank, there were five big banks each holding public deposits aggregating Rs.100 Crores and more, viz. the Central Bank of India Ltd., the Punjab National Bank Ltd., the Bank of India Ltd., the Bank of Baroda Ltd. and the United Commercial Bank Ltd. Rest of the banks were exclusively regional in character holding deposits of less than fifty Crores. Government first implemented the exercise of nationalisation of a significant part of the Indian Banking system in the year 1955, when Imperial Bank of India was Nationalised in that year for the stated objective of "extension of banking facilities on a large scale, more particularly in the rural and semi-urban areas, and for diverse other public purposes" to form State Bank of India. SBI was to act as the principal agent of the RBI and handle banking transactions of the Union & State Governments throughout India. The step was in fact in furtherance of the objectives of supporting a powerful rural credit cooperative movement in India and as recommended by the "The All-India Rural Credit Survey Committee Report, 1954". State Bank of India was obliged to open an accepted number of branches within five years in unbanked centres. Government subsidised the bank for opening unremunerative branches in non-urban centres. The seven banks now forming subsidiaries of SBI were nationalised in the year 1960. This brought one-third of the banking segment under the direct control of the Government of India.

But the major process of nationalisation was carried out on 19th July 1969, when the then Prime Minister of India, Mrs.Indira Gandhi announced the nationalisation of fourteen major commercial banks in the country. One more phase of nationalisation was carried out in the year 1980, when seven more banks were nationalised. This brought 80% of the banking segment in India under Government ownership. The country entered the second phase, i.e. the phase of Nationalised Banking with emphasis on Social Banking in 1969/70.

Chronology of Salient steps by the Government after Independence to Regulate Banking Institutions in the Country

  1. 1949: Enactment of Banking Regulation Act.
  2. 1955 (Phase I): Nationalisation of State Bank of India
  3. 1959 (Phase II): Nationalisation of SBI subsidiaries
  4. 1961: Insurance cover extended to deposits
  5. 1969 (Phase III): Nationalisation of 14 major banks
  6. 1971: Creation of credit guarantee corporation
  7. 1975: Creation of regional rural banks
  8. 1980 (Phase IV): Nationalisation of seven banks with deposits over 200 crores.

Shortcomings in the Functioning of Nationalised Banking Institutions

However Nationalised banks in their enthusiasm for development banking, looking exclusively to branch opening, deposit accretion and social banking, neglected prudential norms, profitability criteria, risk-management and building adequate capital as a buffer to counter-balance the ever expanding risk-inherent assets held by them. They failed to recognise the emerging non-performing assets and to build adequate provisions to neutralise the adverse effects of such assets. Basking in the sunshine of Government ownership that gave to the public implicit faith and confidence about the sustainability of Government-owned institutions, they failed to collect before hand whatever is needed for the rainy day. And surfeit blindly indulged is sure to bring the sick hour. In the early Nineties after two decades of lop-sided policies, these banks paid heavily for their misdirected performance in place of pragmatic and balanced policies. The RBI/Government of India has to step in at the crisis-hour to implement remedial steps. Reforms in the financial and banking sectors and liberal re capitalisation of the ailing and weakened public sector banks followed. However it is relevant to mention here that the advent of banking sector reforms brought the era of modern banking of global standards in the history of Indian banking. The emphasis shifted to efficient, and prudential banking linked to better customer care and customer service. The old ideology of social banking was not abandoned, but the responsibility for development banking is blended with the paramount need for complying with norms of prudency and efficiency.

Composition of Indian Banking System

The Indian banking can be broadly categorized into nationalized (government owned), private banks and specialized banking institutions 2. The Reserve Bank of India acts a centralized body monitoring any discrepancies and shortcoming in the system. Since the nationalization of banks in 1969, the public sector banks or the nationalized banks have acquired a place of prominence and has since then seen tremendous progress. The need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach. The unleashing of products and services through the net has galvanized players at all levels of the banking and financial institutions market grid to look into their existing portfolio offering. Conservative banking practices allowed Indian banks to be insulated partially from the Asian currency crisis. Indian banks are now quoting al higher valuation when compared to banks in other Asian countries (viz. Hong Kong, Singapore, Philippines etc.) that have major problems linked to huge Non Performing Assets (NPAs) and payment defaults. Co-operative banks are nimble footed in approach and armed with efficient branch networks focus primarily on the 'high revenue' niche retail segments. The Indian banking has come from a long way from being a sleepy business institution to a highly proactive and dynamic entity. This transformation has been largely brought about by the large dose of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). The banking in India is highly fragmented with 30 banking units contributing to almost 50% of deposits and 60% of advances. Indian nationalized banks (banks owned by the government) continue to be the major lenders in the economy due to their sheer size and penetrative networks which assures them high deposit mobilization.

The banking system has three tiers. These are the scheduled commercial banks; the Regional rural banks which operate in rural areas not covered by the scheduled banks;

And the cooperative and special purpose rural banks. Under the ambit of the nationalized banks come the specialized banking institutions. These co-operatives, rural banks focus on areas of agriculture, rural development etc., unlike commercial banks these co-operative banks do not lend on the basis of a prime lending rate. They also have various tax sops because of their holding pattern and lending structure and hence have lower overheads. This enables them to give a marginally higher percentage on savings deposits. Many of these cooperative banks diversified into specialized areas (catering to the vast retail audience) like car finance, housing loans, truck finance etc. In order to keep pace with their public sector and private counterparts, the co-operative banks too have invested heavily in information technology to offer high-end computerized banking services to its clients. Given below is the total list of banks operating in India.

SCHEDULED AND NON SCHEDULED BANKS

There are approximately Eighty scheduled commercial banks, Indian and foreign; almost Two Hundred regional rural banks; more than Three Hundred Fifty central cooperative banks, Twenty land development banks; and a number of primary agricultural credit societies. In terms of business, the public sector banks, namely the State Bank of India and the nationalized banks, dominate the banking sector.India had a fairly well developed commercial banking system in existence at the time of independence in 1947. The Reserve Bank of India (RBI) was established in 1935. While the RBI became a state owned institution from January 1, 1949, the Banking Regulation Act was enacted in 1949 providing a framework for regulation and supervision of commercial banking activity.

The first step towards the nationalisation of commercial banks was the result of a report (under the aegis of RBI) by the Committee of Direction of All India Rural Credit Survey (1951) which till today is the locus classicus on the subject. The Committee recommended one strong integrated state partnered commercial banking institution to stimulate banking development in general and rural credit in particular. Thus, the Imperial Bank was taken over by the Government and renamed as the State Bank of India (SBI) on July 1, 1955 with the RBI acquiring overriding substantial holding of shares. A number of erstwhile banks owned by princely states were made subsidiaries of SBI in 1959. Thus, the beginning of the Plan era also saw the emergence of public ownership of one of the most prominent of the commercial banks.

The All-India Rural Credit Survey Committee Report, 1954 recommended an integrated approach to cooperative credit and emphasised the need for viable credit cooperative societies by expanding their area of operation, encouraging rural savings and diversifying business. The Committee also recommended for Government participation in the share capital of the cooperatives. The report subsequently paved the way for the present structure and composition of the Cooperative Banks in the country

There was a feeling that though the Indian banking system had made considerable progress in the '50s and '60s, it established close links between commercial and industry houses, resulting in cornering of bank credit by these segments to the exclusion of agriculture and small industries. To meet these concerns, in 1967, the Government introduced the concept of social control in the banking industry. The scheme of social control was aimed at bringing some changes in the management and distribution of credit by the commercial banks. The close link between big business houses and big banks was intended to be snapped or at least made ineffective by the reconstitution of the Board of Directors to the effect that 51 per cent of the directors were to have special knowledge or practical experience. Appointment of whole-time Chairman with special knowledge and practical experience of working of commercial banks or financial or economic or business administration was intended to professionalise the top management. Imposition of restrictions on loans to be granted to the directors' concerns was another step towards avoiding undesirable flow of credit to the units in which the directors were interested. The scheme also provided for the take-over of banks under certain circumstances.

Political compulsion then partially attributed to inadequacies of the social control, led to the Government of India nationalising, in 1969,fourteen major scheduled commercial banks which had deposits above a cut-off size. The objective was to serve better the needs of development of the economy in conformity with national priorities and objectives. In a somewhat repeat of the same experience, eleven years after nationalisation, the Government announced the nationalisation of seven more scheduled commercial banks above the cut-off size. The second round of nationalisation gave an impression that if a private sector bank grew to the cut-off size it would be under the threat of nationalisation.

From the fifties a number of exclusively state-owned development financial institutions (DFIs) were also set up both at the national and state level, with a lone exception of Industrial Credit and Investment Corporation (ICICI) which had a minority private share holding. The mutual fund activity was also a virtual monopoly of Government owned institution, viz., the Unit Trust of India. Refinance institutions in agriculture and industry sectors were also developed, similar in nature to the DFIs. Insurance, both Life and General, also became state monopolies.

REFORM MEASURES

The major challenge of the reform has been to introduce elements of market incentive as a dominant factor gradually replacing the administratively coordinated planned actions for development. Such a paradigm shift has several dimensions, the corporate governance being one of the important elements. The evolution of corporate governance in banks, particularly, in PSBs, thus reflects changes in monetary policy, regulatory environment, and structural transformations and to some extent, on the character of the self-regulatory organizations functioning in the financial sector. Policy Environment During the reform period, the policy environment enhanced competition and provided greater opportunity for exercise of what may be called genuine corporate element in each bank to replace the elements of coordinated actions of all entities as a "joint family" to fulfill predetermined Plan priorities.

Greater competition has been infused in the banking system by permitting entry of private sector banks (Nine licences since 1993), and liberal licensing of more branches by foreign banks and the entry of new foreign banks. With the development of a multi-institutional structure in the financial sector, emphasis is on efficiency through competition irrespective of ownership. Since non-bank intermediation has increased, banks have had to improve efficiency to ensure survival.

REGULATORY ENVIRONMENT

Prudential regulation and supervision have formed a critical component of the financial sector reform programme since its inception, and India has endeavored to international prudential norms and practices. These norms have been progressively tightened over the years, particularly against the backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and real estate have been curtailed. The Banking Regulation Act 1949 prevents connected lending (i.e. lending by banks to directors or companies in which Directors are interested).

Periodical inspection of banks has been the main instrument of supervision, though recently there has been a move toward supplementary 'on-site inspections' with 'off-site surveillance'. The system of 'Annual Financial Inspection' was introduced in 1992, in place of the earlier system of Annual Financial Review/Financial Inspections. The inspection objectives and procedures, have been redefined to evaluate the bank's safety and soundness; to appraise the quality of the Board and management; to ensure compliance with banking laws & regulation; to provide an appraisal of soundness of the bank's assets; to analyse the financial factors which determine bank's solvency and to identify areas where corrective action is needed to strengthen the institution and improve its performance. Inspection based upon the new guidelines have started since 1997.

SELF REGULATORY ORGANIZATIONS

India has had the distinction of experimenting with Self Regulatory Organisations (SROs) in the financial system since the pre-independence days. At present, there are four SROs in the financial system -

  1. Indian Banks Association (IBA),
  2. Foreign Exchange Dealers Association of India (FEDAI),
  3. Primary Dealers Association of India (PDAI) and
  4. Fixed Income Money Market Dealers Association of India (FIMMDAI).

INDIAN BANKS ASSOCIATION

The IBA established in 1946 as a voluntary association of banks, strove towards strengthening the banking industry through consensus and co-ordination. Since nationalisation of banks, PSBs tended to dominate IBA and developed close links with Government and RBI. Often, the reactive and consensus and coordinated approach bordered on cartelisation. To illustrate, IBA had worked out a schedule of benchmark service charges for the services rendered by member banks, which were not mandatory in nature, but were being adopted by all banks. The practice of fixing rates for services of banks was consistent with a regime of administered interest rates but not consistent with the principle of competition. Hence, the IBA was directed by the RBI to desist from working out a schedule of benchmark service charges for the services rendered by member banks. Responding to the imperatives caused by the changing scenario in the reform era, the IBA has, over the years, refocused its vision, redefined its role, and modified its operational modalities.

FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA (FEDAI)

In the area of foreign exchange, FEDAI was established in 1958, and banks were required to abide by terms and conditions prescribed by FEDAI for transacting foreign exchange business. In the light of reforms, FEDAI has refocused its role by giving up fixing of rates, but plays a multifarious role covering training of banks' personnel, accounting standards, evolving risk measurement models like the VaR and accrediting foreign exchange brokers.

SROS REGULATING FINANCIAL MARKETS

In the financial markets, the two SROs, viz., the PDAI and the FIMMDAI are of recent origin i.e. 1996 and 1997. These two SROs have been proactive and are closely involved in contemporary issues relating to development of money and government securities markets. The representatives of PDAI and FIMMDAI are members of important committees of the RBI, both on policy and operational issues. To illustrate, the Chairmen of PDAI and FIMMDAI are members of the Technical Advisory Group on Money and Government Securities market of the RBI. These two SROs have been very proactive in mounting the technological infrastructure in the money and Government Securities markets. The FIMMDAI has now taken over the responsibility of publishing the yield curve in the debt markets. Currently, the FIMMDAI is working towards development of uniform documentation and accounting principles in the repo market.

REFORMS IN THE INDIAN BANKING SECTOR

Banks have been playing a crucial role in enriching the economic and social life of the nation. Banking has been prevalent in India since ancient times. The need for regulating and controlling commercial banks was felt because of the banking crisis. The RBI was established to bring the indigenous bankers together. In the latter half of the 20th century, banking made rapid strides towards progress. Nationalization of banks was undertaken for augmenting the financial resources for development and safeguarding the interests of the depositors.

Within the broad ambit of the financial sector, the banking sector has been the cynosure of academia and policymakers. One might attribute several reasons for this resurgence of interest in banking. First, the banking sector in a broad sense is akin to the 'brain' of the economy acting as a conduct for channeling resources from ultimate lender to final borrowers. Consequently, policy has been implemented to enhancement of the each of the intermediation in order to lowering the cost at which these resources can be made available to final investors, the reason simply being that lower intermediation costs have a positive externality of enhancing investment and growth in the long-run. Secondly, the worldwide trend towards deregulation of the financial sector, ascendancy of free market philosophy and the growing numbers relating to the linkages between deregulation, various categories of risks facing the banking sector and banking crises. And thirdly, the drastic reductions in the transactions costs facilitated by the improvements in information technology and communications networking have been influential in exercising powerful effects both on the scale and structure of the financial intermediation.

Against this backdrop, the plan of the paper is the following. Some of the crucial issues faced by the banking system at the present juncture require intense academic debate of the late 1980s and early 1990s relating to the rationale for reform itself isn't vociferous any more and the need, thrust and direction of the reform measures have largely been accepted. It may be recalled that at independence in India, the financial sector, particularly banking, was the only organised sector, however weak, it may have been, in terms of economic base and financial structure. It therefore, becomes the backbone in the strategy of growth, rather than being a follower of growth. In this process, the autonomy and profitability of the banking system was seriously compromised and importantly, rather than acting as a conduct of intermediation, the banking system acted as the 'engine' as opposed to being the 'wheel' of economic growth. These short-comings, coupled with the crisis of 1990s, forced reckoning of the imperative for financial sector strengthening. As is known, India, for good reason, 'chooses' a 'grdualistic' approach over 'big-bang' approach .to reform. Such gradualism was the outcome of the fact that reforms were not introduced in the face of prolonged economic crisis. And importantly, gradualism was the outcome of India's democratic and highly pluralistic policy in which reforms would be undertaken only if based on popular consensus.

During pre-nationalisation period (1961-68), commercial banks in India were not very much interested in providing credit to priority sectors. Commercial banks completely neglected the agricultural sector and small industrial sector during this period. More over, they considered the agricultural credit as the most unprofitable from commercial view point. Considering the situation the government of India passed an act known as Banking laws (Amendment) Act, 1968, to confer more powers to Reserve Bank for promoting social and economic objective of planning. This was known as the social control of banks. Under social control, the bankers were asked particularly to meet the needs of the farmers, small industries and other neglected sectors. But as it was felt that social control would be slow to fulfill the needs of the society, the government of India suddenly nationalised 14 major Indian commercial banks in July 1969.

II PRE-REFORM SITUATION

a. Nationalisation of banks

Thus on July 19, 1969 the Govt. of India nationalised top 14 scheduled commercial banks by promulgating an ordinance. Since then with a view of bringing these commercial banks into the mainstream of economic development with definite social obligations and objectives. These nationalised banks have been working as an independent units and the government is determining their credit policy.

The establishment of the state Bank of India in 1955 and the creation of State Bank group by nationalising eight regional banks in 1960 allowed scope for a new-experiment in the Indian Banking. In order to provide some protection to the depositors, an important step in the form of establishment of the Deposit Insurance Corporation was undertaken on January 1, 1962. This was very helpful in moblisation of deposits, as it enhances confidence of the people in banks.

In September 14, 1967, the Hazari Committee in its report on "Industrial planning and Licensing Policy" submitted to the Planning Commission. This indicates "it would be difficult to undertake credit planning unless the linked control of industry and banks in the same hand is snapped by nationalisation of banks. However, the government undertake these social control policy undertaking two measures : (1) Establishment of credit council as an advisory body, & (2) Enactment of the necessary banking legislation.

Again on April 15, 1980 the Govt. of India nationalised six more commercial banks as increased to 20. If we include the S81 and its 7 subsidiaries which are nationalised banks in India at present stands at 27 (New Bank of India since merged with Punjab National Bank in September 1993).

b. Causes of Bank nationalisation.

In her broadcast address of July 19, 1969, on bank natlonalisation, Prime Minister Mrs. Indira Gandhi stated that nationalisation was meant for an early realisation of the objective of social control which were spent out as, "(I) Removal of control by a few (ii) Provision of adequate credit for agriculture and small industry and export, (iii) Given a professional bent to management, (iv) Encouragement of a new class to entrepreneurs and (v) the provision of adequate training as well as terms of service for bank staff.

c. Performance of Nationalised banks

After nationalisation of commercial banks, Indian Banking system has gained much strength and cohesion. The nationalisation has improved the environment in respect of formulation and implementation of monetary and banking policy. Let us now look into the performance of these nationalised banks during the post-nationalisation period.

1. Branch expansion

In order to correct imbalances in the banking system, nationalised banks set an objective to initiate a branch expansion programmes particularly in Unbank and underbanked areas. With a view to strengthen the banking system, many small banks were merged into big banks. In 1950-51, there were 430 branches of commercial banks, a decade later, there were 256 small banks and in 1980-81, there were only 4 such banks. In 1990-91, there were 271 scheduled commercial banks in India.

Govt. Sponsored Programme

In an attempt to alleviate poverty, the government introduced the differential interest rate (DIR) schemes in April 1972 which covered 162 districts. In order to remove imbalances in the rural economy and provide employment opportunities to rural poor,_ the Integrated Rural Development Programme (IRDP) launched in 1978-79.

Moreover, with the establishment of National Housing Bank (NHB) in July 1988, these nationalised commercial banks have started advancing loan directly or indirectly. With the introduction of another Venture Capital Funds (VCF) schemes, one public sector bank subsidiary and one foreign bank have launched VCF with the objective to provide equity capital for pilot plants attempting for commercial application of indigenous technology and adoption of imported technology brought previously to domestic conditions.

III POST-REFORM SITUATION

The recommendations of M. Narasimham Committee, the then former RBI Governor on August 14, 1991, provided the blue print for the First Generation reforms of the financial sector. The Narasimham Committee submitted its report in Nov. 1991 and the report was placed before the Parliament in Dec. 17, 1991.

Considering the growing erosion in the efficiency and profitability of the banking sector, the present government decided to restructure the banking structure in order to infuse greater competition and efficiency in their working and to increase their profitability through introducing various banking recommendations.

A. Recommendations of Narasimham Committee, 1991

The Narasimham Committee report to bravely suggested market friendly approach during the changed scenario of globalisation and liberalisation. The unique aspects of the report is that it drives home the point that setback in productivity in the bankings and financial sector would generate a host of vicious circle. The loss of profitability would be the primary cause of such destructive swing.

The following are the important recommendations suggested by the Narasimham Committee.

  • Capital inadequacy requirements should take into account market risk in addition to the credit risk.
  • The Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) should be progressively brought down from 1991-92. The SLR instrument should be deployed in conformity with original intention of regarding it as a prudential requirement and not be viewed as a major instrument for financing the public sector.
  • Foreign exchange open credit limit risks should be integrated in the calculation of risk weighted assets and should carry 100 percent risk weight.
  • The directed credit programme instead of proving to be purpose­oriented was instrumental in the neglect of the qualitative aspect of lending. There was a built in mechanism to accelerate the growth of overdue.
  • Establishment of a four tier hierarchy for the banking sector consisting of three or four large banks including the SBI at the top, 8 to 10 national banks with a network of countrywide branches, local banks for regional operations and rural banks in the bottom mainly engaged in agriculture and related activities.
  • The government should not contemplate to nationalise any private commercial banks of the country in future and private banks should be treated at par with public sector banks.
  • Lifting the bar on setting up new banks in the private sector and abolishing the licensing procedure for branch expansion.
  • The government should be more liberal in allowing the foreign bank to open more branches keeping in line with the foreign investment policy. Joint ventures of foreign and Indian banks are permitted in respect of merchant and Investment banking. Foreign operations of Indian banks should be rationalised.
  • Interest rate be further deregulated to reflect energizing marketing conditions and the present interest rate on bank deposits may continue to be regulated.
  • Minimum capital to risk assets ratio (CRAR) be increased from the existing 8 percent to 10 percent, an intermediate minimum target of 9 per cent is to be achieved by 2000 and the ratio of 10 per cent by 2K2.
  • Public Sector Banks should be in a position to access the capital market at home or abroad be encouraged, as subscription to bank capital funds cannot be regulated as a priority claim on budgetary resources.
  • For evaluating the quality of assets portfolio, advances covered by Government guarantees, which have turned sticky, be treated as NPA's. Exclusion of such advances should be separately shown to facilitate fuller disclosure and greater transparency of operations.
  • Common staff recruitment system for bank officers be done away with as the part of the banking reforms. Appointments to the key posts should be kept out of political favour. The committee also felt the urgent need of the greater use of computer system.
  • Six special debt recovery tribunals were set up to facilitate the smooth transaction from direct banking to "Banking on commercial lines".
  • The minimum share of holding by government./ Reserve Bank in the equity of nationalised banks and. the state bank should be brought down 33%. The RBI regulator of the monitory system should not be also the owner of the bank in view of the potential for possible conflict of interest.
  • Every public sector bank should set up one or more rural banking subsidiaries to take over all it's rural branches and these should be at par with Regional Rural Banks (RRBs).

All these measures stand testimony to the visionary nature of recommendations in the Narasimham Committee Report.

B. Recommendations of Narasimham Committee, 1998

In order to initiate the second stage of Banking sector reforms, the then Finance Minister Mr. P. Chidambaram constituted a committee on headed by M. Narasimham in the second time April, 1998. The committee on banking sector reform favoured the merger of strong public sector banks and closure of some weaker banks if their rehabilitation is not possible.

The committee revived the idea of setting up an assets reconstruction fund to tackle the problem of huge non-performing assets (NPAs) of banks as recapitalisation of public sector banks.

The commercial banks were advised to enhance the shareholder value through corporate strategy. It was also pointed out that with effective disclosure norms, the RBI need not interfere with the functioning of the commercial banks.

The commercial banks could open branches without the prior sanction of the RBI and given the freedom to close down the loss-making units except those which were in the rural areas.

The committee strongly felt that it is the combination of operational flexibility and outside competition that would improve the functioning of the public sector banks.

Thus the second phase of banking reforms is likely to competitive existance for its viable units.

IV IMPLEMENTATION OF REFORMS BY GOVT. OF INDIA

Narasimham Committee recommended various reforms of which following have been implemented by the Reserve Bank of India so far.

  1. There are overall monetary policy issues relating to interest rates and exchange rates, reduction in SLR and CRR ratios, modification in refinance facilities, development of alternative system of monetary control are implemented.
  2. In order to enable the bank reach the prescribed norms a programme of recapitalisation of banks has been undertaken by infusing more capital. The most important is the move towards complying with the Bank of International settlements (BIS) Capital adequacy norms (CAN) or what is also known as Capital to risk assets ratio (CRAR).
  3. Some movers have been made in the direction of re-organisation of entire banking system. SCICI has been merged with ICICI, there are move towards amalgamation I mergers with some large nationalised banks with some weaker banks.
  4. As recommended by the Committee, the RBI has set up the Board for Financial Supervision (BFS) in an effort to streamline banking operations and make it more transparent.
  5. The RBI has also announced changes in consortium lending arrangements, commercial papers, certificates of deposits (CD) and lending norms to give greater autonomy to banks.
  6. Banking sector Act, 1993 facilities the establishment of Debts Recovery Tribunals for expeditious adjudication of recovery cases within six months.
  7. RBI announced in April 1994 a scheme for disclosure of information regarding defaulting borrowers of banks and financial institutions with outstanding aggregates Rs. One Crore and above on March 31 and Sept. 30, every year.
  8. As a second step an asset reconstruction fund (ARF) which would take over the bad debts of banks and thereby instantly changes the position of banks was also recommended.
  9. Liberalisation of interest rate regim is an important part of the banking sector reforms. There is a progresive freeing of interest rates and banks have been given freedom to accept CDs to any extent.
  10. RBI has also suggested to all the banks to adopt a three-tired administrative structure to replace the existing four tier-branch, region, zone, and head office - for optimum utilisation of resources and speedier decision-making. Reduction of one administrative tier would result in more than 200 zonal or regional offices drawing shutters and at least 25,000 staff possibly being rendered jobless. Beginning January 1994, banks have also been permitted to implement voluntary retirement scheme (VRS).
  11. The policy of branch licensing has been tightened by RBI. Only those banks which fulfill the following conditions can open new branches:
    (i) Three-year profitability record (ii) NPAs below 15% (iii) 8% capital adequacy and (iv) minimum-owned funds of Rs.100 crores. The banks also required to submit their expansion projects to the RBI at least one year in advance.
  12. Since May 1997, Fls have been permitted to raise short-term one year deposits. The then existing investment-wise limits for the resources mobilisation have since been abolished.
  13. Investment in PSU bonds can now be undertaken by the banks upto 5 percent of the banks in credential aggregate deposits of the previous year.
  14. Banks limit for investment in shares and debenture has been raised from 1.5 percent of the annual incremental deposits to 5 per cent since April 1997.
  15. Effective October 4, 1995, the RBI has empowered primary co­operative banks to levy commitment charges at a minimum of 1 % on the unavailed proportion of the working capital limits.
  16. One the treasury side, restriction on banks have been reduced. Previously, banks have been very limited freedom to trade in securities. For instance, 70 percent of the trade have been permanent category and 30 percent of the trading category. Now the ratio has been reduced to 60:40. This has been given to a greater flexibility to the banks to correct asset-liability mismatch.
  17. As far as the management of FOREX risks is concerned, the entire exchange rate risk has been shifted to banks. Previously, on the foreign currency deposit, the RBI assumed the exchange risks.
  18. RBI granted approval on Nov. 6, 1996 to four foreign insurance companies to set up liaison offices in India. The aim is that to opening up the insurance sector.
  19. Introduction of substantial acquisition of shares and Takeover Regulation Act, 1994, open for credit expansion, reduction of NPA and subsequent increase in profitability of the commercial banks.
  20. Since October 1997, bank borrowings from overseas markets have been liberalised. Banks are allowed to borrow up to a maximum extent of 15 percent of their unimpaired tier I capital.

These are the major reforms implemented by the Govt. of India so far

V PRESENT WEAKNESS OF THE BANKING SECTOR

(1) Interest rate deregulation

In the area of interest on deposits I savings, there does not appear any systematic architecture of the interest rate structure. It is apparent that banks, especially public sector banks are not ready for this reform since there is a potential for instability in the form of shifts in saving bank deposits between banks.

(2) Non-performing assets

The NPAs are those loans given by a bank or financial institutions where the borrower defaults or delays interest or principal payments. Operationally, it seems imprudent to treat all non-performing loans as a single 'catch all' category. Broadly, they can categorised as loans to agriculture sector, directed lending, loans to small enterprise and loans to corporate sector. Many of the directed loans are substance loans, where default rates are high and recovery prospects not bright.

(3) Directed lending:

The issue of directed lending is also an area of concern; the share of priority sector advances in total non-food gross bank credit of scheduled commercial banks (SCBs) has come down from 40.3 percent in Dec. 1980 to 35.9 percent in March, 2001. The direct agricultural lending accounts of all PSBs also show a declining trend (2.13 crore in 1994 to 1.5 crore in 2000). Although during 1993 to 1998, the RRBs credit deposit (C-1) ratio has been declined from 67 percent to 44 per cent (42% in 2001), the share of agriculture loans in total loans has come down from 5.4% to 44.4% during this period.

(4) Ownership structure:

Another serious weakness is in the area of ownership and control. The existing the continued government overlap of ownership and regulatory and supervisory functions can lead to problems of regulatory forbearance impact on financial stability.

(5) Corporate governance:

Last, but not the least of the problem areas is the weak corporate governance practices in banks in general and PSBs in particular. Good governance practices are a "coping mechanism" for an institution.

VI CHALLENGES BEFORE THE BANKING SECTOR

(1) Consolidation:

Public sector banks that need to evaluate the opportunities to consolidate as bigger players. Currently, the over-whelming presence of SBI in every segment of market makes it a virtually uniplayer market. It must be reckoned that what is required is not merger of weak bank with a strong one, but of two strong banks.

(2) Recapitalisation:

The recapitalisation of PSBs also is coming into sharp focus. The RBI has estimated that, given the present growth rate of the economy and the extent capital adequacy norms, the PSBs, barring the three weak banks, would need Rs.100 billion in additional capital in the coming five year. The erosion of capital is not the cause of weakness but an effect though it has a cascading effect too.

(3) Prudential Regulation:

Intense consultation process in detailing the prudential regulations are introduced at an 'appropriate' pace, in order to reach the objective of reaching international best practices as soon as feasible and not at a slow pace.

(4) Weak Banks

Treatment of weak banks is another issue of importance. Setting up an Asset Reconstruction fund (ARF) is not a panacea to taking care of the NPA totality. It will only address the 'stock' issue, will neglecting the issue of 'flows'

(5) Legal framework

Closely connected with the NPLs is the issue of legal framework. The current legal framework is loaded in favour of defaulting clients. The introduction of Board for Industrial and Financial Reconstruction (BIFR) and Debt Recovery Tribunal (DRTs) has not yield the desired results.

(6) Ownership issues

Another issue that needs early resolution is one of the potential conflicts as owner /supervisor. In the meantime, it would do well for the RBI and the government to withdraw their officials from the Board of SBI and instead, appoint fully independent directors.

(7) Regulation and supervision

Under the current dispensation, the regulation and supervision continue to function as a part of overall monetary policy and although the Board for Financial Supervision (BFS) is meant to be autonomous, its present constitution Governor as he Chairman.

(8) Corporate Governance

Many of the problems in the banking sector in India can be fundamentally traced to the lack of sound corporate governance practices. In the private sector, voting rights of the individual shareholders are restricted to no more than 10 percent of the bank equity.

(9) Deposit insurance

The way of Deposit Insurance Corporation is structured, managed and Operated needs an urgent review. It is comparable to the pre-reform Federal Deposit Insurance Corporation (FDIC). It offers no distinctive to mismanaged banks.

ROLE OF IT IN INDIAN BANKING

Since about the early eighties there has been an immense drive in the use of computers and communication technology in the country's banking industry. The RBI report on banking published on 15.11.2001 narrates, "In recent years, the banking industry has been undergoing rapid changes, reflecting a number of underlying developments. The most significant has been advances in communication and information technology, which have accelerated and broadened the dissemination of financial information while lowering the costs of many financial activities." The vast network of PSBs has started becoming networked a bit late, and the full benefit of the complete computerisation of the banking system is expected to be perceived by 2010. Most of the new private banks and almost all big foreign banks like Standard Chartered, ANZ Grindlays, ABN Amro or HSBC have offered international-standard banking products and facilities like Credit Card, Debit Card, ATM, Tele-banking and cyber- or internet-banking. However, PSBs have these facilities limited to the metropolitan or important cities only. The sheer size of the branch-network and wide geographical base of customers and limited ISDN availability have been the obstacles for the PSBs to offer these products in every corner of the country. Interestingly, the major foreign banks or new private sector banks exist in these metropolitan cities or important urban areas only - some private banks like UTI and ICICI have taken an aggressive business expansion plan that has resulted in ATMs and tele-banking available in some remote corners of the country already.

The following is a short list of core-banking IT infrastructure already available to the Indian banks in almost all level:

  • Payment and settlement systems like EFT (Electronic Fund Transfer), Real Time Gross Settlement System (RTGS), Centralised Funds Management System (CFMS), Structured Financial Messaging Solution (SFMS)
  • Imaging of Instruments
  • Electronic Clearing Services
  • Indian Financial Network (INFINET)
  • SWIFT (Society for Worldwide Inter-Bank Financial Telecommunication).

ROLE OF PRIVATE BANKS IN INDIAN BANKING SECTOR

Ever since the entry of private players in the Banking sector, the industry witnessed the entry of nine new generations private banks 6. The major differentiating parameter that distinguishes these banks from all the others banks in the Indian banking industry is the level of service that is offered to the customers. Verily, the focus has always been centered around the customers understanding his needs, pre-empting him and consequently delighting him. with various configurations of benefits and a wide portfolio of products and services. These banks have generally been established by promoters of repute or by 'high value' domestic financial institutions. The popularity of these banks can be gauged by the facts that in short span of time; these banks have gained considerable customer confidence and consequently have shown impressive growth rates. Today the private banks corner almost four percent share of the total share of deposits. Most of the banks in this category are concentrated in the high – growth urban areas in metros (that accounts for approximately 70 percent of the total banking business). With efficiency being the major focus , these banks have leveraged on their strengths and competencies viz. management , operational efficiency and flexibility , superior products positioning and higher employee productivity skills. The private banks with their focused business and service portfolio have a reputation of being niche players in the industry. A strategy that has allowed these banks to concentrate on few reliable high net worth companies and individual rather than cater to the mass market. These well- chalked out integrated strategy plans have allowed most of these banks to operate 70 percent of their business in urban areas , this statutory requirement has translated into lower deposit mobilization costs and higher margins relative to public sector banks. Private banks operate on very lean and efficient structures (with minimal overheads and low non- performing assets base) that allow them to anticipate customer requirements better thus pre-emptying any competitive posturings from their public sector counterparts. These banks were among the pioneers in IT infrastructure investment forcing many public sector banks to follow suit. Concepts like 'Sunday banking', anytime banking and flexi- banking pioneered by private banks soon became the order of the day and customer convenience became the new marketing mantra.

FOREIGN BANKS IN INDIAN BANKING SECTOR

In the banking system, diversified ownership of public sector banks has been promoted over the years and the performance of their listed stocks in the face of intense competition indicates improvements in the system 7. Foreign banks have been operating in India for decades with a Few of them having operations in India for over a century. The number of foreign bank branches in India has increased significantly in recent years since RBI issued a number of licenses - well beyond the commitments made to the World Trade Organisation. The presence of foreign banks in India has benefited the financial system by enhancing competition, resulting in higher efficiency. There has also been transfer of technology and specialised skills which has had some "demonstration effect" as Indian banks too have upgraded their skills, improved their scale of operations and diversified into other activities. At a time when access to foreign currency funds was a constraint for the Indian companies, the presence of foreign banks in India enabled large Indian companies to access foreign currency resources from the overseas branches of these banks.

Also with the presence of foreign banks, as borrowers in the money market and their operation in the foreign exchange market has resulted in the creation and deepening of the inter-bank money market. Now, it is the challenge for the supervisors to maximize the advantages and minimize the disadvantages of the foreign banks' local presence.

The new policy, announced by the Reserve Bank of India (RBI), the central bank, on February 28,2005 is likely to encourage foreign banks that want to grow in the $43bn retail loan market to pursue organic growth 8. They may, however, continue to pick up small stakes in profitable private banks until they are allowed to acquire them. Responding to the new rules, HSBC will pump in $180m of capital to support organic growth, and will look at setting up a retail finance company. Citigroup, the Netherlands' RaboBank, and GE Money, the consumer finance arm of General Electric, are already running retail finance company subsidiaries; current regulations impose fewer restrictions on them because they cannot collect public deposits freely. Standard Chartered has set up a retail finance firm and has also developed its own private banks. Several other foreign banks and foreign private equity investors have bought small stakes in private banks. Scotiabank picked up 4.9% in Bank of Punjab in February, and Wa


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