DEVELOPMENT AND REFORMS IN INDIAN

BANKING
GROWTH OF BANKING SYSTEM IN INDIA :
In order to understand present make up of banking sector in India and
its past progress, it will be fitness of things to look at its development in a
somewhat longer historical perspective. The past four decades and
particularly the last two decades witnessed cataclysmic change in the
face of commercial banking all over the world. Indian banking system
has also followed the same trend.
In over five decades since dependence, banking system in India has
passed through five distinct phase, viz.
(1) Evolutionary Phase (prior to 1950)
(2) Foundation phase (1950-1968)
(3) Expansion phase (1968-1984)
(4) Consolidation phase (1984-1990)
(5) Reformatory phase (since 1990)
EVOLUTION PHASE: (PRIOR TO 1950)
Enactment of the RBI Act 1935 gave birth to scheduled banks in India,
and some of these banks had already been established around 1981.
The prominent among the scheduled banks is the Allahabad Bank,
which was set up in 1865 with European management. The first bank
which was establishedwith Indian ownership and management was the
Oudh Commercial Bank, Iformed in 1881, followed by the Ajodhya Bank
in 1884, the Punjab National Bank in 1894 and Nedungadi Bank in 1899.
Thus, there were five Banks inexistence in the 19th century. During the
period 1901-1914, twelve morebanks were established, prominent
among which were the Bank of Baroda(1906), the Canara Bank (1906),
the Indian Bank (1907), the Bank of India(1908) and the Central Bank of
India (1911).
Thus, the five big banks of today had come into being prior to the
commencement of the First World War. In 1913, and also l in 1929, the
IndianBank faced serious crises. Several banks succumbed to these
crises. Publicconfidence in banks received a jolt. There was a heavy
rush on banks. An important point to be noted here is that no commercial

bank was established during the First World War, while as many as
twenty scheduled banks came into existenceafter independence -- two in
the public sector and one in the private sector.
The United Bank of India was formed in 1950 by the merger of four
existingcommercial banks.Certain non-scheduled banks were included in
the second schedule ofthe Reserve Bank in view of these facts, the
number of scheduled banks roseto 81. Out of 81 Indian scheduled
banks, as many as 23 were either liquidatedor merged into or
amalgamated with other scheduled banks in 1968, leaving
58 Indian schedule banks.It may be emphasized at this stage that
banking system in India cameto be recognized in the beginning of 20
century as powerful instrument toinfluence the pace and pattern of
economic development of the county. In1921 need was felt to have a
State Bank endowed with all support andresources of the Government
with a view to helping industries and bankingfacilities to grow in all parts
of the country. It is towards the accomplishment ofthis objective that the
three Presidency Banks were amalgamated to form the
Imperial Bank of India. The role of the Imperial Bank was envisaged as
toextend banking facilities, and to render the money resources of India
moreaccessible to the trade and industry of this country, thereby
promotingfinancial system which is an indisputable condition of the
social and economicadvancement of India.Until 1935 when RBI came
into existence to play the role of CentralBank of the country and
regulatory authority for the banks. Imperial Bank ofIndia played the role
of a quasicentral bank. It was by making it the solerepository of all its
funds and by changing the volume of its deposits with theBank as and
when desired by it, the Government tried to influence the base of
deposits and hence credit creation by Imperial Bank and by rest of the
banking system.Thus, the role of commercial banks in India remained
confined toproviding vehicle for the communitys savings and attending
to the creditneeds of only certain selected and limited segments of the
economy. Banksoperations were influenced primarily by commercial
principle and not bydevelopmental factor.Regulation was still only being
introduced and unhealthy practices inthe banks were then more rules
than exceptions. Failure of banks wascommon as governance in
privately owned joint stock banks left much to bedesired.

FOUNDATION PHASE: 1948-1968

In those initial days, the need of the hour was to reorganize and to
consolidate the prevailing banking network keeping in view the
requirementsof the economy. The first step taken to that end was the
enactment of theBanking Companies Act, 1949 followed by rapid
industrial finance. Roleplayed by banks was instrumental behind
industrialization with the impetusgiven to both heavy and Small Scale
Industries. Subsequently after theadoption of social control, banks
started taking steps in extending credit toagriculture and small
borrowers. Finally, on July l969, 14 banks werenationalised with a view
to extending credit to all segments of the economyand also to mitigate
regional imbalances. Thus, the period of regulated growthfrom 1950 till
bank nationalization witnessed a number of far-reachingchanges in the
banking system.The banking scenario prevalent in the country during the
period 1948-1968 presented a strong focus on class banking on security
rather than onpurpose. The emphasis of the banking system during this
period was onlaying the foundation for a sound banking system in the
country. BankingRegulating Act was passed in 1949 to conduct and
control operations of thecommercial banks in India. Another major step
taken during this period wasthe transformation of Imperial Bank of India
into State Bank of India and aredefinition of its role in the Indian
economy, strengthening of the co-operative
credit structure and setting up of institutional framework for providing
longtermfinance to agriculture and industry. Banking sector, which during
thepreindependence India was catering to the needs of the
government, richindividuals and traders, opened its door wider and set
out for the first time tobring the entire productive sector of the economy
large as well as small, in
its fold.
During this period number of commercial banks declined remarkably.
There were 566 banks as on December, 1951; of this, number
scheduledbanks was 92 and the remaining 474 were non-scheduled
banks. Thisnumber went down considerably to the level of 281 at the
close of the year1968. The sharp decline in the number of banks was
due to heavy fall in thenumber of non-scheduled banks which touched
an all time low level of 210.
The banking scenario prevalent in the country up-tothe year 1968

depicted a strong stress on class banking based on security rather than

on'purpose. Before 1968, only RBI and Associate Banks of SBI were
mainlycontrolled by Government. Some associates were fully owned
subsidiaries ofSBI and in the rest, there was a very small shareholding
by individuals andthe rest by RBI.

EXPANSION PHASE (1968-1984)

The motto of bank nationalization was to make banking services reach
the masses that can be attributed as "first- banking revolution".
Commercialbanks acted as vital instruments for this purpose by way of
rapid branchexpansion, deposits mobilization and credit creation.
Penetrating into ruralareas and agenda for geographical expansion in
the form of branchexpansion continued. The second dose of
nationalization of 6 morecommercial banks on April 15, 1980 further
widened the phase of the public
sector banks and therefore banks were to implement all the government
sponsored programmes and change their attitude in favour of social
banking,which was given the highest priority.This phase witnessed
socialization of banking in 1968. Commercialbanks were viewed as
agents of change and social control on banks.However, inadequacy of
social control soon became apparent because allbanks except the SBI
and its seven associate banks were in the private sectorand could not be
influenced to serve social interests. Therefore, banks werenationalized
(14 banks in 1969 and 6 banks in 1980) in order to control theheights of
the economy in conformity with national policy and objectives. This
period saw the birth and the growth of what is now termed as directed
lendingby banks. It also saw commercial banking spreading to far and
wide areas inthe country with great pace during which a number of
poverty alleviation andemployment generating schemes were sought to
be implemented throughcommercial banks. Thus, this period was
characterized by the death of private
banking and the dominance of social banking over commercial banking.
It washardly realized that banks 'were organizations with social

responsibilities butnot social organizations. This period also witnessed

the birth of RegionalRural Bank (RRBS) in 1975 and NABARAD in 1982
which had priority sectoras their focus of activity.Although number of
commercial banks declined from 281 in 1968 to268 in 1984, number of
scheduled banks shot up from 71 to 264 during thecorresponding period,
number of non-scheduled banks having registeredperceptible decline
from 210 to 4 during the period under reference. The risein the number
of scheduled banks was, as stated above, due to theemergence of
RRBS.
The fifteen years following the banks nationalization in 1969 were
dominated by the Banks expansion at a path breaking pace. As many
as50,000 bank branches were set up; three-fourths of these branches
wereopened in rural and semi-urban areas. Thus, during this period a
distincttransformation of far reaching significance occurred in the
Indianbanking system as it assumed a broad mass base and emerged
as an importantinstrument of socio-economic changes. Thus, with
growth came inefficiency
and loss of control over widely spread offices. Moreover, retail lending to
morerisk-prone areas at concessional interest rates had raised costs,
affected thequality of assets of banks and put their profitability under
strain. Thecompetitive efficiency of the banks was at a low ebb.
Customer servicebecame least available commodity. Performance of a
bank/banker began tobe measured merely in terms of growth of
deposits, advances and other suchtargets and quality became a
casualty.
Theimpact of this phenomenal growth was to bring down the population
perbranch from 60,000 in 1969 to about 14,000. The banking system
thusassumed a broad mass-base and emerged as an important
instrument ofsocial-economic changes. However, this success was
neither unqualifiednor without costs. While the rapid branch expansion,
wider geographicalcoverage has been achieved, lines of supervision and
control had beenstretched beyond the optimum level and had
weakened. Moreover, retaillending to more risk-prone areas at
concessional interest rates had raisedcosts, affected the quality of
assets of banks and put their profitability understrain.

CONSOLIDATION PHASE; (1985-1990)

A realization of the above weaknesses thrust the banking sector into
the phase of consolidation. This phase began in 1985 when a series of
policy initiatives were taken with the objectives of consolidating the gains
of branch expansion undertaken by the banks, and of relaxing albeit
marginally, the verytight regulation under which the system was
operating. Although number ofschedule banks increased from 264 in
1984 to 276 in 1990, branch expansionof the banks slowed down. Hardly
7000 branches were set up during this
period. For the first time, serious attention was paid to improving
housekeeping, customer services, credit management, staff productivity
andprofitability of the banks and concrete steps were taken during this
period torationalize the rates of bank deposits and lending. Measures
were initiated toreduce the structural constraints which were then
inhibiting the developmentof money market.
By this time about 90% of commercial banks were in the public sector
and closely regulated in all its facets. Prices of assets liability were fixed
bythe RBI; prices of service were fixed uniformly by the Indian Banking
Association (IBA); composition of assets was also somewhat fixed in as
muchas 63.5% of bank funds were mopped up by CRR and SLR and the
remainedwas to directed towards priority sector leading and small
loaning; salarystructure was negotiated by the IBA and validated by the
Government. Thus,there was no autonomy in vital decisions
Government. Thus, there was noautonomy in vital decisions.
Commercial approach in operations and drivetowards efficiency was
almost nonexistent. The result was that during thisperiod, the banks
ended up consolidating their losses rather than the gains.
A very interesting development that had taken place during 1960s was
the liquidation of many smaller banks by amalgamation with bigger and
stronger banks. During the two decades 1949 to 1969 the banking
sectorwitnessed the process of Consolidation for the first time. The
number ofbanking companies came down drastically from 620 in 1949 to
89 in 1969.
Deposit Mobilization and Credit Expansion
While acting as financial intermediaries between the savers and

investors, commercial banks render a yeomen service to the

development of an economy. Deposit expansion, which is one of the
parameters indicating thedevelopment of banking, contributed to the
growth of the economy.Nationalization of major banks in 1969
accompanied by massive branchexpansion gave fillip to deposit
mobilization. The total deposits which stood atRs. 908 crore in 1951
increased to Rs. 4646 crore by 1969-an increase of a little more than 5
times. In the subsequent eight years till 1987, the deposits increased by
Rs. 1,02,699 crore They stood at Rs. 2,01,199 crore in
1991.Correspondingly, bank credit had also increased from Rs. 547
crore in 1951to Rs. 3599 crore in 1969 and to Rs. 1,21,865 crore in
1991.
DECLINE IN PRODUCTIVITY AND PROFITABILITY
Despite this commendable progress serious problems have emerged
reflected in a decline in productivity and efficiency and erosion of the
profitability of the banking sector. The squeeze on profitability has
emanatedboth from the factors operating on the side of income and on
the side ofexpenditure. The Narasimham Committee-I identified the
following factors as responsible for decline in income earnings:
i. Directed investment in terms of minimum Statutory Liquidity Ratios
which together with variable Cash Reserve Ratio, pre-empting well
64over half of the total resources mobilized by banks.
ii. Directed credit programme of deploying 40 per cent of bank credit to
the priority sectors at low interest rates.
iii. Low capital base.
iv. Low technology.
v. Phenomenal branch expansion.
vi. Political interference in loan disbursal and poverty eradication
programmes.
The above factors led to the depression in the interest income
available to banks on the one hand and the deterioration in the quality of
loan portfolio both of the priority sector and traditional sectors resulting in
accumulation of non-performing assets on the other. This has been
responsible for erosion of earnings and profitability of banks.
Commenting on the squeeze on the profitability of banks, 'The
Narasimham Committee on Financial System' observed, "Perhaps the
single most important cause for the further increase in expenditure has

been the impact of the phenomenal expansion of branch banking.

Growing diversification of functions, particularly with respect to extending
thecoverage of bank credit to agriculture and small industries, where the
unit cost of administering the loan tend to be high in proportionate terms,
have also contributed to a faster growth of expenditure.Many of rural
branches, unfortunately, have not been able to generateadequate
business to justify their existence, most of them operating below
the break-even point. An inverse correlation between the extent of the
commercial banks presence in rural areas and the volume of business
generated by these outlets is clearly visible.This has decisive impact on
theoverall profits of the banks. The public sector banks, although have a
largenumber of rural branches, only a small proportion of their business
isgenerated by these branches. It is estimated that 41 per cent of PSBs
branches handle only 10 per cent of total advances and the contribution
ofrural branches to deposit mobilization is only 14 per cent. It is a
laborintensiveprocess to handle a large number of small deposit
accounts andthis has resulted in low average business per employee in
rural branches.These branches have to service 39 per cent of small
borrowing accounts amajor number of which are less revenue
generating.The story is not different in the case of private sector banks.
22 percent of their rural branches mobilize only 6 per cent of their
deposits. Theydisburse hardly 4 per cent of the total credit and deploy 11
per cent of thestaff to manage these branches. The rural branches of the
private sectorbanks appear as a small appendage maintained because
of its inevitabilityunder the existing banking regulations than for its utility,
As a result of theabove factors gross profits ie surplus before provision
been declining for the banking system over the past decades and in the
year1989-90, such profit were no more than 1.10 per cent of working
funds. During 1992-93 they posted huge losses to the tune of Rs.
3648 crore. In case of private sector banks too the net profits have
declinedfrom Rs. 77 crore in 1991-92 to Rs. 60 crore. In 1992-93. The
Foreign bankstoo have sustained losses in 1992-93. These losses in
1992-93 may beattributed mainly to the securities scam engineered by
Harshad Mehta andprovisions made for non-performing assets. Further,
it may be noted that the
average Return on Assets in the second half of 1980s was about 0.15
percent, an extraordinarily low figure when compared to the international

standards Reflecting low capitalization of Indian banks, Return on Equity

covered around 9.5 per cent and capital and reserves averaged about
1.05per cent of assets in sharp contrast to 4 to 6 per cent in other Asian
countries. The capital base defined as the ratio of paid-up capital and
reserves to deposits of PSBs at a slightly over 2.85 per cent in 1990-91
compared very poorly with gIobal standards. Thus by 1991, the county
erected an unprofitable, inefficient and financially unsound banking
sector.
The operational efficiency of banking system had been unsatisfactory in
terms of low profitability, growing incidence of NPAs and relatively low
capitalbase. Consequently, the.financial health of banks deteriorated.
Further, thecustomer service was poor, their work technology was
outdated and theywere unable to meet the challenges of a competitive
environment.
These developments have necessitated devising a reform agenda
for the
banking sector.
REFORMATORY PHASE (1991 ONWARDS)
The main objective of the financial sector reforms in India initiated in the
early 1990s was to create an efficient, competitive and stable financial
sector that could then contribute in greater measure to stimulate growth.
Concomitantly, the monetary policy framework made a phased shift from
direct instruments of monetary management to an increasing reliance on
indirect instruments. However, as appropriate monetary transmission
cannot take place without efficient price discovery of interest rates and
exchange rates in the overall functioning of financial markets, the
corresponding development of the money market, Government
securities market and the foreign exchange market became
necessary. Reforms in the various segments, therefore, had to be
coordinated.
FINANCIAL AND BANKING SECTOR REFORMS :
The last two decades witnessed the maturity of India's financial markets.
Since 1991, every governments of India took major steps in reforming
thefinancial sector of the country. The important achievements in the
followingfields, is discussed under separate heads:
Financial markets

 Regulators
The banking system
Non-banking finance companies
The capital market
Mutual funds
Overall approach to reforms
Deregulation of banking system
Capital market developments
Consolidation imperative
The details of the above segments have been explained separately as
under.
FINANCIAL MARKETS
In the last decade, Private Sector Institutions played an important role.
They grew rapidly in commercial banking and asset management
business.With the openings in the insurance sector for these institutions,
they startedmaking debt in the market.Competition among financial
intermediaries gradually helped theinterest rates to decline. Deregulation
added to it. The real interest rate wasmaintained. The borrowers did not
pay high price while depositors hadincentives to save. It was something
between the nominal rate of interest andthe expected rate of inflation.
REGULATORS
The Finance Ministry continuously formulated major policies in the field
of financial sector of the country. The Government accepted the
important role
of regulators. The Reserve Bank of India (RBI) has become more
independent. Securities and Exchange Board of India (SEBI) and the
Insurance Regulatory and Development Authority (IRDA) became
important
institutions. Opinions are also there that there should be a superregulator for
the financial services sector instead of multiplicity of regulators.
68
THE BANKING SYSTEM
Almost 80% of the businesses are still controlled by Public Sector
Banks (PSBs). PSBs are still dominating the commercial banking
system.Shares of the leading PSBs are already listed on the stock
exchanges.The RBI has given licenses to new private sector banks as

part of theliberalization process. The RBI has also been granting

licenses to industrial houses. Many banks are successfully running in the
retail and consumer segments but are yet to deliver services to industrial
finance, retail trade,small business and agricultural finance.
The PSBs will play an important role in the industry due to its number
of branches and foreign banks facing the constraint of limited number of
branches. Hence, in order to achieve an efficient banking system, the
onus ison the Government to encourage the PSBs to be run on
professional lines.
DEVELOPMENTOF FINANCIAL INSTITUTIONS
FIs's access to SLR funds reduced. Now they have to approach the
capital market for debt and equity funds.
Convertibility clause no longer obligatory for assistance to corporates
sanctioned by term-lending institutions.
Capital adequacy norms extended to financial institutions.
DFIs such as IDBI and ICICI have entered other segments of financial
services such as commercial banking, asset management and
insurance through separate ventures. The move to universal banking
has started.
NON-BANKING FINANCE COMPANIES
In the case of new NBFCs seeking registration with the RBI, the
requirement of minimum net owned funds, has been raised to Rs.2
crores.Until recently, the money market in India was narrow and
circumscribed bytight regulations over interest rates and participants.
The secondary marketwas underdeveloped and lacked liquidity. Several
measures have beeninitiated and include new money market
instruments, strengthening of existinginstruments and setting up of the
Discount and Finance House of India(DFHI).
The RBI conducts its sales of dated securities and treasury bills through
itsopen market operations (OMO) window. Primary dealers bid for these
securities and also trade in them. The DFHI is the principal agency for
developing a secondary market for money market instruments and
Government of India treasury bills. The RBI has introduced a liquidity
adjustment facility (LAF) in which liquidity is injected through reverse
repoauctions and liquidity is sucked out through repo auctions.
On account of the substantial issue of government debt, the gilt- edged

market occupies an important position in the financial set- up. The

SecuritiesTrading Corporation of India (STCI), which started operations
in June 1994has a mandate to develop the secondary market in
government securities.Long-term debt market: The development of a
long-term debt market iscrucial to the financing of infrastructure. After
bringing some order to theequity market, the SEBI has now decided to
concentrate on the developmentof the debt market. Stamp duty is being
withdrawn at the time ofdematerialization of debt instruments in order to
encourage paperless trading.
THE CAPITAL MARKET
The number of shareholders in India is estimated at 25 million. However,
only an estimated two lakh persons actively trade in stocks. There has
been adramatic improvement in the country's stock market trading
infrastructureduring the last few years. Expectations are that India will be
an attractiveemerging market with tremendous potential. Unfortunately,
during recenttimes the stock markets have been constrained by some
unsavourydevelopments, which has led to retail investors deserting the
stock markets.
MUTUAL FUNDS
The mutual funds industry is now regulated under the SEBI (Mutual
Funds) Regulations, 1996 and amendments thereto. With the issuance
ofSEBI guidelines, the industry had a framework for the establishment of
manymore players, both Indian and foreign players.
The Unit Trust of India remains easily the biggest mutual fund controlling
a corpus of nearly Rs.70,000 crores, but its share is going down. The
biggest shock to the mutual fund industry during recent times was the
insecurity generated in the minds of investors regarding the US 64
scheme. With the growth in the securities markets and tax advantages
granted for investment inmutual fund units, mutual funds started
becoming popular.
The foreign owned AMCs are the ones which are now setting the pace
for the industry. They are introducing new products, setting new
standards of customer service, improving disclosure standards and
experimenting with new types of distribution.The insurance industry is
the latest to be thrown open to competition fromthe private sector

including foreign players. Foreign companies can only enterjoint

ventures with Indian companies, with participation restricted to 26 per
cent of equity. It is too early to conclude whether the erstwhile public
sectormonopolies will successfully be able to face up to the competition
posed bythe new players, but it can be expected that the customer will
gain fromimproved service.
The new players will need to bring in innovative products as well as
freshideas on marketing and distribution, in order to improve the low per
capitainsurance coverage. Good regulation will, of course, be essential.
OVERALL APPROACH TO REFORMS
The last ten years have seen major improvements in the working of
various financial market participants. The government and the regulatory
authorities have followed a step-by-step approach, not a big bang one.
The entry of foreign players has assisted in the introduction of
internationalpractices and systems. Technology developments have
improved customer service. Some gaps however remain (for example:
lack of an inter-bankinterest rate benchmark, an active corporate debt
market and a developedderivatives market). On the whole, the
cumulative effect of the developmentssince 1991 has been quite
encouraging. An indication of the strength of thereformed Indian financial
system can be seen from the way India was not affected by the
Southeast Asian crisis.
However, financial liberalization alone will not ensure stable economic
growth. Some tough decisions still need to be taken. Without fiscal
control,financial stability cannot be ensured. The fate of the Fiscal
Responsibility Bill remains unknown and high fiscal deficits continue. In
the case of financialinstitutions, the political and legal structures have to
ensure that borrowersrepay on time the loans they have taken. The
phenomenon of richindustrialists and bankrupt companies continues.
Further, frauds cannot betotally prevented, even with the best of
regulation. However, punishment hasto follow crime, which is often not
the case in India.
DEREGULATION OF BANKING SYSTEM
Prudential norms were introduced for income recognition, asset
classification, provisioning for delinquent loans and for capital adequacy.
In order to reach the stipulated capital adequacy norms, substantial

capital wereprovided by the Government to PSBs.Government preemption of banks' resources through statutory liquidityratio (SLR) and
cash reserve ratio (CRR) brought down in steps. Interest rates
on the deposits and lending sides almost entirely were deregulated.
New private sector banks are allowed to promote and encourage
competition. PSBs were encouraged to approach the public for raising
resources. Recovery of debts due to banks and the Financial Institutions
Act,1993 was passed, and special recovery tribunals set up to facilitate
quicker recovery of loan arrears.
Bank lending norms liberalized and a loan system to ensure better
controlover credit introduced. Banks asked to set up asset liability
management(ALM) systems. RBI guidelines issued for risk management
systems in banksencompassing credit, market and operational risks.
A credit information bureau arebeing established to identify bad risks.
Derivative products such as forward rate agreements (FRAs) and
interest rateswaps (IRSs) introduced.
CAPITAL MARKET DEVELOPMENTS
The Capital Issues (Control) Act, 1947, repealed, office of the Controller
of Capital Issues were abolished and the initial share pricing were
decontrolled.SEBI, the capital market regulator was established in 1992.
Foreign institutional investors (FIIs) were allowed to invest in Indian
capitalmarkets after registration with the SEBI. Indian companies were
permitted toaccess international capital markets through euro issues.
The National Stock Exchange (NSE), with nationwide stock trading and
electronic display, clearing and settlement facilities was established.
Severallocal stock exchanges changed over from floor based trading to
screen basedtrading.
PRIVATE MUTUAL FUNDS PERMITTED
The Depositories Act had given a legal framework for the establishment
ofdepositories to record ownership deals in book entry form.
Dematerialisationof stocks encouraged paperless trading. Companies
were required to discloseall material facts and specific risk factors
associated with their projects while making public issues.
To reduce the cost of issue, underwriting by the issuer were made
optional, subject to conditions. The practice of making preferential
allotment ofshares at prices unrelated to the prevailing market prices

stopped and freshguidelines were issued by SEBI.SEBI reconstituted

governing boards of the stock exchanges, introducedcapital adequacy
norms for brokers, and made rules for making client orbroker relationship
more transparent which included separation of client and
broker accounts.
BUY BACK OF SHARES ALLOWED
The SEBI started insisting on greater corporate disclosures. Steps were
taken to improve corporate governance based on the report of a
committee.SEBI issued detailed employee stock option scheme and
employee stockpurchase scheme for listed companies.
Standard denomination for equity shares of Rs. 10 and Rs. 100 were
abolished. Companies given the freedom to issue dematerialized shares
in any denomination.
Derivatives trading start with index options and futures. A system of
rollingsettlements introduced. SEBI empowered to register and regulate
venturecapital funds.The SEBI (Credit Rating Agencies) Regulations,
1999 issued for regulatingnew credit rating agencies as well as
introducing a code of conduct for allcredit rating agencies operating in
India.
CONSOLIDATION IMPERATIVE
Another aspect of the financial sector reforms in India is the
consolidation of existing institutions which is especially applicable to the
commercial banks. In India the banks are in huge quantity. First, there is
noneed for 27 PSBs with branches all over India. A number of them can
bemerged. The merger of Punjab National Bank and New Bank of India
was adifficult one, but the situation is different now. No one expected so
manyemployees to take voluntary retirement from PSBs, which at one
time weremuch sought after jobs. Private sector banks will be self
consolidated whileco-operative and rural banks will be encouraged for
consolidation, andanyway play only a niche role.
In the case of insurance, the Life Insurance Corporation of India is a
behemoth, while the four public sector general insurance companies will
probably move towards consolidation with a bit of nudging. The UTI is
yet
again a big institution, even though facing difficult times, and most other
publicsector players are already exiting the mutual fund business. There

are anumber of small mutual fund players in the private sector, but the
businessbeing comparatively new for the private players, it will take
some time.We finally come to convergence in the financial sector, the
newbuzzword internationally. Hi-tech and the need to meet increasing
consumer needs is encouraging convergence, even though it has not
always been asuccess till date. In India organizations such as IDBI,
ICICI, HDFC and SBIare already trying to offer various services to the
customer under oneumbrella. This phenomenon is expected to grow
rapidly in the coming years.
Where mergers may not be possible, alliances between organizations
may beeffective. Various forms of bank assurance are being introduced,
with the RBIhaving already come out with detailed guidelines for entry of
banks intoinsurance. The LIC has bought into Corporation Bank in order
to spread itsinsurance distribution network. Both banks and insurance
companies havestarted entering the asset management business, as
there is a great deal of synergy among these businesses. The pensions
market is expected to openup fresh opportunities for insurance
companies and mutual funds.It is not possible to play the role of the
Oracle of Delphi when a vastnation like India is involved. However, a few
trends are evident, and thecoming decade should be as interesting as
the last one.
Indian banking system has been subject to widespread structural
reforms initiated since June 1991. This phase can be regarded as
"secondbanking revolution". Reform measures such as introduction of
new accountingand prudential norms, liberalization measures etc., are
heading towards atruly competitive and well structured banking system
resilient from aninternational perspective.Continued financial profligacy
of the Government coupled with closemonitoring and control rendered
the financial systems completely dependentand inefficient so much so
that by the year 1991, the situation was ripe fordrastic reforms. It was,
however, precipitated by the unprecedented economiccrisis which
engulfed the economy in 1991. For the first time in its history,India faced
the problem of defaulting on its international commitments. The
access to external commercial credit markets was completely denied;
International credit ratings had been downgraded and the international
financial communitys confidence in Indias ability to manage its
economy hadbeen severally eroded. The economy suffered from serious

inflationarypressures, emerging scarcities of essential commodities and

breakdown offiscial discipline.
The Government took swift action to restore international confidence in
the economy and redress the imbalances. Various macro-economic
structuralreformatory measures were undertaken in the field of foreign
trade, taxsystem, industrial policy and financial and other sectors. The
objective was toimprove the underlying strength of the economy, attempt
to ensure againstfuture crises and further the fundamental
developmental; objectives of growth with equity and self reliance.
NARASIMHAM COMMITTEE I (FIRST GENERATION REFORMS)
To restore the financial health of commercial banks and to make their
functioning efficient and profitable, the Government of India appointed a
committee called 'The Committee on Financed System' under the
chairmanship of Sri M. Narasimham, ex-Governor of Reserve Bank of
India which made recommendations in November 1991. The Committee
laid downa blue print of financial sector reforms, recognized that a
vibrant andcompetitive financial system was central to the wide ranging
structuralreforms. In order to ensure that the financial system operates
on the basis ofoperational flexibility and functional autonomy, with a view
to enhanceefficiency, productivity and profitability, the Committee
recommended a seriesof measures aimed at changes according greater
flexibility to bank operations,especially in Pointing out statutory
stipulations, directed credit program,improving asset quality, institution of
prudential norm, greater disclosures,better housekeeping, in terms of
accounting practices. In the words of BimalJalan, ex-Governor of RBI,
"the central bank is a set of prudential norm thatare aimed at imparting
strength to the financial institutions, and inducinggreater accountability
and market discipline. The norms include not onlycapital adequacy,
asset classifications and provisioning but also accountingstandards,
exposure and disclosure norms and guidelines for investment, risk
management and asset liability management." These recommendations
are alandmark in the evolution of banking system from a highly regulated
to moremarket-oriented system.
The reforms introduced since 1992-93 breathed a fresh air in the
banking sector. Deregulation and liberalization encouraged banks to go
in forinnovative measures, develop business and earn profits. These

reforms, theNarasimham Committee-I felt, will improve the solvency,

health and efficiencyof institutions. The measures were aimed at
(i) ensuring a degree of operational flexibility,
(ii) internal 'autonomy for public sector banks in their decision-making
process, and
(iii) greater degree of professionalism in banking operations
The Reserve Bank of India grouped the first phase of reform measures
into three main areas: Enabling measures, Strengthening measures and
Institutional measures. In other way, they can also be classified into five
different groups
(a) Liberalization measures,
(b) Prudential norms,
(c) Competition directed measures,
(d) Supportive measures, and
(e) Other measures.
(A) LIBERALIZATION MEASURES
Statutory Liquidity Ratio (SLR) /Cash Reserve Ratio (CRR): The SLR
and CRR measures were originally designed to give the RBI two
additionalmeasures of credit control, besides protecting the interests of
depositors.Under the SLR, commercial banks are required to maintain
with the RBIminimum 25 per cent of their total net demand and time
liabilities in the formof cash, gold and unencumbered eligible securities
(under the BankingRegulation Act, 1949). The RBI is capital adequacy
which have all beenimplemented.
(B) PRUDENTIAL NORMS
In April 1992, the RBI issued detailed guidelines on a phased
introduction ofprudential norms to ensure safety and soundness of
banks and impart greatertransparency and accounting operations. The
main objective of prudentialnorms is the strengthening financial stability
of banks.Inadequacy of capital is a serious cause for concern. Hence, as
per Basle Committee norms, the RBI introduced capital: adequacy
norms. It wasprescribed that banks should achieve a minimum of 4 per
cent capitaladequacy ratio in relation to risk weighted assets by March
1993, of which

Tier I capital should not be less than 2 per cent. The BIS standard of 8
percent should be achieved over a period of three years, that is, by
March 1996,For banks with international presence, it is necessary to
reach the figure evenearlier. Before arriving at the capital adequacy ratio
of each bank, it isnecessary that assets of banks should be evaluated on
the basis of theirrealizable value.
Those banks whose operations are profitable and which enjoy reputation
in the markets are all over to approach capital market for enhancement
of capital. In respect of others, the Government should meet the
shortfall by direct subscription to capital by providing loan.
As per the recommendations of the Narasimham Committee banks
cannot recognize income (interest income on advances) on assets
whereincome is not received within two quarters after it is past due. The
committee recommended international norm of 90 days in phased
mannerby 2002.
The assets are now classified on the basis ,of their performance into 4
categories:
(a) standard,
(b) sub-standard,
(c) doubtful, and
(d) loss assets.
Adequate provision is required to be made for bad and doubtful debts
(substandard assets). Detailed instructions for provisioning have been
laid
down. In addition, a credit exposure norm of 15 per cent to a single party
and40 per cent to a group has been prescribed. Banks have been
advised tomake their balance sheets transparent with maximum
'disclosure' on thefinancial health of institutions.
The Committee recommended provisioning norms for nonperforming
assets. On outstanding substandard assets 10 percent general provision
should be made (1992). On loss assets the permission shall be 100
percent.On secured portion of doubtful assets, the provision should be
20 to 50 percent.:"
(C) COMPETITION DIRECTED MEASURES
Since 1969 none bank had allowed to be opened in India. That policy

changed in January 1 1993 when the RBI announced guidelines for

openingof private sector banks public limited companies. The criteria for
setting up of new banks in private sector were: (a) capital of Rs. 100
crore, (b) mostmodern technologic, and (c) head office at a nonmetropolitan centre, InJanuary' 2001, paid-up capital of these banks was
increased to Rs. 200 crorewhich has to be raised to Rs. 300 crore within
a period of 3 years after thecommencement of business, The promoters
share in a bank shall not be lessthan 40 per cent. After the issue of
guidelines in 1993, 9 new banks have been set up in the private sector.
Foreign banks have also been permitted toset-up subsidiaries, joint
ventures or branches, Their number have increasedfrom 24 in 1991 to
42 in 2000 and their branch network increased from 140 to185 over the
same period.
Banks have also been permitted to rationalize their existing branches,
spinning off business at other centers, opening of specialized branches,
convert the existing non-urban rural branches into satellite offices. Banks
have also been permitted to close down branches other than in rural
areas.Banks attaining capital adequacy norms and prudential accounting
standardscan set-up new branches without the prior approval of RBI.
Tworecommendation of the Narasimham Committee was to abolish the
system ofbranch licensing and allow foreign banks free entry.
(D) SUPPORTIVE MEASURES
Revised format for balance sheet and profit and loss account reflecting
andactual health of scheduled banks were introduced from the
accounting year1991-92. There have also been changes in the
institutional framework. TheRBI evolved a risk-based supervision
methodology with international bestpractices. New Board of Financial
Supervision was set-up in the RBI totighten up the supervision of banks.
The system of external supervisionhas been revamped with the
establishment in November 1994 of the Boardof Financial Supervision
with the operational support of the Department ofBanking. supervision.
In tune with international practices of supervision, athree-tier supervisory
model comprising outside inspection, off-sitemonitoring and periodical
external auditing based on CAMELS (CapitalAdequacy, Asset quality,
Management, Earnings, Liquidity and Systemcontrols) had been put in
place. Special Recovery Tribunals are set-up to

expedite loan recovery process.21 The recent Securitization and

Reconstruction of Financial; Assets and Enforcement of Security
Interests(SARFAAESI) Act, 2002 enables the regulation of securitization
of andreconstruction of financial assets and enforcement of security
interests bysecured creditors. The Act will enable banks to dispose of
securities ofdefaulting borrowers to recover debt.
(E) OTHER MEASURES
The Banking Companies (Acquisition and Transfer of Undertaking) Act
was amended with effect from July 1994 permitting public sector banks
toraise capital up to 49 per cent from the public. There are number of
otherrecommendations of the Narasimham Committee such as reduction
in prioritysector landings, appointment of .special tribunals for speeding
up the processof loan recoveries, and reorganization of the rural credit
structure, all of whichneed detailed examination as these
recommendations have far-reachingimplications both in terms of the
structure of the financial system and also thefinancing required to
implement them.
The Committee proposed structural reorganization of the banking
sector which involves a substantial reduction of public sector banks
throughmergers and acquisitions. It proposed a pattern of
a) 3 or 4 large banks of international character,
b) 8 to 10 national banks engaged in "general or universal banking
c) local banks whose operation be confined to a specific areas, and
d) RRBs financing permanently agriculture I and allied activities. The
Government had not taken any decision regarding this suggestion.
RECOMMENDATIONS OF NARASIMHAM COMMITTEE I
The main recommendations of the Committee were :1. Reduction of Statutory Liquidity Ratio (SLR) to 25 percent over a
period of five
years
2. Progressive reduction in Cash Reserve Ratio (CRR)
80
3. Phasing out of directed credit programmes and redefinition of the
priority
sector
4. Deregulation of interest rates so as to reflect emerging market
conditions I

5. Stipulation of minimum capital adequacy ratio of percent to risk

weighted
assets by March 1993, 8 percent by March 1996, and 8 percent by those
banks having international operations by March 1994.
6. Adoption of uniform accounting practices in regard to income
recognition,
asset classification and provisioning against bad and doubtful debts
7. Imparting transparency to bank balance sheets and making more
disclosures
8. Setting up of special tribunals to speed up the process of recovery of
loans
9. Setting up of Asset Reconstruction Funds (ARFs) to take over from
banks a
portion of their bad and doubtful advances at a discount
10. Restructuring of the banking system, so as to have 3 or 4 large
banks, which
could become international in character, 8 to 10 national banks and local
banks confined to specific regions. Rural banks, including Regional
Rural
Banks (R.RBs), confined to rural areas.
11. Setting up one or more rural banking subsidiaries by Public Sector
Banks
12. Permitting RRBs to engage in all types of banking business
13. Abolition of branch licensing
14. Liberalizing the policy with regard to allowing foreign banks to open
offices in
India.
15. Rationalisation of foreign operations of Indian banks
16. Giving freedom to individual banks to recruit officers
17. Inspection by supervisory authorities based essentially on the
internal audit
and inspection reports.
18. Ending duality of control over banking system by Banking Division
and RBI
19. A separate authority for supervision of banks and financial institutions
which
would be a semi-autonomous body under RBI

20. Revised procedure for selection of Chief Executives and Directors of

Boards
of public sector banks
21. Obtaining resources from the market on competitive terms by DFIs
22. Speedy liberalization of capital market
23. Supervision of merchant banks, mutual funds, leasing companies
etc., by a
separate agency to be set up by RBI and enactment of a separate
legislation
providing appropriate legal framework for mutual funds and laying down
prudential norms for these institutions, etc.
Several recommendations have been accepted and are being
implemented in a phased manner. Among these are the reductions
SLR/CRR,
adoption of prudential norms for asset classification and provisions,
introduction of capital adequacy norms, and deregulation of most of the
interest rates, allowing entry to new entrants in private sector banking
sector,
etc.
IMPACT OF FIRST GENERATION REFORMS
The visible impact of first generation reforms may be summarized as
follows:
(i) The banking system is well diversified with the establishment
of new private banks and about 20 new foreign banks after
1993. The entry of modern, professional private sector banks
and foreign banks has enhanced competition. With the
deregulation of interest rates both for advances as well as
deposits, competition between different bank groups and
between banks in the same group has become intense. What
is more important is that apart from growth of banks and
commercial banking, various other financial intermediaries like
mutual funds, equipment leasing and hire purchase
companies, housing finance companies etc., which are
sponsored by banks have cropped up.
(ii) Finance regulation through statutory preemptions has been
lowered while stepping up of the prudential regulations.

(iii) Steps have been taken to strengthen PSBs through increasing

their autonomy, recapitalization, etc. Based on specified
criteria nationalized banks were given: autonomy in the
matters of creation, abolition, up- gradation of posts for their
administrative officers up to the level of Deputy General
Manager. Rs. 10,987.12 crore for capitalization funds were
pumped into banks during 1993-95. This indicates the extent
of capital erosion faced by the nationalized banks.
(iv) A set of micro-prudential measures have been stipulated with
regard to capital adequacy, asset classification, provisioning,
accounting rules, valuation norms, etc. CRAR (Per cent to the
risk weighted assets) of banks stood at 8 per cent. The
percentage of Net NPAS to net advances of PSBs has
declined from 14.4 per cent in 1993-94 to 8.5 per cent by
1997-98. The prudential norms have been significantly
contributed towards improvement in pre-sanction appraisal
and post-sanction appraisal and control, the impact of which is
clearly seen in the decrease in fresh addition of performing
accounts into the NPA category. As per RBI Report on
Currency and Finance consequent upon prudential norms, the
most visible structural change has been improvement in asset
quality.
(v) Measures have been taken to broaden the ownership base of
PSBs by allowing them]o approach the capital market. The
Government of India, in a major policy announcement, decided
to reduce its stake in PSBs from 100 per cent to 51 per cent
retaining, however, the policy parameters of PSBs. The
Government proposes to reduce further its stake to 33 per
cent. Moreover, there is a provision for foreign investments to
the extent of 20 per cent. The net result of the dilution in
ownership of PSBs is that these banks are becoming slowly
joint sector banks. A number of PSBs like State Bank of India,
Andhra Bank, Bank of Baroda, Canara Bank, Punjab National
Bank have gone up for public issue since 1994.
(vi) Mergers and acquisitions have been taking place in the
banking sector. In the past, due to the existence of a large
83

number of small non-viable banks, the RBI encouraged larger

of small banks with big banks. Now, market driven mergers
between private banks have been taking place.
(vii) As intense competition becomes a way of doing, banks have
to pay attention to customer service. Product innovations and
process engineering are the order of the day. Since interest
income has fallen with lowering of interest rates on advances,
banks have to look for enhancing fee-based income, to fill the
gap in interest income. Banks have therefore been mooring
towards providing value added services to customers. Under
the impact of technological up-gradation and financial
innovations, banks have now become super markets one stop
shop of varied financial services.
The set of measures, coupled with many others, did have a positive
impact on the system. There has been considerable improvement in
profitability of the banking system. There has been improvement in key
financial indicators of all bank groups during the period 1992-98. For
example,the net profits of the scheduled commercial banks as a
percentage of the totalassets has been turned around from a negative
figure of 1.0 per cent onaverage during 1992-93 and 1993-94 to a
positive of 0.5 per cent during1994-95 to 1997-98. Simply, net profits as
a percentage of working fundswhich was 0.39 per cent in 1991-92 and
(-)1.08 per cent in 1992-93 turnedpositive in 1994-95 and reached 0.81
per cent by 1997-98.In case of most of the public sector banks business
per employee andprofit per employee have shown improvement in the
recent period, For egg.,in 1991-92 the average profit per employee of
PSBs ,vas Rs. 1.58 crore, itbecame positive in 1996-97 at Rs. 0.35 crore
It further improved to Rs, 0.59crore by 1999-2000 and Rs. 1.63 crore in
2002-03. By 1997, almost all publicsector banks achieved the minimum
capital adequacy norms of 8 per cent.The gross and net NPAs of
banking system as a percentage ofadvances have dec1ined to 16 per
cent and 8.2 per cent respectively byMarch 1998, In terms of percentage
of total assets, gross and net nonperforming assets have declined to 7.0
per cent and 3.3 per cent respectivelyby March 1998.
As the second report of Narasimham Committee has observed, "this
improvement has arrested the deterioration in these parameters that had
marked the functioning of the system earlier. There is still a considerable

distance to traverse. The process of strengthening the banking system

has tobe viewed as a continuing process.
NARASIMHAM COMMITTEE-II (1998)(SECOND GENERATION
REFORMS)
The recommendations of Narasimham Committee-I (1991) provided
blueprint for first generation reforms of the financial sector. The period
1992-97 witnessed laying of the foundations for reforms of the banking
system.26It also saw the implementation of prudential norms relating to
capitaladequacy, asset classification, income recognition and
provisioning,exposure norms, etc. The difficult task of ushering in some
of the structuralchanges accomplished during this period provided the
bedrock for futurereforms. In fact, India withstood the contagion of 1997
(South-East Asiacrisis) indicates the stability of the banking system
Against such a backdrop,the Report of the Narasimham Committee-II in
1998 provided the road mapfor the second-generation reform process.
Two points are worth noting atthis juncture. First, the financial sector
reforms were undertaken in the earlyreform cycle, and secondly, the
reforms in the financial sector were initiatedin well structured, sequenced
and phased manner with cautious and propersequencing, mutually
reinforcing measures; complementarily between
reforms in the banking sector and changes in the fiscal, external and
monetary policies, developing financial infrastructure; and developing
financial markets. The Government appointed a second high-level
Committee on Banking Sector Reforms under the chairmanship' of Mr.
Narasimham to "review the progress of banking sector reforms to date
andchart a programme of financial sector reforms necessary to
strengthen theIndian Financial System and make it internationally
competitive.TheCommittee in its report (April 1998) made wide-ranging
recommendationscovering entire gamut of issues ranging from capital
adequacy, assetquality, NPAs, prudential norms, asset-liability
management, earnings andprofits, mergers and acquisitions, reduction
in government shareholdings to33 per cent in public sector banks, the
creation of gIobal-sized banks,recasting banks boards to revamping
banking legislation.
The second generation reforms could be conveniently looked at in
terms of three broad inter-related issues:
(i) measures that need to be taken to strengthen the

foundations of the banking system,

(ii) related to this, streamlining procedures, upgrading"
technology and human resource development, and
(iii) structural changes in the system. These would cover
aspects of banking policy, institutional, supervisory and
legislative dimensions.
The important recommendation of the Committee may be stated as
under:
A. MEASURES TO STRENGTHEN THE BANKING SYSTEM
(i) Capital Adequacy
The Committee set new an(t. Higher norms of capital adequacy. It
recommended that the "minimum capital to risk assets ratio be increased
to10 per cent from its present level of 8 per cent in a phased manner -9
per centto be achieved by the year 2000 and the ratio of 10 per cent by
2002. The RBIshould have authority to rise further in respect of
individual banks if in its
judgment the situation warrants such increase.
(ii) Asset Quality NPAs and Directed Credit
The Committee recommended that and asset be classified as doubtful
if it is in the substandard category for 18 months in the first instance and
eventually 12 months and loss of it has been identified but not written
off.Advances guaranteed by the government should also be treated as
NPAs.Banks should avoid the practice 9f 'ever greening' by making fresh
advance tothe troubled parties with a view to settle interest dues and
avoiding such loanstreating as NPAs. The Committee believes that the
objective should be toreduce the average level of net NPAs for all banks
to below 5 per cent by theyear 2000 and to .3 per cent by 2002. For
banks with international presence,the minimum objective should be to
reduce gross NPAs to 5 per cent and 3per cent by 2000 and 2002
respectively and net NPA and to 3 per cent and 0per cent by these
dates. For banks with a high NPA portfolio, the Committeesuggested the
setting up of an Asset Reconstruction Company to take overbad debts.
(iii) Prudential Norms and Disclosure Requirements
It recommended moving to international practice for income recognition
and recommended 90 days norm in a phased manner by the year 2002.
Infuture income recognition, asset classification and provisioning must
applyeven to government guaranteed advances.

Banks should pay greater attention to asset liability' management to

avoidmismatches.
B. SYSTEMS AND METHODS IN BANKS
The internal control systems which are internal inspection and audit,
including concurrent audit submission of controls returns by banks and
controlling offices to higher level offices, risk management system, etc.
should
be strengthened. There are recommendations for inducting an additional
whole time director on the board of the banks, recruitment of skilled
manpower, revising remuneration to persons at managerial level, etc.
C. STRUCTURAL ISSUES
(i) Mergers
The Committee is of the view that the convergences of activities
between bank and DFIs, the DFIs over a period of time convert
themselvesinto banks. There will be only two forms of financial
intermediarys banks andnon-bank financial companies. Mergers
between banks and between banksand DFIs and NBFCs need to base
on synergies and location and businessspecific complementarities of the
concerned institutions. Merger of publicsector banks should emanate
from the management of banks, thegovernment playing supportive role.
Mergers should not be seen as bailingout weak banks. Mergers between
strong banks would make for greatereconomic and commercial sense
and would be a case where the whole is greater than the sum of parts
and have a 'force multiplied effect',
(ii) Weak Banks
A weak bank should be one whose accumulated losses and net NPAs
exceed its net worth or one whose operating profits less, its income on
recapitalization bonds is negative for three consecutive years. A case-bycaseexamination of weak banks should be undertaken to identify those
that arepotentially viable with a programme of financial and operational
restructuring.Such banks should be nurtured into healthy units by
eschewing high costfunds, confinement of expenditure recovery
initiatives, etc. Mergers should beallowed only after they clean up their
balance sheets.
(iii) Narrow Banks
Those banks, which have become weak because of high proportion of
NPAs (20 per cent of the total assets in some cases), the Committee

recommended the concept of 'Narrow banking'. Narrow banking implies

thatthe weak banks place their funds in the short-term risk-free assets.
(iv) New Banks
The Committee also recommended the policy of permitting new private
banks. It is also of the view that foreign banks may be allowed to set-up
subsidiaries or joint ventures in India. They should be treated on par with
private banks and subject to the same conditions in the regard to
branchesand directed credit as other banks.
(v) Need for Stronger Banks
The Committee made out a strong case for stronger banking system in
the country, especially in the context of capital account convertibility,
whichwould involve large inflows, and outflows of capital and
consequentcomplications for exchange rate management and domestic
stability. TheCommittee therefore recommended winding up of unhealthy
banks andmerger of strong and weak banks.
(vi) Banking Structure
The Committee has argued for the creation of 2 or 3 banks of
international standard and 8 or 10 banks at the national level. It also
suggested the setting up of small local banks, which would be confined
to alimited area to serve local trade, small industry and agriculture at the
sametime these banks will have corresponding relationship with the
large nationaland international banks.
(vii) Local Area Banks
In the 1996-97 budget, the Government of India announced the setting
up of new Private Local Area Banks (LABs) with jurisdiction over three
contiguous districts. This banker will help in mobilizing rural saving and
inchanneling them into investment in local areas. The RBI has issued
guidelinesfor setting up such banks in 1996 and gave its approval 'in
principle' to thesting up of seven LABs in the private sector. Of these,
RBI had issuedlicenses to 5 LABs, located in Andhra Pradesh,
Karnataka, Rajasthan, Punjaband Gujarat. These LABs have
commenced business.
(viii) Public Ownership and Autonomy
The Committee argued that the government ownership and
management of banks does not enhance autonomy and flexibility in the
working of public sector banks. In this connection, the Committee

recommended a review of functions of boards so that they remain

responsibleto the shareholders. The management boards are to be
reorganized and theyshall not be any government interference.
(ix) Review of Banking Laws
The Committee suggested the need to review and amend the
provisions of RBI Act, SBI Act, Banking Regulation Act, and Banking
Nationalization Act, etc. so as to bring them in line with the current needs
of the industry.
Other recommendations pertain to computerization process,permission
to establish private sector banks, setting up of Board of
FinancialRegulation and Supervision and increasing the powers of debt
recoverytribunals.
To summarize, the major recommendations were:
1. Capital adequacy requirements should take into account market risks
also
2. In the next three years, entire portfolio of Govt. securities should be
marked to
market
3. Risk weight for a Govt. guaranteed account must be 100%
4. CAR to be raised to 10% from the present 8%; 9% by 2000 and 10%
by 2002
5. An asset should be classified as doubtful if it is in the sub-standard
category
for 18 months instead of the present 24 months
6. Banks should avoid ever greening of their advances .
7. There should be no further re-capitalization by the Govt.
8. NPA level should be brought down to 5% by 2000 and 3% by 2002
9. 9. Banks having high NPA should transfer their doubtful and loss
categories to
Asset Reconstruction Company (ARC) which would issue Govt. bonds
representing the realizable value of the assets.
10. We should move towards international practice of income recognition
by
introduction of the 90 day norm instead of the present 180 days.
11. A provision of 1% on standard assets is required.
12. Govt. guaranteed accounts must also be categorized as NPAs under
the

usual norms
13. Banks should update their operational manuals which should form
the basic
document of internal control systems.
14. There is need to institute an independent loan review mechanism
especially
for large borrower accounts to identify potential NPAs.
90
15. Recruitment of skilled manpower directly from the market be given
urgent
consideration
16. To rationalize staff strengths, an appropriate VRS must be
introduced.
17. A weak bank should be one whose accumulated losses and net
NPAs exceed
its net worth or one whose operating profits less its income on recap
bonds is
negative for 3 consecutive years.
The Narsimham Committee seeks to consolidate the gains made in the
Indian financial sectors while improving the quality of portfolio, providing
greater operational flexibility, autonomy in the internal operations of the
banksand FIs so to nurture in, a healthy competitive and vibrant financial
sector.
REVIEW OF BANKING SECTOR REFORMS:
In line with the recommendations of the second Narasimham
Committee, the Mid-Term Review of the Monetary and Credit Policy of
October 1999 announced a gamut of measures to strengthen the
bankingsystem. Important measures on strengthening the health of
banks included:
(i)
assigning of risk weight of 2.5 per cent to cover market risk in respect of
investments in securities outside the SLR by March 31, 2001 (over and
abovethe existing 100 per cent risk weight) in addition to a similar
prescription forGovernment and other approved securities by March 31,
2000, and (ii)

lowering of the exposure ceiling in respect of an individual borrower from

25per cent of the banks capital fund to 20 per cent, effective April 1,
2000.
CAPITAL ADEQUACY AND RECAPITALISATION OF BANKS
Out of the 27 public sector banks (PSBs), 26 PSBs achieved the
minimum capital to risk assets ratio (CRAR) of 9 per cent by March
2000. Of this, 22 PSBs had CRAR exceeding 10 per cent. To enable the
PSBs tooperate in a more competitive manner, the Government adopted
a policy ofproviding autonomous status to these banks, subject to certain
benchmarks.As at endMarch 1999, 17 PSBs became eligible for
autonomous status.
PRUDENCIAL ACCOUNTING NORMS FOR BANKS The Reserve Bank persevered with the ongoing process of
strengthening prudential accounting norms with the objective of
improving thefinancial soundness of banks and to bring them at par with
internationalstandards. The Reserve Bank advised PSBs to set up
Settlement AdvisoryCommittees (SACs) for timely and speedier
settlement of NPAs in the smallscale sector, viz., small scale industries,
small business including trading andpersonal segment and the
agricultural sector. The guidelines on SACs wereaimed at reducing the
stock of NPAs by encouraging the banks to go in forcompromise
settlements in a transparent manner. Since the progress in the
recovery of NPAs has not been encouraging, a review of the scheme
wasundertaken and revised guidelines were issued to PSBs in July 2000
toprovide a simplified, non-discriminatory and non-discretionary
mechanism forthe recovery of the stock of NPAs in all sectors. The
guidelines will remainoperative till March 2001. Recognising that the high
level of NPAs in the PSBscan endanger financial system stability, the
Union Budget 2000-01 announcedthe setting up of seven more Debt
Recovery Tribunals (DRTs) for speedyrecovery of bad loans. An
amendment in the Recovery of Debts Due to Banksand Financial
Institutions Act, 1993, was effected to expedite the recovery
process.
ASSET LIABILITY MANAGEMENT (ALM) SYSTEM The Reserve Bank advised banks in February 1999 to put in place an
ALM system, effective April 1, 1999 and set up internal asset liability

management committees (ALCOs) at the top management level to

oversee itsimplementation. Banks were expected to cover at least 60 per
cent of theirliabilities and assets in the interim and 100 per cent of their
business by April1, 2000. The Reserve Bank also released ALM system
guidelines in January2000 for all-India term-lending and refinancing
institutions, effective April l,2000. As per the guidelines, banks and such
institutions were required toprepare statements on liquidity gaps and
interest rate sensitivity at specifiedperiodic intervals.
RISK MANAGEMENT GUIDELINES The Reserve Bank issued detailed guidelines for risk management
systems in banks in October 1999, encompassing credit, market and
operational risks. Banks would put in place loan policies, approved by
theirboards of directors, covering the methodologies for measurement,
monitoringand control of credit risk. The guidelines also require banks to
evaluate theirportfolios on an on-going basis, rather than at a time close
to the balancesheet date. As regards off-balance sheet exposures, the
current and potentialcredit exposures may be measured on a daily basis.
Banks were also askedto fix a definite time-frame for moving over to the
Value-at-Risk (VaR) andduration approaches for the measurement of
interest rate risk. The bankswere also advised to evolve detailed policy
and operative framework foroperational risk management. These
guidelines together with ALM guidelineswould serve as a benchmark for
banks which are yet to establish anintegrated risk management system.
DISCLOSURE NORMS As a move towards greater transparency, banks were directed to
disclose the following additional information in the Notes to accounts in
thebalance sheets from the accounting year ended March 31, 2000: (i)
maturitypattern of loans and advances, investment securities, deposits
andborrowings, (ii) foreign currency assets and liabilities, (iii) movements
in NPAsand (iv) lending to sensitive sectors as defined by the Reserve
Bank from timeto time.
TECHNOLOGICAL DEVELOPMENTS IN BANKING India, banks as well as other financial entities have entered domain of
information technology and computer networking. A satellite-based Wide
AreaNetwork (WAN) would provide a reliable communication framework
for thefinancial sector. The Indian Financial Network (INFINET) was

inaugurated inJune 1999. It is based on satellite communication using

VSAT technology andwould enable faster connectivity within the financial
sector. The INFINETwould serve as the communication backbone of the
proposed IntegratedPayment and Settlement System (IPSS). The
Reserve Bank constituted a
National Payments Council (Lnairman: Shri S. P. Talwar) in 1999-2000
tofocus on the policy parameters for developing an IPSS with a real time
grosssettlement (RTGS) system as the core.
REVIVAL OF WEAK BANKS The Reserve Bank had set up a Working Group (Chairman: Shri S.
Verma) to suggest measures for the revival of weak PSBs in February
1999.
The Working Group, in its report submitted in October 1999, suggested
thatan analysis of the performance based on a combination of seven
parameters covering three major areas of (i) solvency (capital adequacy
ratio and
coverage ratio), (ii) earnings capacity (return on assets and net interest
margin) and (iii) profitability (operating profit to average working funds,
cost to
income and staff cost to net interest income plus all other income) could
serveas the framework for identifying the weakness of banks. PSBs
were,accordingly, classified into three categories depending on whether
none, all orsome of the seven parameters were met. The Group primarily
focused onrestructuring of three banks, viz., Indian Bank, UCO Bank and
United Bank ofIndia, identified as weak as they did not satisfy any (or
most) of the sevenparameters. The Group also suggested a two-stage
restructuring process,whereby focus would be on restoring competitive
efficiency in stage one, withthe options of privatization and/or merger
assuming relevance only in stagetwo.
Deposit Insurance
Reforms.Reforming the deposit insurance system, as observed by the
Narasimham Committee (1998), is a crucial component of the present
phaseof financial sector reforms in India. The Reserve Bank constituted
a WorkingGroup (Chairman: Shri Jagdish W. Kapoor) to examine the
issue of depositinsurance which submitted its report in October 1999.
Some of the majorrecommendations of the Group are : (i) fixing the
capital of the DepositInsurance and Credit Guarantee Corporation

(DICGC) at Rs. 500 crore,contributed fully by the Reserve Bank, (ii)

withdrawing the function of creditguarantee on loans from DICGC and
(iii) risk-based pricing of the depositinsurance premium in lieu of the
present, flat rate system. A new law, insupersession of the existing
enactment, is required to be passed in order toimplement the
recommendations. The task of preparing the new draft law has
been taken up. The relevant proposals in this respect would be
forwarded to the Government for consideration.
Banking Reform in India
1 Introduction
Measured by share of deposits, 83 percent of the banking business in
India is in the hands ofstate or nationalized banks, which are banks that
are owned by the government, in some, increasinglyless clear-cut way.
Moreover, even the non-nationalized banks are subject to extensive
regulations on who they can lend to, in addition to the more standard
prudential regulations.
Government control over banks has always had its fans, ranging from
Lenin to Gerschenkron.While there are those who have emphasized the
political importance of public control overbanking, most arguments for
nationalizing banks are based on the premise that profit maximizing
lenders do not necessarily deliver credit where the social returns are the
highest. The Indiangovernment, when nationalizing all the larger Indian
banks in 1969, argued that banking wasinspired by a larger social
purpose and must subserve national priorities and objectives such
as rapid growth in agriculture, small industry and exports.1
There is now a body of direct and indirect evidence showing that credit
markets in developingcountries often fail to deliver credit where its social
product might be the highest, and bothagriculture and small industry are
often mentioned as sectors that do not get their fair share ofcredit. If
nationalization succeeds in pushing credit into these sectors, as the
Indian government
claimed it would, it could indeed raise both equity and efficiency.
The cross-country evidence on the impact of bank nationalization is not
very encouraging.

For example, La Porta et. al. find in a cross-country setting that

government ownership of banks is negatively correlated with both
financial development and economic growth. Theyinterpret this as
support for their view, which holds that the potential benefits of public
ownershipof banks, and public control over banks more generally, are
swamped by the costs thatcome from the agency problems it creates:
cronyism, leading to the deliberate misallocation ofcapital, bureaucratic
lethargy, leading to less deliberate, but perhaps equally costly errors in
theallocation of capital, as well as inefficiency in the process of
mobilizing savings and transformingthem into credit.Unfortunately the
interpretation of this type of cross-country analysis is never easy, and
never more so than the case of something like bank nationalization,
which typically occurs as part of a package of other policies. For
example, Bertrand et. al. study a 1985 banking
deregulation in France, which gave banks much greater freedom to
compete for clients.Theyfind that deregulated banks respond more to
profitability when making lending decisions. After
the reform, firms that suffer a negative shock are much more likely to
undertake restructurinmeasures, and there is more entry and exit in
bank-dependent industries.Micro studies of the effect of bank
nationalization are rare: an important exception is Mianwho examines
the privatization of a large public bank in Pakistan in 1991.5 He finds
that theprivatized bank does a better job both at choosing profitable
clients and monitoring existingclients, than the commercial banks that
remained public.Our previous paper uses micro data from a nationalized
bank to evaluate the effectiveness ofthe Indian banking system in
delivering credit.6 The conclusion from that paper was that the
Indian financial system is characterized by under-lending in the sense
that there are many firms that could earn large profits if they were given
access to credit at the current market prices.
This paper builds on the previous work with the aim of using that
evidence and evidencefrom other research by ourselves and others, to
come to an assessment of the appropriate roleof the Indian government
vis a vis the banking sector. We first provide a very brief history of
banking in India.

there is substantial under-lending in India. To understand what role

public ownership of banksmay play in underlending, we identify
differences between public and private banks in the sectoral
allocation of credit between public and private banks. In particular, we
focus on the question ofwhether being nationalized has made these
banks more responsive to what the Indian governmentwants them to do.
We report results, based on work by Cole showing that on many of the
declaredobjectives of social banking, the private banks were no less
responsive than the comparablenationalized banks, with the exception of
agricultural lending. Finally, the last sub-section
compares the performance of public and private banks as financial
intermediaries and concludesthat the public banks have been less
aggressive than private banks both in lending, in attractingdeposits and
in setting up branches, at least since 1990.In section 4, we dig deeper
into the lending processes used by the nationalized banks, in an
attempt to understand under-lending. We find that official lending policy
is very rigid. Moreover,loan officers do not appear to use what little
flexibility they have. We argue that the evidencesuggests that bankers in
the public sector have a preference for what we may call passive
lending.
To understand why this is the case, we examine the incentives and
constraints faced by publicloan officers. We focus on whether vigilance
activity impedes lending, and whether public sectorbanks prefer to lend
to the government, rather than private firms.
The penultimate section compares the performance of public and private
banking in twoother areas. First, we examine how nationalization of
banks has affected the availability of bankbranches in rural areas, and
find that, if anything, nationalization appears to have inhibited the
growth of rural branches. Second, we try to say something about the
sensitive issue of NPAsand bailouts. While the dataset we have now is
sparse, it appears that the bailouts of thepublic banks have proved more
expensive for the government, but once we control for differencesin size
between the public and private banks, it is less clear-cut.
We conclude in section 6 with a short discussion of the implications of
these results for thefuture of banking reform.
2 Background

India has a long history of both public and private banking. Modern
banking in India began inthe 18th century, with the founding of the
English Agency House in Calcutta and Bombay. In the
first half of the 19th century, three Presidency banks were founded. After
the 1860 introductionof limited liability, private banks began to appear,
and foreign banks entered the market. Thebeginning of the 20th century
saw the introduction of joint stock banks. In 1935, the presidency
banks were merged together to form the Imperial Bank of India, which
was subsequently renamedthe State Bank of India. Also that year,
Indias central bank, the Reserve Bank of India (RBI),began operation.
Following independence, the RBI was given broad regulatory authority
overcommercial banks in India. In 1959, the State Bank of India acquired
the state-owned banks ofeight former princely states. Thus, by July
1969, approximately 31 percent of scheduled bankbranches throughout
India were government controlled, as part of the State Bank of India.
The post-war development strategy was in many ways a socialist one,
and the Indian government
felt that banks in private hands did not lend enough to those who needed
it most. InJuly 1969, the government nationalized all banks whose
nationwide deposits were greater thanRs. 500 million, resulting in the
nationalization of 54 percent more of the branches in India,and bringing
the total number of branches under government control to 84 percent.
Prakesh Tandon, a former chairman of the Punjab National Bank
(nationalized in 1969)
describes the rationale for nationalization as follows:
Many bank failures and crises over two centuries, and the damage they
did underlaissez faire conditions; the needs of planned growth and
equitable distribution ofcredit, which in privately owned banks was
concentrated mainly on the controllingindustrial houses and influential
borrowers; the needs of growing small scale industryand farming
regarding finance, equipment and inputs; from all these there emerged
an inexorable demand for banking legislation, some government control
and a centralbanking authority, adding up, in the final analysis, to social
control and nationalization.
After nationalization, the breadth and scope of the Indian banking sector
expanded at a rateperhaps unmatched by any other country. Indian

banking has been remarkably successful atachieving mass participation.

Between the time of the 1969 nationalizations and the present,
over 58,000 bank branches were opened in India; these new branches,
as of March 2003, hadmobilized over 9 trillion Rupees in deposits, which
represent the overwhelming majority ofdeposits in Indian banks.9. This
rapid expansion is attributable to a policy which requiredbanks to open
four branches in unbanked locations for every branch opened in banked
locations.
Between 1969 and 1980, the number of private branches grew more
quickly than public banks,and on April 1, 1980, they accounted for
approximately 17.5 percent of bank branches in India.
In April of 1980, the government undertook a second round of
nationalization, placing undergovernment control the six private banks
whose nationwide deposits were above Rs. 2 billion,or a further 8
percent of bank branches, leaving approximately 10percent of bank
branches inprivate hands. The share of private bank branches stayed
fairly constant between 1980 to 2000.Nationalized banks remained
corporate entities, retaining most of their staff, with the exception
of the board of directors, who were replaced by appointees of the central
government.
The political appointments included representatives from the
government, industry, agriculture,as well as the public. (Equity holders in
the national bank were reimbursed at approximately
par).Since 1980, has been no further nationalization, and indeed the
trend appears to be reversingitself, as nationalized banks are issuing
shares to the public, in what amounts to a step towardsprivatization. The
considerable accomplishments of the Indian banking sector
notwithstanding,advocates for privatization argue that privatization will
lead to several substantial improvements.
Recently, the Indian banking sector has witnessed the introduction of
several new privatebanks, either newly founded, or created by
previously extant financial institutions. The newprivate banks have grown
quickly in the past few years, and one has grown to be the secondlargest
bank in India. India has also seen the entry of over two dozen foreign
banks since thecommencement of financial reforms. While we believe
both of thesetypes of banks deserve study,our focus here is on the older

private sector, and nationalized banks, since they represent

theoverwhelming majority of banking activity in India.
The Indian banking sector has historically suffered from high
intermediation costs, due inno small part to the staffing at public sector
banks: as of March 2002, there were 1.17 crores ofdeposits per
employee in nationalized banks, compared to 2.05 crores per employee
in privatesector banks. As with other government-run enterprises,
corruption is a problem for public sectorbanks: in 1999, there were 1,916
cases which attracted attention from the Central VigilanceCommission.
While not all of these represent crimes, the investigations themselves
may have aharmful effect, if bank officers fear that approving any risky
loan will inevitably lead to scrutiny.Advocates for privatization also
criticize public sector banking as unresponsive to credit needs.
In the rest of the paper, we use recent evidence on banking in India to
shed light on therelative costs and benefits of nationalized banks.
Throughout this exercise, it is important to bearin mind that the Indian
banking sector is going through something like a transformation. Thus,
it is potentially a dangerous time to evaluate its performance using
historical data. Nevertheless,
data from the past is all we have, and we believe things are not
changing so quickly that the
lessons learned are not useful.
3 Quality of Intermediation
3.1 Is there under-lending?
3.1.1 Identifying under-lending
A firm is getting too little credit if the marginal product of capital in the
firm is higher than therate of interest the firm is paying on its marginal
rupee of borrowing. Under-lending therefore isa characteristic of the
entire financial system: the firm has not been able to raise enough
capitalfrom the market as a whole. In other words, while we will focus on
the clients of a public sectorbank, if these firms are getting too little credit
from that bank, they should in theory have theoption of going elsewhere
for more credit. If they do not or cannot exercise this option, the
market cannot be doing what, in its idealized form, we would have
expected it to do.
However, we know that the Indian financial system does not function as
the ideal credit

market might. Most small or medium firms have a relationship with one
bank, which they havebuilt up over some timethey cannot expect to
walk into another bank and get as much creditas they want. For that
reason, their ability to finance investments they need to make does
depend on the willingness of that one bank to finance them. In this
sense the results we report
below might very well reflect the specificities of the public sector banks,
or even the one bankthat was kind enough to share its data with us,
though given that it is seen as one of the bestpublic sector banks, it
seems unlikely that we would find much better results in other banks in
its category. On the other hand we do not have comparable data from
any private bank andtherefore cannot tell whether under-lending is as
much of a problem for private banks. We will,however, later report some
results on the relative performance of public and private banks in
terms of overall credit deliveryOur identification of credit constrained
firms is based on the following simple observation:
if a firm that is not credit constrained is offered some extra credit at a
rate below what it ispaying on the market, then the best way to make use
of the new loan must be to pay down thefirms current market borrowing,
rather than to invest more. This is because, by the definition
of not being credit constrained, any additional investment will drive the
marginal product ofcapital below what the firm is paying on its market
borrowing. It follows that a firm that isnot facing any credit constraint will
expand its investment in response to additional subsidized
credit becoming available, only if it has no more market borrowing. By
contrast, a firm that iscredit constrained will always expand its
investment to some extent.A corollary to this prediction is that for
unconstrained firms, growth in revenue should be
slower than the growth in subsidized credit. This is a direct consequence
of the fact that firmsare substituting subsidized credit for market
borrowing. Therefore, if we do not see a gap inthese growth rates, the
firm must be credit constrained. Of course, revenue could increase
slowerthan credit even for non-constrained firms, if the technology has
declining marginal return tocapital.
These predictions are more robust than the traditional way of measuring
credit constraintsas the excess sensitivity of investment to cash flow.

The evidence for under-lending

Data: The data we use were obtained from one of the better-performing
Indian public sectorbanks. We use data from the loan folders maintained
by the bank on profit, sales, credit linesand utilization, and interest rates.
The loan folders also report all numbers that the banker was
required to calculate (e.g. his projection of the banks future turnover, his
calculation of thebanks credit needs, etc.) in order to determine the
amount to be lent. We also record these,
and will make use of them in the analysis described in the next section.
We have data on 253firms (including 93 newly eligible firms). The data is
available for the entire 1997 to 1999 periodfor 175 of these firms.
Specification Through much of this section we will estimate an equation
of the form yit yit1 = yBIGi + yPOSTt + yBIGi POSTt + yit, (1)
with y taking the role of the various outcomes of interest (credit, revenue,
profits, etc.) and thedummy POST representing the post January 1998
period. We are in effect comparing how theoutcomes change for the big
firms after 1998, with how they change for the small firms. Sincey is
always a growth rate, this is, in effect, a triple differencewe can allow
small firms and bigfirms to have different rates of growth, and the rate of
growth to differ from year to year, butwe assume that there would have
been no differential changes in the rate of growth of small and
large firms in 1998, absent the change in the priority sector regulation.
Using, respectively, the log of the credit limit and the log of next years
sales (or profit) inplace of y in equation 1, we obtain the first stage and
the reduced form of a regression of sales
on credit, using the interaction BIG POST as an instrument for credit.
We will present the
corresponding instrumental variable regressions.
Results: The change in the regulation certainly had an impact on who
got priority sector
credit. The credit limit granted to firms below Rs. 6.5 million in plant and
machinery (henceforth,
small firms) grew by 11.1 percent during 1997, while that granted to firms
between Rs.6.5
million and Rs. 30 million (henceforth, big firms), grew by 5.4 percent. In
1998, after the change

in rules, small firms had 7.6 percent growth while the big firms had 11.3
percent growth.

Bank Ownership and Sectoral Allocation of Credit

As mentioned above, an important rationale for the Indian bank
nationalizations was to direct
credit towards sectors the government thought were underserved,
including small scale industry,
as well as agriculture and backward areas. Ownership was not the only
means of directing
credit: the Reserve Bank of India issued guidelines in 1974, indicating
that both public and
private sector banks must provide at least one-third of their aggregate
advances to the priority
sector by March 1979. In 1980, it was announced that this quota would
be increased to 40
percent by March 1985. Sub-targets were also specified for lending to
agriculture and weaker
sectors within the priority sector. Since public and private banks faced
the same regulation, in
this section we focus on how ownership affected credit allocation.
The comparison of nationalized and private banks is never easy: banks
that fail are often
merged with healthy nationalized banks, which makes the comparison of
nationalized banks
and non-nationalized banks close to meaningless.
Bank Ownership and the Quality of Intermediation
Limitations on Public Sector Banks
Official Lending Policies
While public sector banks in India are nominally independent entities,
they are subject tointense regulation by the Reserve Bank of India (RBI).
This includes rules about how much abank should lend to individual
borrowersthe so-called maximum permissible bank finance.

Until 1997, the rule was based on the working capital gap, defined as the
difference between thecurrent assets of the firm and its total current
liabilities excluding bank finance (other currentliabilities). The
presumption is that the current assets are illiquid in the very short run
andtherefore the firm needs to finance them. Trade credit is one source
of finance, and what thefirm cannot finance in this way constitutes the
working capital gap.Firms were supposed to cover a part of this
financing need, corresponding to no less than 25percent of the current
assets, from equity. The maximum permissible bank finance under this
method was thus:
0.75 CURRENT ASSETS OTHER CURRENT LIABILITIES (5)
The sum of all loans from the banking system was supposed not to
exceed this amount.
This definition of the maximum permissible bank finance applied to loans
above Rs. 20million. For loans below Rs.20 million, banks were
supposed to calculate the limit based on the
projected turnover of the firm. Projected turnover was to be determined
by a loan officer inconsultation with the client. The firms financing need
was estimated to be 25 percent of theprojected turnover and the bank
was allowed to finance up to 80 percent of what the firm needs,
i.e. up to 20 percent of the firms projected turnover. The rest, amounting
to at least 5 percentof the projected turnover has again to be financed by
long term resources available to the firm.In the middle of 1997, following
the recommendation of the committee on financing of thesmall scale
industries (the Nayak committee), the RBI decided to give each bank the
flexibility
Nayak committee recommended that the turnover rule be used to
calculate the lending limit for all loans under Rs. 40 millions.
Given the freedom to choose the rule, different banks went for slightly
different strategies.
The bank we studied adopted a policy which was, in effect, a mix
between the now recommendedturnover-based rule and the older rule
based on the firms asset position. First the limit onturnover basis was
calculated as:
min(0.20 Projected turnover, 0.25 Projected turnover available
margin) (6)

The available margin here is the financing available to the firm from long
term sources (suchas equity), and is calculated as Current Assets
Current Liabilities from the current balance
sheet. In other words the presumption is that the firm has somehow
managed to finance thisgap in the current period and therefore should
be able to do so in the future. Therefore the bank
only needs to finance the remaining amount. Note that if the firm had
previously managed toget the bank to follow the turnover based rule
exactly, its available margin would be precisely 5percent of turnover and
the two amounts in 6 would be equal.
The rule did not stop here. For all loans below Rs 40 million (all the loans
in our sampleare below 40 million), the loan officer was supposed to use
both equation 6 and the older rulerepresented by 5. The largest
permissible limit on the loan was the maximum of these twonumbers.
Two comments about the nature of this rule are in order. First, this
turnover based approachto working capital finance is relatively standard
even in the USA. However the view in the USAis that working capital
finance is essentially financing inventories and is therefore backed by
thevalue of the inventories. In India, the inventories do not seem to
provide adequate security, asevidenced by the high rates of default. In
such cases it may be much more important to payattention to
profitability, since profitable companies are less likely default. Second, in
the USAthe role of finding promising firms and promoting them is carried
out, to a significant extent, byventure capitalists. In India the venture
capital industry is still nascent and it will be a whilebefore it can play the
role that we expect of its US equivalent. Therefore banks may have to
bemore pro-active in promoting promising firms. Following a rule that
doesnot put any weighton profits may not be the way to favor the most
promising firms: while the projected turnovercalculation does favor faster
growing firms, the loan officer is not allowed to project a growth
rate greater than 15 percent. This may be enough to meet the needs of a
mature firm, but asmall firm that is growing fast clearly needs much more
than 15 percent. It is important thatthe rules encourage the loan officers
to lend more to companies on the basis of promise.
TheFutureofBankingReform

When we take this evidence together, where does it leave us? There are
obvious problems withthe Indian banking sector, ranging from underlending to unsecured lending, which we havediscussed at some length.
There is now a greater awareness of these problems in the Indian
government and a willingness to do something about them.
One policy option that is being discussed is privatization. The evidence
from Cole, discussedabove, suggests that privatization would lead to an
infusion of dynamism in to the bankingsector: private banks have been
growing faster than comparable public banks in terms of credit,
deposits and number of branches, including rural branches, though it
should be noted that inour empirical analysis, the comparison group of
private banks were the relatively small old
private banks.48 It is not clear that we can extrapolate from this to
whatwe could expectwhen 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 specific ways, 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
more willing to lend aggressively where the prospects are good, though,
as will be discussed
later, better regulation of public banks may also achieve similar goals.
Historically, a crucial difference between public and private sector banks
has been their
willingness to lend to the priority sector. The recent broadening of the
definition of priority
sector has mechanically increased the share of credit from both public
and private sector banks
that qualify as priority sector. The share of priority sector lending from
public sector banks was
42.5 percent in 2003, up from 36.6 percent in 1995. Private sector
lending has shown a similar

increase from its 1995 level of 30 percent. In 2003 it may have

surpassed for the first time ever
public sector banks, with a share of net bank credit to the priority sector
at 44.4 percent to the
priority sector.49
Still, there are substantial differences between the public and private
sector banks. Most
notable is the consistent failure of private sector banks to meet the
agricultural lending subtarget,
though they also lend substantially less in rural areas. Our evidence
suggests that
privatization will make it harder for the government to get the private
banks to comply with
what it wants them to do. However it is not clear that this reflects the
greater sensitivity
of the public banks to this particular social goal. It could also be that
credit to agriculture,
being particularly politically salient, is the one place where the
nationalized banks are subject
to political pressures to make imprudent loans.
Finally, one potential disadvantage of privatization comes from the risk of
bank failure. In the
past there have been cases where the owner of the private bank
stripped its assets, and declared
that it cannot honor its deposit liabilities. The government is,
understandably, reluctant to let
banks fail, since one of the achievements of the last forty years has
been to persuade people that
their money is safe in the banks. Therefore, it has tended to take over
the failed bank, with the
resultant pressure on the fiscal deficit. Of course, this is in part a result of
poor regulationthe
regulator should be able to spot a private bank that is stripping its
assets. Better enforced
prudential regulations would considerably strengthen the case for
privatization.

On the other hand, public banks have also been failingthe problem
seems to be part
corruption and part inertia/laziness on the part of the lenders. As we saw
above, the cost of
bailing out the public banks may well be larger (appropriately scaled)
than the total losses
incurred from every bank failure since 1969.
49All numbers are from various issues of Report on Trends and
Progress of banking in India.
39
Once again the fact that the new private banks pose a problem: So far
none of them have
defaulted, but they are also new, and as a result, have not yet had to
deal with the slow decline
of once successful companies, which is one of the main sources of the
accumulation of bad debt
on the books of the public banks.
On balance, we feel the evidence argues, albeit quite tentatively, for
privatizing the nationalized
banks, combined with tighter prudential regulations. On the other hand
we see no obvious
case for abandoning the social aspect of banking. Indeed there is a
natural complementarity
between reinforcing the priority sector regulations (for example, by
insisting that private banks
lend more to agriculture) and privatization, since with a privatized
banking sector it is less likely
that the directed loans will get redirected based on political expediency.
However there is no reason to expect miracles from the privatized
banks. For a variety of
reasons including financial stability, the natural tendency of banks, public
or private, the world
over, is towards consolidation and the formation of fewer, bigger banks.
As banks become larger,
they almost inevitably become more bureaucratic, because most lending
decisions in big banks,

by the very fact of the bank being big, must be taken by people who
have no direct financial
stake in the loan. Being bureaucratic means limiting the amount of
discretion the loan officers
can exercise and using rules, rather human judgment wherever possible,
much as is currently
done in Indian nationalized banks. Berger et al. have argued in the
context of the US that this
leads bigger banks to shy away from lending to the smaller firms.50 Our
presumption is that this
process of consolidation and an increased focus on lending to corporate
and other larger firms
is what will happen in India, with or without privatization, though in the
short run, the entry
of a number of newly privatized banks should increase competition for
clients, which ought to
help the smaller firms.
In the end the key to banking reform may lie in the internal bureaucratic
reform of banks,
both private 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 financeand blue-chip sectors.
This will require a set of smaller step reforms, designed to affect the
incentives of banker in private and public banks. A first step would be to
make lending rulesmore responsive to current profits and projections of
future profits. This may be a way to both target better andguard against
potential NPAs, largely because poor profitability seems to be a good
predictor offuture default. It is clear however that choosing the right way
to include profits in the lendingdecision will not be easy. On one side
there is the danger that unprofitable companies default.On the other
side, there is the danger of pushing a company into default by cutting its
access tocredit exactly when it needs it the most, i.e. right after a shock
to demand or costs has pushedit into the red. Perhaps one way to
balance these objectives would be to create three categoriesof firms: (1)
Profitable to highly profitable firms. Within this category lending should
respondto profitability, with more profitable firms getting a higher limit,

even if they look similar on theother measures. (2) Marginally profitable

to loss-making firms that used to be highly profitablein the recent past
but have been hit by a temporary shock (e.g. an increase in the price of
cottonbecause of crop failures, etc.). For these firms the existing rules
for lending might work well.(3) Marginally profitable to loss-making firms
that have been that way for a long time or havejust been hit by a
permanent shock (e.g., the removal of tariffs protecting firms producing
in anindustry in which the Chinese have a huge cost advantage). For
these firms, there should be anattempt to discontinue lending, based on
some clearly worked out exit strategy (it is importantthat the borrowers
be offered enough of the pie that they feel that theywill be better off
byexiting without defaulting on the loans).Of course it is not always going
to be easy to distinguish permanent shocks from the temporary.In
particular, what should we make of the firm that claims that it has put in
placestrategies that help it survive the shock of Chinese competition, but
that they will only work ina couple of years? The best rule may be to use
the information in profitsand costs over several
years, and the experience of the industry as a whole.One constraint on
moving to a rule of this type is that it puts more weight on the judgmentof
the loan officer. The loan officer would now have to also judge whether
the profitability of acompany (or the lack of it) is permanent or temporary.
This increased discretion will obviouslyincrease both the scope for
corruption and the risk of being falsely accused of corruption. As wesaw
above, the data is consistent with the view that the loan officers worry
about the possibilityof being falsely accused of corruption and that this
pushes them in the direction of avoidingtaking any decisions if they can
help it. It is clear that it would be difficultto achieve better
41targeting of loans without reforming the incentives of the
loanofficers.There are probably a number of steps that can go some
distance towards this goal, evenwithin public banks. First, to avoid a
climate of fear, there should be a clear separation betweeninvestigation
of loans and investigations of loan officers. The loan should be
investigated first(could the original sanction amount have made sense at
the time it was given, were there obviouswarning signs, etc.) and a prima
facie case that the failure of the loan could have been predicted,must be
made before the authorization to start investigating the officer is given.
Ideally, untilthat point the loan officer should not know that there is an

investigation. The authorization toinvestigate a loan officer should also

be based on the most objective available measures of thelife-time
performance of the loan officer across all the loans where hemade
decisions and weight
should be given both to successes and failures. A loan officer with a
good track record shouldbe allowed a number of mistakes (and even
suspicious looking mistakes) before he is open to
investigation.
Banks should also create a division, staffed by bankers with high
reputations, which isallowed to make a certain amount of high risk loans.
Officers posted to this division shouldbe explicitly protected from
investigation for loans made while in this division. This may notbe
enough, and some extra effort to reach out more effectively to the
smaller and less wellestablishedfirms will probably be needed, not just
on equity grounds, but also because thesefirms may have the highest
returns on capital. A possible step in this direction would be toencourage
established reputable firms in the corporate sector as well as
multinationals to setup small specialized companies whose only job is to
lend to smaller firms in a particular sector(and possibly in particular
location). In other words these would be the equivalents of the
manyfinance companies that do extensive lending all over India, but with
links to a much biggercorporate entity and therefore creditworthiness.
The banks would then lend to these entities atsome rate that would be
somewhat below the cost of capital (instead of doing priority
sectorlending) and these finance companies would then make loans to
the firms in their domain,at a rate that is at most x per cent higher than
their borrowing rates. By being small andconnected to a particular
industry, these finance companies would have the ability to
acquiredetailed knowledge of the firms in the industry and the incentive
to make loans that wouldappear adventurous to outsiders.
Finally we feel that giving banks a stronger incentive to lend by cutting
the interest rate ongovernment borrowing will also help. The evidence
reported above is only suggestive but it doessuggest that where lending
is difficult, making lending to the government less lucrative can havea
strong effect on the willingness of bankers to make loans to the private
sector. Thus it is theless obviously creditworthy firms that suffer most
from the high rates of government borrowing.

CONCLUSION
The banking sector reforms, which were implemented as a part of
overall economic reforms, witnessed the most effective and impressive
changes, resulting in significant improvements within a short span. The
distinctive features of the reform process may be stated thus:
(i) The process of reforms has all along been pre-designed with a
longterm
vision. The two Committees on financial sector reforms
(Narasimham Committee-I and II) have outlined a clear long-term
vision for the banking segment particularly in terms of ownership of
PSBs, level of competition, etc.
(ii) Reform measures have been all pervasive in terms of coverage of
almost all problem areas. In fact, it can be said that, it is difficult to find
an area of concern in the banking sector on which there has not been a
Committee or a group.
(iii) Most of the reform measures before finalization or implementation
were
passed through a process of extensive consultation and discussion
with the concerned parties.
(iv) Most of the reform measures have targeted and achieved
international
best practices and standards in a systematic and phased manner. .
(v) All the reform measures and changes have been systematically
recorded and are found in the annual reports as well as in the annual
publications of RBI on "Trend and Progress of Banking in India".
The banking system, which was over-regulated and over
administered, was freed from all restrictions and entered into an era of
95competition since 1992. The entry of modern private banks and
foreignbanks enhanced competition. Deregulation of interest rates had
alsointensified competition. Prudential norms relating to income
recognition,asset classification, provisioning and capital adequacy have
led to theimprovement of financial health of banks. Consequent upon
prudentialnorms the most visible structural change has been
improvement in thequality of assets. Further, there has been
considerable improvement in theprofitability of banking system. The net
profits of SCBs, which were negativein 1992-93, become positive in

1994-95 and stood at Rs. 17,077.07 Croreby March 2003. The

profitability of the Indian Banking System wasreasonably in line with
International experience.
It may be pointed out that the banking sector reform is certainly not a
one-time affair. It has evolutionary elements and follows a progression of
being and becoming. Form this point, Indian experience of restructuring
banking sector has been reasonably a successful one. There was no
majorbanking crisis and the reform measures were implemented
successfully
since 1992. Some expressed the fear that the reforms will sound a blow
tosocial banking. The Government did not accept the Narasimham
Committee-I recommendation that advances to priority sector should be
brought down from 40 per cent to 10 per cent. The Banks continued to
bedirected to lend a minimum of 18 per cent of total banks credit
toagriculturesector.
References
Banerjee, Abhijit, 2003. Contracting Constraints, Credit Markets, and
Economic Development.
in M. Dewatripoint, L. Hansen and S. Turnovsky, eds. Advances in
Economics
and Econometrics: Theory and Applications, Eight World Congress of
the Econometric
Society, Volume III. Cambridge University Press.