Author Name:   sujay_ilnu

Banking is an ancient business in India with some of oldest references in the writings of Manu. Bankers played an important role during the Mogul period....

Liberalisation of Indian Banking And Regulation

Banking is an ancient business in India with some of oldest references in the writings of Manu. Bankers played an important role during the Mogul period. During the early part of the East India Company era, agency houses were involved in banking. Modern banking (i.e. in the form of joint-stock companies) may be said to have had its beginnings in India as far back as in 1786, with the establishment of the General Bank of India. Three Presidency Banks were established in Bengal, Bombay and Madras in the early 19th century. These banks functioned independently for about a century before they were merged into the newly formed Imperial Bank of India in 1921. The Imperial Bank was the forerunner of the present State Bank of India. The latter was established under the State Bank of India Act of 1955 and took over the Imperial Bank.

The Swadeshi movement witnessed the birth of several indigenous banks including the Punjab National Bank, Bank of Baroda and Canara Bank. In 1935, the Reserve Bank of India was
established under the Reserve Bank of India Act as the central bank of India. In spite of all these developments, independent India inherited a rather weak banking and financial system marked by a multitude of small and unstable private banks whose failures frequently robbed their middle-class depositors of their life’s savings. After independence, the Reserve Bank of India was nationalized in 1949 and given wide powers in the area of bank supervision through the Banking Companies Act (later renamed Banking Regulations Act). The nationalization of the Imperial bank through the formation of the State Bank of India and the subsequent acquisition of the state owned banks in eight princely states by the State Bank of India in 1959 made the government the dominant player in the banking industry. In keeping with the increasingly socialistic leanings of the Indian government, 14 major private banks, each with deposits exceeding Rs. 50 crores, were nationalized in 1969. This raised the proportion of scheduled bank branches in government control from 31% to about 84%. In 1980, six more private banks each with deposits exceeding Rs 200 crores , were privatized further raising the proportion of government controlled bank branches to about 90%. As in other areas of economic policy-making, the emphasis on government control began to weaken and even reverse in the mid-80s and liberalization set in firmly in the early 90’s. The poor performance of the public sector banks, which accounted for about 90% of all commercial banking, was rapidly becoming an area of concern. The continuous escalation in non-performing assets (NPAs) in the portfolio of banks posed a significant threat to the very stability of the financial system. Banking reforms, therefore, became an integral part of the liberalization agenda.
The first Narasimham Committee set the stage for financial and bank reforms in India. Interest rates, previously fixed by the Reserve Bank of India, were liberalized in the 90’s and directed lending through the use of instruments of the Statutory Liquidity Ratio was reduced. While several committees have looked into the ailments of commercial banking in India, but major work has been done according to the Narsimham committee reports.
- the Narasimham committee I (1992) and II (1998)


Liberalization
Liberalization (or liberalization) refers to a relaxation of previous government restrictions, usually in areas of social or economic policy. In some contexts this process or concept is often, but not always, referred to as deregulation. In the arena of social policy it may refer to a relaxation of laws restricting. Most often, the term is used to refer to economic liberalization, especially trade liberalization or capital market liberalization.

Liberalization in Indian Banking Sector-
Liberalization in Indian banking sector was begun since 1992, following the Narsimham Committee Report (December 1991). The 1991 report of the Narasimham Committee served as the basis for the initial banking sector reforms .In the following years, reforms covered the areas of interest rate deregulation, directed credit rules, statutory pre-emptions and entry deregulation for both domestic and foreign banks. The objective of banking sector reforms was in line with the overall goals of the 1991 economic reforms of opening the economy, giving a greater role to markets in setting prices and allocating resources, and increasing the role of the private sector. The Narsimhan Committee was first set up in 1991 under the chairmanship of Mr. M. Narasimham who was 13th governor of RBI. Only a few of its recommendations became banking reforms of India and others were not at all considered. Because of this a second committee was again set up in 1998.As far as recommendations regarding bank restructuring, management freedom, strengthening the regulation are concerned, the RBI has to play a major role. If the major recommendations of this committee are accepted, it will prove to be fruitful in making Indian banks more profitable and efficient.

Problems Identified By The Narasimham Committee
1. Directed Investment Program : The committee objected to the system of maintaining high liquid assets by commercial banks in the form of cash, gold and unencumbered government securities. It is also known as the Statutory Liquidity Ratio (SLR). In those days, in India, the SLR was as high as 38.5 percent. According to the M. Narasimham's Committee it was one of the reasons for the poor profitability of banks. Similarly, the Cash Reserve Ratio- (CRR) was as high as 15 percent. Taken together, banks needed to maintain 53.5 percent of their resources idle with the RBI.

2. Directed Credit Program : Since nationalization the government has encouraged the lending to agriculture and small-scale industries at a confessional rate of interest. It is known as the directed credit programme. The committee opined that these sectors have matured and thus do not need such financial support. This directed credit programme was successful from the government's point of view but it affected commercial banks in a bad manner. Basically it deteriorated the quality of loan, resulted in a shift from the security oriented loan to purpose oriented. Banks were given a huge target of priority sector lending, etc. ultimately leading to profit erosion of banks.

3. Interest Rate Structure : The committee found that the interest rate structure and rate of interest in India are highly regulated and controlled by the government. They also found that government used bank funds at a cheap rate under the SLR. At the same time the government advocated the philosophy of subsidized lending to certain sectors. The committee felt that there was no need for interest subsidy. It made banks handicapped in terms of building main strength and expanding credit supply.

4. Additional Suggestions : Committee also suggested that the determination of interest rate should be on grounds of market forces. It further suggested minimizing the slabs of interest.

Along with these major problem areas M. Narasimham's Committee also found various inconsistencies regarding the banking system in India.

Narasimham Committee Report I - 1991
The Narsimham Committee was set up in order to study the problems of the Indian financial system and to suggest some recommendations for improvement in the efficiency and productivity of the financial institution.

The committee has given the following major recommendations:-
1. Reduction in the SLR (Statutory Liquidity Ratio) and CRR(Cash Reserve Ratio) : The committee recommended the reduction of the higher proportion of the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR). Both of these ratios were very high at that time. The SLR then was 38.5% and CRR was 15%. This high amount of SLR and CRR meant locking the bank resources for government uses. It was hindrance in the productivity of the bank thus the committee recommended their gradual reduction. SLR was recommended to reduce from 38.5% to 25% and CRR from 15% to 3 to 5%.

2. Phasing out Directed Credit Programme : In India, since nationalization, directed credit programmes were adopted by the government. The committee recommended phasing out of this programme. This programme compelled banks to earmark then financial resources for the needy and poor sectors at confessional rates of interest. It was reducing the profitability of banks and thus the committee recommended the stopping of this programme.

3. Interest Rate Determination : The committee felt that the interest rates in India are regulated and controlled by the authorities. The determination of the interest rate should be on the grounds of market forces such as the demand for and the supply of fund. Hence the committee recommended eliminating government controls on interest rate and phasing out the concessional interest rates for the priority sector.

4. Structural Reorganizations of the Banking sector : The committee recommended that the actual numbers of public sector banks need to be reduced. Three to four big banks including SBI should be developed as International banks. Eight to Ten Banks having nationwide presence should concentrate on the national and universal banking services. Local banks should concentrate on region specific banking. Regarding the RRBs (Regional Rural Banks), it recommended that they should focus on agriculture and rural financing. They recommended that the government should assure that henceforth there won't be any nationalization and private and foreign banks should be allowed liberal entry in India.

5. Establishment of the ARF Tribunal : The proportion of bad debts and Non-performing asset (NPA) of the public sector Banks and Development Financial Institute was very alarming in those days. The committee recommended the establishment of an Asset Reconstruction Fund (ARF). This fund will take over the proportion of the bad and doubtful debts from the banks and financial institutes. It would help banks to get rid of bad debts.

6. Removal of Dual control : Those days banks were under the dual control of the Reserve Bank of India (RBI) and the Banking Division of the Ministry of Finance (Government of India). The committee recommended the stepping of this system. It considered and recommended that the RBI should be the only main agency to regulate banking in India.

7. Banking Autonomy : The committee recommended that the public sector banks should be free and autonomous. In order to pursue competitiveness and efficiency, banks must enjoy autonomy so that they can reform the work culture and banking technology upgradation will thus be easy.

Some of these recommendations were later accepted by the Government of India and became banking reforms.

Narasimham Committee Report II - 1998
In 1998 the government appointed yet another committee under the chairmanship of Mr. Narsimham. It is better known as the Banking Sector Committee. It was told to review the banking reform progress and design a programme for further strengthening the financial system of India. The committee focused on various areas such as capital adequacy, bank mergers, bank legislation, etc.

It submitted its report to the Government in April 1998 with the following recommendations.

1. Strengthening Banks in India: The committee considered the stronger banking system in the context of the Current Account Convertibility (CAC). It thought that Indian banks must be capable of handling problems regarding domestic liquidity and exchange rate management in the light of CAC. Thus, it recommended the merger of strong banks which will have 'multiplier effect' on the industry.

2. Narrow Banking: Those days many public sector banks were facing a problem of the Non-performing assets (NPAs). Some of them had NPAs were as high as 20 percent of their assets. Thus for successful rehabilitation of these banks it recommended 'Narrow Banking Concept' where weak banks will be allowed to place their funds only in short term and risk free assets.

3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian banking system the committee recommended that the Government should raise the prescribed capital adequacy norms. This will further improve their absorption capacity also. Currently the capital adequacy ration for Indian banks is at 9 percent.

4. Bank ownership: As it had earlier mentioned the freedom for banks in its working and bank autonomy, it felt that the government control over the banks in the form of management and ownership and bank autonomy does not go hand in hand and thus it recommended a review of functions of boards and enabled them to adopt professional corporate strategy.

5. Review of banking laws: The committee considered that there was an urgent need for reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking Regulation Act, State Bank of India Act, Bank Nationalisation Act, etc. This upgradation will bring them in line with the present needs of the banking sector in India.

Apart from these major recommendations, the committee has also recommended faster computerization, technology upgradation, training of staff, depoliticizing of banks, professionalism in banking, reviewing bank recruitment, etc.

Changes due to the recommendations made by the Narsimham committee are-
1. Statutory pre-emptions: The degree of financial repression in the Indian banking sector was significantly reduced with the lowering of the CRR and SLR, which were regarded as one of the main causes of the low profitability and high interest rate spreads in the banking system. During the 1960s and 1970s the CRR was around 5%, but until 1991 it increased to its maximum legal limit of 15%.The reduction of the CRR and SLR resulted in increase flexibility for banks in determining both the volume and terms of lending.

2. Priority sector lending: Besides the high level of statutory pre-emptions, the priority sector advances were identified as one of the major reasons for the below average profitability of Indian banks. The Narasimham Committee therefore recommended a reduction from 40% to 10%. However, this recommendation has not been implemented and the targets of 40% of net bank credit for domestic banks and 32% for foreign banks have remained the same.

3. Interest rate liberalization: Prior to the reforms, interest rates were a tool of cross-subsidization between different sectors of the economy. To achieve this objective, the interest rate structure had grown increasingly complex with both lending and deposit rates set by the RBI. The deregulation of interest rates was a major component of the banking sector reforms that aimed at promoting financial savings and growth of the organized financial system. The lending rate for loans in excess of Rs200,000 that account for over90% of total advances was abolished in October 1994. Banks were at the same time required to announce a prime lending rate (PLR) which according to RBI guidelines had to take the cost of funds and transaction costs into account.

4. Entry barriers: Before the start of the 1991 reforms, there was little effective competition in the Indian banking system for at least two reasons. First, the detailed prescriptions of the RBI concerning for example the setting of interest rates left the banks with limited degrees of freedom to differentiate themselves in the marketplace. Second, India had strict entry restrictions for new banks, which effectively shielded the incumbents from competition.Through the lowering of entry barriers, competition has significantly increased since the beginning of the1990s. Seven new private banks entered the market between 1994 and 2000. In addition, over 20 foreign banks started operations in India since 1994. By March 2004, the new private sector banks and the foreign banks had a combined share of almost 20% of total assets. Deregulating entry requirements and setting up new bank operations has benefited the Indian banking system from improved technology, specialized skills, better risk management practices and greater portfolio diversification..

5. Prudential norms: The report of the Narasimham Committee was the basis for the strengthening of prudential norms and the supervisory framework. Starting with the guidelines on income recognition, asset classification, provisioning and capital adequacy the RBI issued in 1992/93, there have been continuous efforts to enhance the transparency and accountability of the banking sector. The improvements of the prudential and supervisory framework were accompanied by a paradigm shift from micro-regulation of the banking sector to a strategy of macro-management .

6. Public Sector Banks : At the end of the 1980s, operational and allocative inefficiencies caused by the distorted market mechanism led to a deterioration of Public Sector Banks' profitability. Enhancing the profitability of PSBs became necessary to ensure the stability of the financial system. The restructuring measures for PSBs were threefold and included recapitalization, debt recovery and partial privatization.

Despite the suggestion of the Narasimham Committee to rationalize PSBs, the Government of India decided against liquidation, which would have involved significant losses accruing to either the government or depositors. It opted instead to maintain and improve operations to allow banks to create a good starting basis before a possible privatization.

Conclusion
Nevertheless, more than a decade since the beginning of economic reforms, the banking sector is still struggling under the burden of considerable NPAs and the poor performance of public sector banks continues to be a major issue. Liberalization has, however, had a predictable effect in the distribution of scheduled commercial banking in India. The reforms era growth in banking have focused on the more profitable urban and metro areas of the country. Between 1969 and 1991 for instance, the share of the rural branches increased from about 22% to over 58%. In 2004, the corresponding figure stood at a much lower 46%. The number of rural bank branches actually declined from the 1991 figure of over 35,000 branches by about 3000 branches. Between 1969 and 1991 the share of urban and metro branches fell from over 37% to less than 23%. In the years since it has crawled back up to over 31%.

Since India has decided to move toward a more market-based system, it is now important for policy makers to create the conditions for the well-functioning of a market based banking system. Among the necessary tasks are the building and strengthening of the necessary institutions like oversight bodies, accounting standards and regulations as well as the further restructuring and privatization of PSBs. If India continues on its current path of banking sector liberalization, it should be in a position to further strengthen its banking system, which will be vital to support its economic growth in the years to come.

Thus Liberalisation has proved to be a great boon to the banking system as the structural changes which have been implemented due to the liberalisation has transformed the Indian banking system and moreover the recommendations of various committees has led to further strengthening banking system. Thus liberalisation has made banking from class banking to mass banking.

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# Available at http://en.wikipedia.org/wiki/Swadeshi_movement visited on September 15,2011.
# Statutory Liquidity Ratio is the amount of liquid assets, such as cash, precious metals or other approved securities, that a financial institution must maintain as reserves other than the Cash with the Central Bank.
# Rajesh Chakrabarti , Banking in India - Reforms and Reorganization
# Sullivan, Arthur; Sheffrin, Steven M. (January 2002). Economics: Principles in Action. New Jersey: Pearson Prentice Hall. ISBN 0-13-063085-3.
# Available at http://www.scribd.com/doc/53006431/Narasimham-Committee-on-Banking-Sector-Reforms visited on September 15,2011.
# Arun, T.G./ Turner, J.D. (2002a): Financial liberalisation in India, in: Journal of International Banking Regulation, 4 (2),p.183;A brief overview of the most important reforms follows.
# Available at http://kalyan-city.blogspot.com/2010/09/narasimham-committee-report-1991-1998.html visited on September 15,2011.
# Statutory Liquidity Ratio
# Ibid
# Available at http://kalyan-city.blogspot.com/2010/09/narasimham-committee-report-1991-1998.html visited on September 15,2011.
# Current account convertibility refers to freedom in respect of Payments and transfers for current international transactions.
# A debt obligation where the borrower has not paid any previously agreed upon interest and principal repayments to the designated lender for an extended period of time. The nonperforming asset is therefore not yielding any income to the lender in the form of principal and interest payments.
# Available at http://kalyan-city.blogspot.com/2010/09/narasimham-committee-report-1991-1998.html visited on September 15,2011.
# Shirai, Sayuri (2002b): Road from State to Market - Assessing the Gradual Approach to Banking Sector Reforms in India, in: Asian Development Bank Institute Research Paper, No. 32, p. 12
# Kamesam, Vepa (2002): Indian Economy - Financial Sector Reforms and Role of RBI, in: RBI Bulletin, May, p. 379
# Ganesan, P . (2003): Impact of Priority Sector Advances on Profitability of Public Sector Banks in India, in: Journal of Financial Management and Analysis, 16 (2), p. 15
# Arun, T.G./ Turner, J.D. (2002b): Financial Sector Reforms in Developing Countries: The Indian Experience, in: World Economy, 25 (3), p. 437
# Deolalkar, G.H. (1999): The Indian Banking Sector: On the Road to Progress, in: (ed.): Rising to the Challenge in Asia: A Study of Financial Markets - India, Manila, p. 60
# Arun, T.G./ Turner, J.D. (2002b): Financial Sector Reforms in Developing Countries: The Indian Experience, in: World Economy, 25 (3), p. 439;
# Reserve Bank of India (2004a): Report on Trend and Progress of Banking in India 2003-04, p. 167
# Ibid,p.24
# Kamesam, Vepa (2002): Indian Economy - Financial Sector Reforms and Role of RBI, in: RBI Bulletin, May 2002, p. 377
# Shirai, Sayuri (2002b): Road from State to Market - Assessing the Gradual Approach to Banking Sector Reforms in India, in: Asian Development Bank Institute Research Paper, No. 32, p. 26

The  author can be reached at: sujay_ilnu@legalserviceindia.com

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