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CHAPTER- IV

STRUCTURE AND STRUCTURAL CHANGE IN INDIAN BANKING

This chapter gives a detailed account of structure of Indian Banking

Industry and structural changes that have taken place in Indian Banking since

its inception.

India’s financial system has a very comprehensive structure. Indian

banking industry is characterized by a large number of banks with mixed

ownership. It consists of variety of banks, financial institutions, capital market

institutions, non-banks indigenous banking and financial institutions.

Traditionally, it was divided into two sectors that organised and unorganised

financial sector. The organised sector traditionally meant the Imperial Bank of

India (now State Bank of India), the exchange banks and the Indian joint stock

banks. The unorganised sector consisted of Indigenous bankers, money

lenders, chit funds, nidhi etc. The share of unorganised sector in the rural

sector was higher than in urban areas. At the time of Independence, the share

of unorganised sources in debt of rural households was as high as 92.8

percent. At the time of Independence India had a relatively weak structure.

The structure of the banking system is currently being shaped by three Cs:

Competition, Convergence and Consolidation.1 The banking system in India

consists of the Central bank, Commercial banks, Development banks,

specialized banks and foreign banks.

The banking structure that India inherited at Independence in 1947

suffered from two major drawbacks: (i) interlocking of directorship of industry

houses and banks, and (ii) paucity of credit to socially and economically

important sectors of the economy. In the wake of these drawbacks, decision

was taken to nationalize 14 private banks in 1969 as well as for subsequent

nationalization of six more banks.2 Indian Banking structure possesses a

heterogeneous mass of indigenous bankers, joint- stock banks and

cooperative banks as its base layers, the highly organized and developed

1 Prasad A. & Ghosh Saibal "Competition in Indian Banking", IMF Working Paper, WP/05/141,

July 2005, p. 22. 2 Nachane D.M., Ghosh Saibal & Ray Partha "Banking in India", MRPA Paper No. 17400, May

2007.

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State Bank as its middle layer and a state-owned central bank known as the

Reserve Bank of India as its apex.3

RESERVE BANK OF INDIA

The Central bank in India is known as the Reserve Bank of India. RBI

is the supreme monetary and banking authority in the country. It has the

responsibility to control the banking system in the country. The Reserve Bank

of India and the Banking Regulation Act determine and regulate the structure,

organization, operations of the Indian Banking system.

It monitors any discrepancies and shortcomings in the system. The

Reserve Bank of India is an autonomous body, with minimal pressure from

the Government. The urgent need for central banking institution was

recognised when the three Presidency Banks were amalgamated in 1921 to

form the Imperial Bank of India. It was hoped that this institution might

develop into a full- fledged Central Bank. The Imperial Bank did perform

certain central banking functions such as acting as banker to government etc. The Reserve Bank was established on April 1, 1935 in accordance with

the provisions of the Reserve Bank of India Act 1934. After the partition of the

country, the Bank was nationalised in 1948.

The bank was nationalised “to implement the government’s policies

that the bank should function as a state-owned institution and to meet the

general desire that the control of the government over the bank’s activities

should be extended to ensure greater co-ordination in the monetary,

economic and financial policies”.4

Functions of RBI Under Section 22 of the Reserve Bank of India Act, the Bank has the

sole right to issue bank notes of all denominations. The distribution of one

rupee notes and coins and small coins all over the country is undertaken by

the Reserve Bank as agent of the Government.

The Reserve Bank is agent of Central Government and of all State

Governments in India excepting that of Jammu and Kashmir. It receives and

3 Mongia J.N. "Banking Around the World: A Treatise on Comparative Banking", Allied Publishers

Private Limited, New Delhi, 1982, p. 226. 4 Aggarwal C.S. & Jain Shashi "Money, Banking & International Trade", New Academic Publishing

Co., Jalandhar, p. 2010.

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makes payment on behalf of the government and carries out their banking

operations and exchange remittances. The Bank helps the Central as well as

the State Government to float new loans and to manage public debt. Since

commercial banks can always expect the Reserve Bank of India to come to

their help in times of banking crisis, the Reserve Bank become not only the

banker’s bank but also the lender of the last resort.

The primary function of the Reserve Bank is to control credit and currency in

such a way as to promote economic development. The Reserve Bank of India

has the responsibility to maintain the official rate of exchange. Besides,

maintaining the rate of exchange of the rupee, the Reserve Bank has to act as

the custodian of India’s reserve international currencies. In addition to its traditional central banking functions, the Reserve Bank

has certain non-monetary functions of banks and promotion of sound banking

in India. It relates to licensing and establishments, branch expansion, liquidity

of their assets, management and methods of working, amalgamation,

reconstruction and liquidation. The supervisory functions of the RBI have

helped a great deal in improving the standard of banking in India to develop

on sound lines and to improve the methods of their operation.

RBI performs a variety of developmental and promotional functions.

The Reserve Bank was asked to promote banking habit, extend banking

facilities to rural and semi-urban areas and establish and promote new

specialised financing agencies. It has played an effective role in influencing

the allocation of credit in favour of priority sectors. The RBI has paid special

attention to the credit needs of the rural sector. Towards this end the

Agricultural Refinance and Development Corporation (ARDC) was set up as a

wholly-owned subsidiary of the RBI in 1963. The National Bank for Agriculture

and Rural Development (NABARD) is another example of the promotional role

of the RBI in the agricultural sector.

COMMERCIAL BANKS Commercial bank is a financial intermediary which accepts deposits of

money from the public and lends them with a view to make profits.

Commercial banks play an important role in the development process of

under-developed countries. Commercial Banks inculcate banking habits

among people. It converts idle savings into productive ones. Commercial

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banks improve the allocation of resources by lending money to priority sectors

of the economy.

Commercial banks are also known as joint stock banks and were

established under the Indian Companies Act. The Swadeshi Movement

further stimulated the Indian Banking. Banking Regulation Act passed in 1949

brought drastic changes in Indian commercial banking system both

structurally and organisationally. On July 19, 1969, 14 major stock commercial

banks were nationalised. Again on 15 April, 1980, six more banks were

nationalised. With nationalisation 91% of the total banking came under full

governmental control.

In India, commercial banks are classified into two parts that is

Scheduled Banks and Unscheduled banks.

Scheduled commercial banks constitute the major segment of the

banking system. Scheduled commercial banks can be further classified into

public sector banks comprising of the State Bank of India, its seven

associates, other nationalised banks and the Regional Rural Banks (RRBs)

and private sector banks which can be either domestic or foreign.

With increased competition, in 1994-95, six private banks namely UTI

Bank Ltd, Indus Ind. Bank Ltd, ICICI Banking Corporation Ltd, Global Trust

Bank Ltd, Centurion Bank Ltd, HDFC Bank Ltd were set up. In 1995-96, four

more new private banks namely Times Bank Ltd, Bank of Punjab Ltd,

Development Credit Bank Ltd and IDBI Bank were set up.

Regional Rural Banks (RRBs) came into existence since the middle of

1970s with the specific objective of providing credit and deposit facilities

particularly to the small and marginal farmers, agricultural labourers and

artisans and small entrepreneurs.

CO-OPERATIVE BANKS Co-operative Bank is an institution founded on co-operative lines and

dealing in ordinary banking business. The bank accepts deposits, discount

bills, grant loans and advances. This type of bank like joint stock banks is

founded by collecting funds in the form of shares. Co-operative banks are

organized on unit banking principle. They are mainly rural based although

there are some banks operating in urban areas. Co-operatives occupy an

important position in the Indian financial system.

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Co-operatives were the first formal institution to be conceived and

developed to purvey credit to rural India.5

Co-operative banking in India has a federal structure. There is a state

co-operative bank in each state at the apex level, central co-operative bank at

the district level and the primary credit societies at the base that in rural and

urban areas. This structure of co-operative banks meets the short term needs.

For long term needs of agriculture, there are Land Mortgage Banks. These

financial institutions meet the developmental and long term requirements. The

co-operative banking structure in India comprises urban co-operative banks

and rural co-operative credit institutions.

The rural co-operative movement was started in over 100 years back

largely with a view to providing agriculturists funds for agricultural operations

at low rates of interest and protect them from the clutches of money lenders.

Co-operative Banks came into existence with the enactment of the

Agricultural Credit Co-operative Societies Act in 1904. Primary agricultural co-

operative societies were started in villages to promote thrift and self-help

among villagers and to provide credit facilities to the agriculturists. To provide

financial strength to the primary agricultural credit societies, district and state

co-operative banks were started.

EXCHANGE BANKS

Exchange banks are those banks which deal in foreign exchange and

finance the foreign trade. In addition to these they undertake all commercial

banking functions. In India, such functions are mainly performed by foreign

banks through their branches and hence are known as Foreign exchange

banks. The Reserve Bank of India was given wide powers for the regulation of

business of foreign exchange banks under Indian Banking Companies Act

1949. Later on these powers were enhanced under the Social Control of

Banks Act.

SPECIALIZED BANKS A number of apex banks are working in specialised areas. They include

NABARD, IDBI, EXIM bank and National Housing Bank. They have been

established to serve as apex banks in their specified areas of responsibility

5 Reserve Bank of India, Report on Trend and Progress of Banking in India, 2008-09, RBI Mumbai,

p. 157

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and concern. Among these the three most important lending institutions are

IDBI, ICICI and ICFI. These three important lending institutions dominate the

term lending market and provide medium and long term financial assistance

to corporate sector. IDBI, IFCI, ICICI banks perform various functions to

promote economic development of India. They provide medium and long-term

finance to industry. They provide guarantees for term loans and underwrite

new equity. These banks perform various types of promotional roles for the

private entrepreneurs. It helps in identification of investment projects,

management services and technical advice.

The structure of the Indian banking system may be shown as follows:

Fig 4.1 STRUCTURE OF INDIAN BANKING:

(As on March 31, 2007)

Source: Datt Ruddar & Sundharam K P M “Indian Economy”, S Chand & Company Ltd, New

Delhi, 2009, p. 837. As regards, the structure of banking in India, it was dominated by

public sector banks, after the bank nationalization in 1969. Public sector

banks have a wide spread network of 44,145 branches, this fact enables them

to dominate not only the deposit and credit markets but also allows them to

play important role in money and capital markets.6 Indian Banking is

6 Ajit D. & Bangar R.D. "Banks in Financial Intermediation: Performance and Issues", RBI

Occasional Papers, Vol. 18, Nos. 2 & 3, Special Issue, June - September, 1997, p. 245.

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particularly interesting because of different and changing regulatory

environment and the diversity of bank ownership: State Bank of India (SBI)

Group, Nationalized Banks (NBs), privately owned banks as well as foreign

banks.7 The public sector banks dominated in the financial intermediation

process over the years. They expanded remarkably geographically and

functionally. They mobilized savings and provided funds for investment in

agriculture and small scale industry. Scheduled commercial banks forms the

major banks of banking Industry. As on 31st March 2007, there were total 227

scheduled commercial banks of which 27 were Public Sector Banks (19

Nationalised Banks and 8 State Bank of India & its Associates), 25 Private

Sector Banks (17 Old Private Banks and 8 New Private Banks), 39 Foreign

Banks, 86 Regional Rural Banks.

ANALYSIS OF STRUCTURE OF INDIAN BANKING INDUSTRY

The study has analytically examined the structure of Indian Banking

Sector under following sub heads:

Structure of Financial Performance The structure of financial performance is given in table 4.1. It gives

basic parameters of financial performance like total income, total expenditure,

operating profit, provisions and contingencies, net profit. In terms of total

income the share of public sector banks in the total industry in year 2008-09 is

65.23 percent. The share of Indian private banks is 22.21 percent and share

of foreign banks is just 9.75 percent. The behaviour of total expenditure both

in value terms and in percentage terms is exactly the same as behaviour of

total income. The share of regional rural banks in the total industry is just 2.81

percent in terms of total income and 2.96 percent in terms of total

expenditure. Moreover, large portion of net profit also goes to the public

sector banks. This share is 63.55 percent. The shares of Indian private and

foreign banks in the total net profit of the industry are 19.78 and 14.23 percent

respectively. As compared to income and expenditure shares, the share of

foreign banks in the total profit is slightly higher that is an indicative of their

better efficiency.

7 Shanmugam K.R. & Das A. "Efficiency of Indian Commercial Banks during the reform period",

Applied Financial Economics, 2004, p. 681.

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Table 4.1 Structure of Financial Performance of Indian Banking Industry in Year

2008-09. (Rs Crores)

Total Income Total Expenditure Operating Profit Provision &

Contingencies Net Profit

Bank Group Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent

Public Sector Banks 302586 65.23 269052 65.45 65594 58.9 32059 54.73 33535 63.55

State Bank Group 105268 22.69 93373 22.71 23410 21.02 11515 19.66 11896 22.54

Nationalized Banks 197318 42.54 175679 42.74 42184 37.88 20544 35.07 21639 41.01

Indian Private Banks

103016 22.21 92148 22.42 24279 21.80 13412 22.89 10437 19.78

Old Private Banks 21572 4.65 19163 4.66 4799 4.31 2390 4.08 1978 3.75

New Private Banks 81444 17.56 72985 17.76 19480 17.49 11022 18.82 8459 16.03

Foreign Banks 45213 9.75 377039 9.17 20098 18.05 12588 21.49 7510 14.23

Total Commercial Banks

450815 97.19 398903 97.04 10997 98.76 58059 99.11 51482 97.56

Regional Rural Banks 13022 2.81 12163 2.96 1378 1.24 519 0.89 1289 2..44

Total of all Banks 463837 100.00 411066 100.00 111349 100.00 58578 100.00 52771 100.00

Source: Report on Trends and Progress of Banking in India, Reserve Bank of India, Mumbai, 2008-09.

Structure of Business Share

In the banking industry, the volume of business done by a bank

highlights its contribution in Industry. Volume of business may be defined as

the sum of deposits, advances and investments done by a bank. Total

business done by the Indian banking Industry as on March 2009 is

Rs.8513583 Cr. Banking Industry of India formed the major sector of Indian

economy. Table 4.2 indicates that 71.88 percent of business is done by Public

sector banks out of which State Bank Group has 24.72 percent and

Nationalized Bank has 47.16 percent. The share of Indian private banks is

19.01 percent and out of which more business is done by new private sector

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banks that 14.31 percent and less by old private sector banks that 4.69

percent. The share of foreign banks is 5.99 percent only. The Regional Rural

Banks have just 3.12 percent of the total business. The components of

business that deposits, advances and investment display same pattern as that

of total business. It is concluded that public sector banks play a significant and

major role in the business of Indian Banking Industry.

Table 4.2 Structure of Bank Group-wise Business Share for the Year 2008-09.

(As at end March 2009) (Rs Crores)

Deposits Advances Investments Total Business Bank Group Amount Percent Amount Percent Amount Percent Amount Percent

Public Sector Banks

3000347 73.84 2156727 71.8 962618 66.41 6119692 71.88

State Bank Group

1007042 24.78 739606 24.64 357624 24.67 2104272 24.72

Nationalized Banks

1993305 49.06 1417121 47.22 604994 41.74 4015420 47.16

Indian Private Banks

736379 18.12 575336 19.17 306455 21.14 1618170 19.01

Old Private Banks

199274 4.90 128512 4.28 72316 4.99 400102 4.69

New Private Banks

537105 13.22 446824 14.89 234139 16.15 1218068 14.31

Foreign Banks 214077 5.27 165415 5.51 130354 8.99 509846 5.99 Total Commercial Banks

3950803 97.23 2897478 96.55 399427 96.55 8247708 96.88

Regional Rural Banks

112400 2.77 103428 3.45 50047 3.45 265875 3.12

Total of all Banks

4063203 100.00 3000906 100.00 1449474 100.00 8513583 100.00

Source: Report on Trend and Progress of Banking in India, Reserve Bank of India, 2008-09. Structure of Market Coverage (i) Structure of Branch Expansion

The distribution of total number of branches indicates the expansion of

Indian banking industry. As shown in the Table 4.3. Public Sector banks are

leading the banking industry in terms of branch expansion. Its share is 85.14

percent. Share of nationalized banks in the number of branches is 509.9

percent and the share of SBI and its associate banks is 25.16 percent. The

share of private banks in terms of branches is 14.43 percent. The share of old

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private banks and new private banks is almost equal 7.18 percent and 7.24

percent. Foreign banks which are new entrants in the banking Industry has

just a minor share in number of branches that is 0.43 percent. (ii) Employment Structure

In term of manpower, 77.77 percent of the total employment industry is

with the public sector banks. Private Banks have just 19.29 percent and the

foreign banks have 2.94 percent of the total employees of the industry. It

leads to misconception that as if public sector banks are overstaffed. Overall

industry average employee per branch comes out to be 13. As compared to

this benchmark, irrespective of branch size and nature of ownership, the

nationalized banks have employees of just 11 per branch as against the 11

per branch in old private sector banks and 24 in new private sector banks and

mark of 90 per branch in foreign banks. Table 4.3

Distribution of Total Number of Branches and

Employees in Indian Banking Industry in the Year 2009-10 (Numbers)

Banks Branches Employees

Number Percent Number Percent Employees per Branch

Public Sector Banks 61301 85.14 734594 77.77 12

Nationalized Banks 43187 59.9 467262 49.47 11

SBI & its Associates 18114 25.16 267332 28.30 15

Private Banks 10387 14.43 182284 19.29 18

Old Private 5174 7.18 54860 5.81 11

New Private 5213 7.24 127424 13.49 24

Foreign 310 0.43 27742 2.94 90

Total 71998 100.00 944620 100.00 13 Source: Reserve Bank of India, Profile of Banks

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Fig 4.2A Bank wise Distribution of Total Number of Branches

Fig 4.2B Bank wise Distribution of Total Number of Employees

Population-wise Structure of Banking Population group-wise distribution of resource mobilization and

deployment thereof may also give some revealing facts of the banking

structure. Table 4.4 gives population group-wise distribution of deposits,

credits and credit deposit ratio. In the resource mobilization, major share

comes from the metropolitan regions that 56.3 percent. It is followed by urban

region which contribute just 20.9 percent. Share of rural and semi-urban

region taken together comes out to be just 22.8 percent.

Generally, the deployment of the resources is in the form of advances

or investments. In terms of credit, 67.2 percent of the total advances go to

metropolitan areas as against their contribution of 56.3 percent in deposits. As

against 20.9 percent contribution of urban regions, the credit is to the tune of

16.2 percent. The share of both rural and semi-urban in the total credit is

much below their contribution in term of deposits. This depicts an interesting

fact that depositors and credit seekers belong to different regions. The rural

and semi-urban areas generate deposits but the credit is sought by customers

of metropolitan and urban regions. Metropolitan regions are characterized by

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higher credit-deposit ratio as compared to rural, semi-urban and urban

regions. Table 4.4

Population Group-Wise Structure of Banking (As on March 2009)

(Rs. Crore) Deposits Credit

Credit/Deposit Group Amount Percent Amount Percent Rural 365491 9.3 208694 7.3 0.571 Semi-Urban 531944 13.5 266736 9.3 0.501 Urban 824463 20.9 461870 16.2 0.560 Metropolitan 2215437 56.3 1920225 67.2 0.867 All India 3937335 100.00 2857525 100.00 0.726 Source: Statistical Tables Relating to Banks in India (2008-09).

Fig 4.3

Population Group-Wise Structure of Banking

Structure of Sector-wise Deployment of Gross Bank Credit Table 4.5 shows sector-wise Gross Bank Credit of Scheduled

Commercial Banks. Contribution of gross bank credit to agriculture and allied

activities increased from 11.96% in 2007 to 13.02% in 2009. The contribution

of gross bank credit is less as compared to industrial and services sector.

Large percent of non-food credit is contributed towards Industry. Industrial

sector forms the backbone of the economy and promotes economic

development of the country. Contribution towards personal loans which mainly

includes housing, education etc declined from 25.4% to 21.62%. Priority

sector share also increased from 34.48% in 2007 to 35.83% in 2009.

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Table 4.5 Sector-wise Gross Bank Credit of Scheduled Commercial Banks

(% of Gross Bank Credit) Gross Bank Credit 2007 2008 2009

Food Credit 1.99 2.07 1.75

Non-Food Credit 98 97.9 98.25

Agriculture & Allied Activities 11.96 11.71 13.02

Industry 38.8 41.24 40.52

Services 23.7 24.02 24.84

Personal Loans 25.4 23.02 21.62

Priority Sector 34.48 33.44 35.83

Source: RBI, Statistical Tables Relating to Banks in India, 2008-09.

Fig 4.4 Sector-wise Gross Bank Credit of Scheduled Commercial Banks:

STRUCTURAL CHANGE IN INDIAN BANKING

Since its inception, Indian Banking Industry has shown remarkable

developments and changes. Since Independence, Indian banks have gone

through three major changes- a period of consolidation of banks (up to 1966);

a period of historic expansion in both geographical and functional terms (from

1966 to mid 1980s) and another period of consolidation (from mid 1980s to

1991). This was followed by the era of reforms which imparted an altogether

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different dimension to the nuances of banking.8 Financial sector reforms

initiated as part of economic reforms in 1991 brought sea change in the Indian

banking Industry.

The recommendations of the Narasimham Committee- I in 1991

provided the blueprint for the first-generation reform of the financial sector.

The period 1992-97 laid the foundation for reforms in the banking sector.

During this period various norms related to capital adequacy, income

recognition, asset classification and provisioning, exposure norms etc were

implemented. It was in this period the difficult task of introducing some of the

structural changes was accomplished and it provided the base for framing

further reforms. For reform is not a product, but a dynamic socio-political

process. At time of Independence, the banking sector was only organised

sector of the country though weak in terms of economic base and financial

structure.9 Banking sector forms the backbone in the growth strategy rather

than being a follower of growth.

In August 1991, Narasimham Committee was appointed by the

Government of India to provide solution to problems of Indian banking system

and suggest appropriate measures. The Committee on the Financial System

(Narasimham 1991), recognized that a vibrant and competitive financial

system was central to the wide ranging structural reforms. Reform of banking

sector has become necessary in the light of certain developments that have

taken place in the pre-reform period. It is necessary to have overview of

Indian banking in pre-reform period in order to have better understanding of

reform measures introduced and its impact on Indian banking.

INDIAN BANKING IN PRE-REFORM PERIOD The pre-reform phase consists of three distinct phases- Foundation,

Expansion and Consolidation.

Foundation Phase The foundation phase covers the period from 1948 to 1969 that till

nationalization of banks in 1969. At the time of Independence, there was the 8 Tandon Deepak, Ahuja Kanhiya, Tandon Neelam "Relative Performance of Bank: A Study", The

Indian Banker, Vol. IV, No. 7, July 2009, p. 39. 9 Bhide M.G., Prasad A. & Ghosh Saibal "Banking Sector Reforms: A Critical Overview",

Economic & Political Weekly, February 2, 2002, p. 399.

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Reserve Bank of India which was established in 1935 and which performed

the functions of Central bank. Though RBI has supervisory powers under the

RBI Act there was no legislative framework for the regulation of the banking

system. The Government enacted Banking Regulation Act which came into

force in March 1949. The Act imposed discipline through various provisions

on the joint stock banks in India. The banking system at the time of

Independence was largely urban-oriented and remained out of reach of rural

population. Commercial banking was guided by large business and industrial

houses and lending was mainly directed to commerce, industry and trade.

Agriculture was neglected sector and farmers were forced to borrow from

village money lenders. Lending was mainly security-oriented. In order to re-

organize rural credit structure, Imperial Bank of India was nationalized and

renamed as the State Bank of India on July 1, 1955. State Bank of India was

entrusted with responsibility of expanding its rural branch network. In process

of geographical expansion of banking facilities, eight banking companies

functioning in former princely states were converted into subsidiaries of SBI,

which later came to be known as ‘Associate Banks of SBI’.

Expansion Phase The second phase had begun in early sixties. Nationalization of 14

major banks in July 19, 1969 brought a revolutionary change in Indian

banking industry. The main objective of nationalization were; provision of

adequate credit for priority sector which included agriculture, small-scale

industry, exports and weaker section of the society and to reduce regional

disparities. On April 15, 1980 six more private sector banks were nationalized,

and the number of public sector banks increased to twenty seven.

During this period, credit facilities were provided to neglected sectors

and sections of society, banks also participated in various employment

generation and poverty alleviation programmes. The important development

after nationalization was the emergence of Social Banking. Banks became the

instrument for promoting socio-economic objectives. Banking thus converted

itself from class banking to mass banking. Though there was vast branch

expansion in rural areas to fulfil the credit needs of rural population yet large

section of rural population remained outside the banking net. It was in

response to this weakness that Narasimham Committee recommended

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establishment of Regional Rural Banks. Regional Rural Banks were

established in 1975 under Regional Rural Banks Act 1975 by Public sector

banks in collaboration with Central and State Government in selected districts.

Banking system during this period emerged as an important instrument

of socio-economic changes. “However, this success was neither unqualified

nor without costs. While the rapid branch expansion, wider geographical

coverage has been achieved; lines of supervision and control had been

stretched beyond the optimum level and had weakened. Moreover, retail

lending to more risk prone areas at concessional rates had raised costs,

affected the quality of assets of banks and put their profitability under strain.

The competitive efficiency of Indian bank was at low ebb.”10

Consolidation Phase The third period is regarded as period of consolidation which began in

1985. During this period policy initiatives and relaxation of controls over the

banks were initiated. The process of branch expansion slowed down during

this period. Modern technology was introduced in phased manner in banks.

The area of focus was financial viability of banks through improvements in

profitability, strengthening capital base of banks allowing flexibility in several

areas of their operations.

Though there was phenomenal expansion in the geographical

coverage and functional spread of banking and financial system since

nationalization, yet large number of defects crept into the banking and

financial system. As a result, productivity, efficiency and profitability had been

eroded and the portfolio quality also deteriorated.

Several Public Sector Banks and Financial Institutions had become weak and

some Public Sector Banks had been incurring losses year after year.

These public sector banks were unable to meet competitive pressures

due to obsolete work technology and poor customer service. It was under

these circumstances that the Government of India set up a High Level

Committee with Mr. M. Narasimham, a former Governor of the Reserve Bank

of India as Chairman to examine all aspects relating to the structure,

10 Rao Suryachandra D. "Banking Reforms in India: An Evaluative Study of the Performance of

Commercial Banks", Regal Publications, New Delhi, 2008, p. 52.

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organisation, functions and procedures of the financial system. The

Committee on the Financial System submitted its report in November 1991.

The basic approach of Narasimham Committee was to improve the

financial health of Public sector banks and development financial institutions.

It was held that greater market orientation would strengthen the financial

system and thus improve its efficiency.

RECOMMENDATIONS OF THE NARASIMHAM COMMITTEE, 1991 The Narasimham Committee’s recommendations were based on the

fundamental assumption that resources of the bank came from general public

and were held by the banks in trust and that they were to be deployed for

maximum benefit of the depositors. The Narasimham Committee

recommendations were made to fulfil certain objectives such as to ensure a

degree of operational flexibility, internal autonomy for the Public Sector Banks

in their decision making process, greater degree of professionalism in banking

operations. The financial sector reforms aimed at providing a diversified,

efficient and competitive financial system. The ultimate objective was to

improve the allocative efficiency of available resources, to increase the return

on investments in order to promote the growth of the real sector of the

economy.

The First phase of the reforms started with the implementation of the

recommendations of Narasimham Committee- I which have brought

revolutionary changes in the banking sector. Some of the major

recommendations are as follows:

Statutory Liquidity Requirements (SLR) The Narasimham Committee (1991) recommended that the

government should reduce the SLR from the present 38.5 percent of the net

demand and time liabilities of banks to 25 percent over the next five years. A

reduction in the SLR levels would leave more funds with banks for allocation

to agriculture, industry, trade etc.

Cash Reserve Ratio (CRR) The Narasimham Committee (1991) recommended that RBI should

rely on open market operations increasingly and reduce its dependence on

CRR. The Committee proposed that CRR should be progressively reduced

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from the present high level of 15 percent to 3 to 5 percent. Due to this

recommendation an amount of idle cash balances kept by Banks with RBI

under CRR would reduce and release the amount for more productive and

remunerative purpose.

Direct Credit Programme The Committee recommended that the system of directed credit

programme should be gradually phased out. The reason for this

recommendation was that agriculture and small industry has developed and

there is no need for special assistance. The Committee also proposed that the

concept of priority sector should be redefined to include only the weaker

sections of the rural community such as marginal farmers, rural artisans,

village and cottage industries, tiny sector etc.

The directed credit programme for this redefined priority sector should

be fixed at 10 percent of the aggregate bank credit. The system should be

reviewed after a period of three years.

The structure of Interest Rates The Narasimham Committee recommended that the level and structure

of interest rates in the country should be broadly determined by market forces.

All controls and regulations on interest rates on lending and deposit rates of

banks and financial institutions on debentures and company deposits etc

should be removed. The Committee further proposed that RBI should be the

sole authority to simplify the structure of interest rate.

The Structural Re-organisation of the Banking Structure To bring about greater efficiency in banking operations, the

Narasimham Committee proposed a substantial reduction in the number of

Public Sector Banks through mergers and acquisitions. According to the

Committee, the broad pattern should consist of:

(a) 3 or 4 large banks (including the State Bank of India) which could

become international in character.

(b) 8 or 10 national banks with a network of branches throughout the

country engaged in general or universal banking.

(c) Local banks whose operations would be generally confined to specific

region.

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(d) Rural banks including RRBs whose operations should be confined to

the rural areas and whose business would be predominantly engaged

in financing of agriculture and allied activities.

Since the country had already a network of rural and semi-urban

branches, the Narasimham Committee proposed that the present system of

licensing of branches with the objective of spreading banking habit should be

discontinued. Banks should have freedom to open branches on purely

profitability considerations.

The Committee wanted the Government to make a positive declaration

that there will be no more nationalization of banks. RBI should permit the

setting up of new banks in the private sector, provided they conform to the

minimum start-up capital and other requirements. There should be no

difference in the treatment between Public Sector Banks and Private Sector

Banks.

The Narasimham Committee recommended that the Government

should allow foreign banks to open offices in India either as branches or as

subsidiaries. They should fulfil the same or similar social obligations as the

Indian Banks. Foreign banks and Indian banks should be permitted to set up

joint ventures in regard to merchant and investment banking, leasing and

other newer forms of financial services.

OTHER RECOMMENDATIONS RELATING TO THE BANKING SYSTEM Setting up of Asset Reconstruction Fund (ARF) Nationalized Banks and Development Finance Institutions (DFIs) were

burdened with sub-standard, doubtful and loss assets known as non-

performing assets (NPAs). Narasimham Committee recommended the setting

up of the Asset Reconstruction Fund (ARF) to take over from the nationalized

banks and financial institutions, a portion of their bad and doubtful debts at

discount. All bad and doubtful debts of banks and financial institutions were to

be transferred in a phased manner to ensure smooth and effective functioning

of the ARF. This arrangement would help the banks and the financial

institutions to take off bad and doubtful debts from their balance sheets and

recycle the funds realised through this process into more productive uses.

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Remove the Duality of Control The Narasimham Committee recommended that the present system of

dual control over the banking system between RBI and the Banking Division

of the Ministry of Finance should end immediately and that RBI should be the

primary agency for the regulation of the banking system.

Free and Autonomous Banks The Narasimham Committee recommended that the Public sector

banks should be free and autonomous. Every bank should go for a radical

change in work technology and culture, so as to become competitive internally

and to be in co-ordination with wide ranging of innovations taking place

abroad. RBI should examine all the guidelines and directions issued to the

banking system in the context of the Independence and autonomy of banks.

Prudential Norms The purpose of the prudential system of recognition of income,

classification of assets and provisioning of bad debts is to ensure that the

books of the commercial banks reflect their financial position more accurately

and in accordance with internationally accepted accounting practices. These

help in more effective supervision of banks.

The assets are now classified on the basis of their performance in 4

categories (a) standard (b) sub-standard (c) doubtful (d) loss assets.

Adequate provision is required for bad and doubtful debts. Detailed

instructions for provisioning have been laid down. Banks have been advised

to make their balance sheets transparent with maximum disclosure on the

financial health of institutions. The Committee recommended provisioning

norms for non-performing assets. On outstanding substandard assets 10

percent general provision should be made. On loss assets the provision shall

be 100 percent. On secured portion of doubtful assets the provision should be

20 to 50 percent.

Capital Adequacy Norms Inadequacy of capital is a serious cause of concern. As per Basle

Committee norms, the RBI introduced capital adequacy norms. It was

prescribed that banks should achieve a minimum of 4 percent capital

adequacy ratio in relation to risk weighted assets by March 1993, of which

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Tier I capital should not be less than 2 percent. The BIS standard of 8 percent

should be achieved over a period of three years that is by March 1996. A new

capital framework was introduced for Indian scheduled commercial banks

based on the Basle Committee recommendation. Two tiers of capital for the

banks were presented.

(i) Tier I or core capital considered the most permanent and readily

available support against unexpected losses includes paid-up capital,

statutory reserves, share premium and capital reserve

(ii) Tier II capital consisting of undisclosed reserves, fully paid-up

cumulative perpetual preference shares, revaluation reserves, general

provisions and loss reserves etc.

It was also prescribed that Tier II capital should not be more than 100

percent of Tier I capital.

Branch Licensing The Committee recommended that branch licensing should be

abolished. The opening and closing of branches should be left to the

judgement of individual banks. Government should be more liberal with

opening of foreign banks. They should be treated at par with domestic banks.

The internal organisation be left to the bank. In case of national banks a three

tier of structure of head office, zonal office and branch is favoured. Local

banks may be two-tiered and SBI may have four tiers.

Computerisation

The Committee favoured Rangarajan Committee on computerisation.

Computer is indispensable for enhanced customer services.

IMPLEMENTATION OF REFORMS Despite stiff opposition from bank unions and political parties in the

country, the Government of India accepted all the major recommendations of

Narasimham Committee (1991) and started implementing them.

Statutory liquidity ratio (SLR) On incremental net demand and time liabilities has been reduced from

38.5 percent to 25 percent and SLR on outstanding net domestic demand and

time liabilities were introduced gradually from 38.5 percent to 25 percent in

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October 1997, this was the minimum stipulated under section 24 of the

Banking Regulation Act, 1949.

Cash Reserve Ratio (CRR) The incremental cash reserve ratio of 10 percent was abolished. But

RBI could not reduce CRR immediately. When conditions eased and money

growth started slowing down since 1995-96, RBI reduced CRR gradually from

15 percent to 5.5 percent in December 2001. The purpose of reducing CRR

was to release funds locked up with RBI for lending to the industrial and other

sectors which do not have adequate availability of bank credit.

Interest Rate Slabs Interest rate slabs were gradually reduced from 20 to 2 by 1994-95.

The important changes in interest rates since 1991-92 are as follows:

(i) Interest rate on domestic term deposits has been decontrolled.

(ii) The prime lending rates of SBI and most other banks on general

advances of over Rs. 2 lakhs has been reduced.

(iii) Rate of interest on bank loans above Rs. 2 lakhs has been fully

decontrolled.

(iv) Interest rates on deposits and on advances of all cooperative banks

(except urban cooperative banks) have been regulated.

The purpose of deregulation of interest rate on the high slab of bank

advances was to stimulate healthy competition among the banks and

encourage their operational efficiency. Scheduled commercial banks have

now the freedom to set interest rates on their deposits subject to minimum

floor rates and maximum ceiling rates.

Prudential Norms These norms have been started by RBI as part of the reformative

process. The purpose of prudential system of recognition of income,

classification of assets and provisioning of bad debts is to ensure that the

books of commercial banks reflect their financial position more accurately and

in accordance with internationally accepted accounting practices. These help

in more effective supervision of banks.

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Capital Adequacy Ratio All banks are required to attain capital to risk weighted ratios as per

BIS norms by March 1997. All banks except (UCO & Indian Bank) have

attained the norms.

Access to Capital Market The Government of India amended the Banking Companies

(Acquisition and Transfer of Undertakings) Act to enable the nationalised

banks to access the market for capital funds through public issues, subject to

the provision that the holding of the Central Government would not fall below

51 percent of the paid-up capital.

Freedom of operation Scheduled commercial banks have now been given freedom to open

new branches and upgrade extension counters, after obtaining capital

adequacy norms and prudential accounting standards. They are also

permitted to close non-viable branches other than in rural areas. Bank lending

norms have been liberalised and banks have been given freedom to decide

levels of holding of individual items of inventories and receivables.

New Private Sector Banks Ten private sector banks have already started functioning. These new

private sector banks are allowed to raise capital contribution from foreign

institutional investor upto 20 percent and from non-resident Indians (NRIs)

upto 40 percent.

Local Area Banks In the1996-97 budget, the Government of India announced the setting

up of new private local area banks (LABs) with jurisdiction over three

contiguous districts. These banks would help to mobilise rural savings and to

channelize them into investment in local areas. The RBI has issued guidelines

for setting up such banks in 1996 and gave its approval in principle to the

setting up of seven LABs in the private sector. Of these, RBI had issued

licenses to 5 LABs, located in Andhra Pradesh, Karnataka, Rajasthan, Punjab

and Gujarat. These LABs are already in business.

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Supervision of Commercial Banks Supervision of commercial banks is being tightened by RBI, especially

after the securities scam of 1992. RBI has set up a Board of Financial

Supervision with an Advisory Council under the chairmanship of the Governor

to strengthen the supervisory and surveillance system of banks and financial

institutions. RBI has also established in December 1993 a new department

known as Department of Supervision as an independent unit for supervision

of commercial banks and to assist the Board of Financial Supervision.

Recovery of Debts The Government of India passed ‘Recovery of Debts due to banks and

Financial institutions Act, 1993’ in order to facilitate and speed up the recovery

of debts due to banks and financial institutions. Six Special Recovery

Tribunals have been set up at Kolkata, New Delhi, Jaipur, Ahmadabad,

Bangalore and Chennai to facilitate quicker recoveries of loan arrears within

six months and an Appellate Tribunal has also been set up in Mumbai.

RECOMMENDATION OF NARASIMHAM COMMITTEE- II (1998) The Finance Ministry of the Government of India appointed Mr.

Narasimham as chairman of one more Committee that is Committee on the

Banking Sector Reforms. The purpose of Committee was to review the

progress of banking sector reforms to date and chart a programme on

financial sector reforms in order to strengthen India’s financial system and

make it internationally competitive. The Narasimham Committee on the

Banking Sector Reforms submitted its report to the Government in April 1998.

The important recommendations are:

Need For Stronger Banking System The Narasimham Committee on Banking Sector Reforms (1998) made

out a strong case for a stronger banking system in the country especially in

the context of capital account convertibility (CAC) which would involve large

inflows and outflows of capital and consequent complications for exchange

rate management and domestic liquidity. The Narasimham Committee

recommended the merger of strong banks with strong banks. It was against

merger of weak banks with strong banks because it might have a negative

impact on the asset quality of the stronger bank. The Committee

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recommended that two or three large banks be given international or global

status.

Capital Adequacy Ratio The Narasimham Committee (1998) suggested that the Government

should consider raising the prescribed capital adequacy ratio to improve

inherent strength of banks and to improve their risk absorption capacity. The

Committee suggested higher capital adequacy requirements for banks and

the setting up of an Asset Reconstruction Fund (ARF) to take over the bad

debts of the banks. It recommended that the minimum capital to risk asset

ratio be increased to 10 percent from its present level of 8 percent in a phased

manner- 9 percent to be achieved by the year 2000 and the ratio of 10

percent by 2002.

Asset Quality NPAs and Directed Credit The Committee recommended that an 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 of ‘evergreening’ by making fresh advance to

the troubled parties with a view to settle interest dues and avoiding such loans

treating as NPAs. For banks with a high NPA portfolio, the Committee

suggested the setting up of an Asset Reconstruction Company to take over

bad debts.

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. In

future income recognition, asset classification and provisioning must apply

even to government guaranteed advances. Banks should pay greater

attention to asset liability management to avoid mismatches.

Systems and Methods in Banks The internal control systems which are internal inspection and audit

should be strengthened. There are recommendations for inducting an

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additional whole time director on the board of the banks, recruitment of skilled

manpower, revising remuneration to persons at managerial level etc.

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. The Committee recommended a review of

functions of boards so that they remain responsible to the shareholders. The

management boards are to be reorganised and there shall not be any

government interference.

Narrow Banking for Weak Banks The Narasimham Committee (1998) was seriously concerned with the

rehabilitation of weak Public Sector Banks which have accumulated a high

percentage of non-performing assets (NPAs), which in some cases was as

high as 20 percent of the total assets. The Committee suggested the concept

of Narrow banking to rehabilitate such weak banks. Narrow banking implies

that the weak banks place their funds only in the short-term in risk free assets

and these banks attempt to match their demand deposits by safe liquid

assets.

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 branches

and directed credit as other banks.

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

limited area to serve local trade, small industry and agriculture and at the

same time these banks have corresponding relationship with the large

national and international banks.

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Review and Update 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 Financial

Regulation and Supervision and increasing the powers of debt recovery

tribunals. Some of these recommendations more or less resemble the

recommendation of the Narasimham Committee- I.

IMPACT OF BANKING SECTOR REFORMS IN INDIA The banking sector reforms which were implemented as a part of

overall economic reforms brought the effective and impressive changes

resulting in significant improvements within a short span. The banking system

which was over-regulated and over-administered was freed from all

restrictions and entered into an era of competition since 1992. The entry of

modern private banks and foreign banks enhanced competition. Prudential

norms relating to income recognition, asset classification, provisioning and

capital adequacy have led to the improvement of financial health of banks.

Consequent upon prudential norms the most visible structural change has

been improvement in the quality of assets. Further there has been

considerable improvement in the profitability of banking system. The visible

impact of reforms can be summarised below:

(i) The banking system has become well diversified with the

establishment of new private banks and about 20 new foreign banks

after 1993. Entry of modernised 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. In

addition to growth of banks and commercial banking, various other

financial intermediaries like mutual funds, equipment leasing and hire

purchase companies; housing finance companies which were

sponsored by banks have cropped up.

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(ii) Finance regulation through statutory pre-emptions has been lowered

while stepping up of the prudential regulations.

(iii) Steps have been taken to strengthen Public sector banks through

increasing their autonomy, recapitalisation etc. Based on specified

criteria, nationalised banks were given autonomy in matters of creation,

abolition, upgradation of posts for their administrative officers’ upto the

level of Deputy General Manager.

(iv) A set of micro- prudential measures have been stipulated with regard

to capital adequacy, asset classification, provisioning, accounting rules,

valuation norms etc.

(v) Measures have been taken to broaden the ownership base of Public

sector banks by allowing them to approach the capital market. The

Government of India, in a major policy announcement, decided to

reduce its stake in Public sector banks from 100 percent to 51 percent

retaining however the policy parameters of Public sector banks. The

Government proposes to reduce further its stake to 33 percent.

Moreover there is a provision for foreign investments to the extent of 20

percent. The net result of the dilution in ownership of Public sector

banks is that these banks are becoming slowly joint sector banks. A

number of Public sector banks like State Bank of India, Andhra Bank,

Canara Bank, Punjab National Bank have gone up for a 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 number of small non-viable

banks, the RBI encouraged merger of small non-viable banks, the RBI

encouraged merger of small banks with big banks. Now, market driven

mergers between private banks have been taking place.

(vii) Intense competition among banks has motivated banks to pay attention

to customer service. Product innovations and process engineering

have become matter of routine. 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 been moving towards providing value added services to

customers. Under the impact of technological up-gradation and

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financial innovations, banks have now become super-markets that is

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.

Even though public sector banks continue to dominate the Indian

banking system, accounting for nearly three-fourth of the total assets and

incomes, the increasing competition in the banking system has led to the

falling share of public sector banks, and increasing share of new private

sector banks, which were set up around mid 1990s.

The ratio of assets of Scheduled commercial banks to GDP increased

to 91.4 percent at end March 2007 from 85.0 percent at end March 2006. It

suggested a faster growth of the banking system in relation to the real

economy. Net Profits of SCBs increased by 27.0 percent during 2006-07 as

compared with 17.3 percent during 2005-06. Balance sheet of Scheduled

Commercial banks continued to register a strong growth during 2006-07 on

the back of robust macroeconomic performance. Banks were able to sustain

their profitability despite sharp increase in provisions and contingencies. Their

capital adequacy level remained at the previous year’s level, despite a sharp

increase in the risk weighted assets. Asset quality, as reflected in gross and

net NPA levels improved further during the year.

Some significant changes were witnessed in the use of technology by

banks. Increased use of technology combined with other some specific

measures helped to improve customer service by banks. A major

achievement is significant improvement in the profitability of the banking

sector. Capital position of banks also improved significantly. Corporate

Governance practices were strengthened. There was sharp increase in the

flow of credit to agriculture and SME sectors.

As clear that financial sector in general and banking sector in particular

witnessed remarkable changes since its inception. It is the banks themselves

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rather than the regulator or supervisor that was mainly responsible for their

performance as well as financial health.11

It can be concluded that Indian banking structure is characterised by

sound, vibrant and resilient frame work. A large number of structural changes

took place in Indian banking such as nationalisation, consolidation, banking

reforms etc. which has changed the face of Indian banking industry and it

occupies an important place in international market.

*********

11 Reserve Bank of India, Report on Currency and Finance, 2006-08, Vol. II, RBI Mumbai, p. 515.