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Banking Sector Reforms in India
Dr Subhash Gupta
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Bank of Hindustan, set up in 1870, was the earliest IndianBank.
Banking in India on modern lines started with theestablishment of three presidency banks under Presidency
Bank's act 1876 i.e. Bank of Calcutta, Bank of Bombay andBank of Madras.
In 1921, all presidency banks were amalgamated to form theImperial Bank of India. Imperial bank carried out limitedcentral banking functions also prior to establishment of RBI.
Reserve Bank of India Act was passed in 1934 & ReserveBank of India (RBI) was constituted as an apex bank withoutmajor government ownership.
Banking Regulations Act was passed in 1949. Thisregulation brought Reserve Bank of India under governmentcontrol
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Indian Financial Sector: different phases
Three distinct periods: 1947-68, 1969-91, 1991 onward
1947-68: relatively liberal environment - the role of RBI
was to supervise and control the banks
1969-91: Bank nationalization and Financial repression
banking policies re-oriented to meet social objectives such
as the reduction in inequalities and the concentration of
economic power interest rate controls and directed credit
programs
1991 onward: financial sector liberalization
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Indian Financial Sector: Pre-Nationalization
RBI Act: scheduled commercial banks are required tomaintain a minimum cash reserve of 7% of their demandand time liabilities - SLR was 20% (cash, gold, govt.securities)
1962: RBI was empowered to vary the CRR between 3%and 15% - empowered to stipulate minimum lending ratesand ceilings rates on various types of advances
Problem of bank failures and compulsory merger of weak
banks with relatively stronger ones (no. of banks fell from566 in 1951 to 85 in 1969 due to mergers).
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Indian Financial Sector: Pre-Nationalization
1962: Deposit insurance scheme with the establishment
of the Deposit Insurance Corporation 1964: RBI directly regulated the interest on deposits
(prior to this, interest rates were governed by a voluntaryagreement among the important banks)
Certain disquieting features: (i) banking business waslargely confined to the urban areas (neglect of rural andsemi-urban areas) (ii) agriculture sector got only a verysmall share of total bank credit (iii) within industry, thelarge borrowers got the greatest share of credit
The pattern of credit disbursement was inconsistent withthe goal of achieving an equitable allocation of creditand the priorities set in the plans - bank nationalizationin 1969
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Indian Financial Sector: Bank nationalization
1969: 14 largest scheduled commercial banks
nationalized; 22 largest banks accounting for 86% ofdeposits had become public sector banks; 6 more banks
nationalized in 1980 bringing the share of public sector
banks deposits to 92%
Rural branch expansion to mobilize deposits andenhancement of agriculture credit
Priority sector lending (agriculture, small scale industries,
retail trade, transport operators etc); requirement was
33%, raised to 40% in 1979.
UTI and IDBI, IFCI and ICICI were set up with specific
objectives in mind
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A decade of change and evolution
Pre-reform
Extensiveregulation
Focus on
industrialsector
The 1990s Today
Indianeconomy
Financial
sector
..financial sector mirroring macro-economic
change
Liberalisation
Globalisation
Structuralchange services
Resilientindustry
Buoyant
servicessector
Highlysegmented
Public sectordominance
Opening upof varioussub-sectors
Privatesectorparticipation
Diversifiedfinancialgroups
Globallybenchmarked
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The banking sector today
Depth Countrywide coverage
Large number of players
Increasinglysophisticated financialmarkets
Technology
Increasing use of
technology in operations Poised to expand and
deepen technology usage
Diversification Emergence of integrated
players
Diversifying capitaldeployment
Leveraging synergies
Regulation
Robust regulatory systemaligned to internationalstandards
Efficient monetarymanagement
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Sector snapshot
Size Total assets of US$ 335 billion
Total deposits of US$ 279 billion
Number ofbanks
Over 290 scheduled banks
Public sector: 27
Private sector: new 9; old 24
Foreign: 37
Over 190 regional rural banks
Branch network
Over 66,000 branches Public sector: 46,000
Private sector: 5,500 Foreign: 190 Regional rural: 14,400
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A new orientation among banks
Sell products
Product research: whatwill sell?
Product sales and
profitability targets Product specialist
groups
Introduce newofferings every few
years/months Branch banking
Focus - customeracquisition
Meet customers needs
Customer research:what does the customerwant?
Customer segmentsales and profitabilitytargets
Customer owners
Customer specific new
offerings everyweek/day
Customer convenience
Deepen relationships
Traditional/ public sector New/ private sector
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Why Banking Sector Reforms High Regulated Sector
Prevalence of High Reserve Requirements
Interest Rate Controls
Large Allocations to Priority Sector
Poor Lending Strategies
Lack of Internal Risk Management
Low Yields on Government Securities
Waiver of Loans on Political Grounds Lack of Competition
High Cost of Operations
Poor Customer Service
Poor Loan Recovery
Weak Capital Position
Political Interference Lack of Institutional Autonomy
Lack of Accountability in Banks
Vague Reporting Formats
Technology Deficiency
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Reforms in Banking Sector
The first wave of financial liberalization took place in thesecond half of the 1980s, mainly taking the form of Introduction of Treasury Bills
Development of money markets
Partial Interest Rate Deregulation
In 1988, the Discount and Financial House of India wasestablished
In 1989, both commercial paper and certificates of depositwere introduced
Based on the 1985 report of the Chakravarty Committee,coupon rates on government bonds were gradually increasedto reflect demand and supply conditions
In 1988, the maximum (or ceiling) lending rate and ranges inminimum rates were unified and switched to a minimum-
lending rate (MLR) in 1988. As a result, banks were able toset interest rates more flexibly.
In 1989, the maximum interest rates on call money wereliberalised
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Reforms in Banking Sector
Second wave of Liberalisation started withNarsimham Committee Recommendations Reduction of the CRR and SLR
The CRR has declined gradually from 15% in 1991 to5.75% in November 2001 and to 5.5% in December 2001.
The SLR was reduced gradually from 38.5% in 1991 to25% in October 1997. The SLR has remained at this rateuntil today, while the legal upper limit has stayed at 40%throughout the period
Interest Rate Deregulation The Government started interest rate deregulation in 1992.
This led to a complete liberalization of all term deposit ratesand lending rates on advances in excess of Rs200,000.
The remaining interest rate controls are savings deposit ratesand lending rates up to Rs200,000.
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Reforms in Banking SectorReform of Priority SectorLending
Advances to the priority sectorsshould be reduced from 40% to 10%.
While the targets of 40% imposed ondomestic banks and 32% on foreignbanks have not changed during thereform period, the burden of thisdirected lending practice has beengradually reduced by (1) expandingthe definition of priority sector lending,and (2) liberalizing lending rates onadvances in excess of Rs200,000,
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Reforms in Banking Sector
Deregulation ofEntry Barriers and Branching RestrictionsEntry Deregulation
The RBI issued guidelines in 1993 governing the establishment ofnew private sector banks. The guidelines stated that a new bankneeded to
maintain minimum paid-up capital of Rs1 billion;
list its shares on stock exchanges; fulfill the priority sector lending requirement with modification allowed in the
composition of such lending for an initial period of three years;
set a ceiling of 1% of total voting rights held by an individual shareholder asstipulated by the Banking Regulation Act of 1949;
postpone setting up a subsidiary or mutual fund until at least three years afterits establishment, and
use modern infrastructural facilities to provide good customer service
In 1994, the Banking Regulation Act of 1949 was amended in order toraise the ceiling of voting rights of an individual shareholder in a privatebank from 1% to 10%.
The RBI approved six new private sector banks in 1994
The RBI granted an .in principle. approval to three local areabanks.
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Deregulation of Branch Restrictions
The RBI changed its licensing policy in 1992in order to provide banks with operationalautonomy to rationalize their branch networks.
Banks were allowed to shift their existingbranches within the same locality, open certaintypes of specialized branches, convert existing
nonviable rural branches into satellite offices,spin off business of a branch, and open extensioncounters and administrative units without priorapproval of the RBI.
The RBI allowed banks to open branches freely,provided that a bank met the capital adequacy
ratio of 8%; earned a net profit for threeconsecutive years, and had NPAs not exceeding15% of total outstanding loans. In 1998/99, oldand new foreign banks were permitted to open upto 12 branches a year, as against the earlierstipulation of eight branches.
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Adoption of Prudential Norms: The RBI issued guidelines in 1992/93 on
income recognition, asset classification, and
provisioning.
Restructuring of Public SectorBanks
Recapitalization
Debt Recovery and Bankruptcy
Partial Privatization Writing-Off of Bad Debts
Setting up of an Asset Reconstruction
Company
Reduction of Operational Costs
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Journey Ahead
reforms have not been a total success, for the followingreasons:
First, public sector banks still remain dominant. Inaddition, the profitability of nationalized banks has notimproved
Second, partial privatization has not significantlyimproved corporate governance, due to the ceiling ofindividual voting rights at 10%, the Governmentscontinued dominance as the largest shareholder, andthe absence of major reforms determining the boards ofdirectors.
Third, priority sector lending still remains a hindrance forthe full commercialization of banks.
Fourth, banks large-scale holdings of governmentsecurities lower banks incentives to improve their riskmanagement skills on lending activities