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    SUMAN VISHWAKARMA

    SOCIAL CONTROL OVER

    BANKING

    SEMINAR SUBMITTED TO THE UNIVERSITY OFMUMBAI FOR L.L.M DEGREE SEM 3RD IN

    BUSSINESS.

    BY.SUMAN

    VISHWAKARMA

    UNDER

    THE

    GUIDENCE

    OF

    PROF.

    MR.SANJAYJADHAVDEPARTMENTOFLAW,UNIVERSITYOF

    MUMBAI2012TO2013

    04Sep13

    The banks are the custodians of savings and powerful institutions to provide credit. They mobilize theresources from all the sections of the community by way of deposits and channelize them to industries

    and others by way of granting loans. In 1955 the Imperial Bank of India was nationalized and SBI was

    constituted.

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    BackgroundThe banks are the custodians of savings and

    powerful institutions to provide credit. They mobilise the resources from all thesections of the community by way of deposits and channelize them to industries

    and others by way of granting loans. In 1955 the Imperial Bank of India was

    nationalised and SBI was constituted.

    It was observed that commercial banks weredirecting their advances to the large and medium scale industries and the

    priority sectors such as agriculture, small-scale industries and the exports wereneglected.

    The chairmen and directors of banks weremostly industrialists and many of them were interested in sanctioning largeamount of loans and advances to the industries with which they were connected.

    To overcome these deficiencies found in the working of the banks, the Banking

    Laws (Amendment) Act was passed in December 1968 and came into force on1-2-1969. It is known as the scheme of 'social control' over the banks. The then

    deputy Prime Minister, Mr. Morarji Desai made a statement in the Parliamenton the eve of introducing the bill to amend the banking laws Act.

    He explained that the aim of social control was,"to regulate our social and economic life so as to attain the optimum growth rate

    for our economy and to prevent at the same time monopolistic trend,

    concentration of economic power and misdirection of resources".The following are the main provisions of this

    amendment, Bigger banks had to be managed by whole time chairman

    possessing special knowledge and practical experience of the working of abanking company or of finance, economics or business administration.

    The majority of directors had to be persons with special knowledge or practicalexperience in any of the areas such as accountancy, agriculture and rural

    economy, banking, co-operative, economics, finance, law, small scale industriesetc.The banks were also prohibited from making any loans or advances, secured

    or unsecured to their directors or to any companies in which they havesubstantial interest.

    The growth of commercial banking during the

    first three plan periods has been lopsided. Without demanding proper security

    some banks were diverting funds to large and medium industries.

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    Bank branches were opened only in big cities.Rural areas were neglected. Banks made discrimination between private sectorand public sector between rural and urban and between agriculture, trade and

    industry. The banks were financing those industries which were producing

    luxury goods.

    The government felt that this type of growth wasnot in consonance with planning. The growth appeared to be defiant in many

    respects. There was a growing demand for the bank credit for the developmentof agriculture, industry and self-employment. So it was essential for the banking

    system to attract savings.Therefore, the government felt that need for social

    banking as against capitalist banking. A scheme of social control was

    introduced in 1967. The government enacted Banking Laws Amendment Act in

    1968.This act has given more power to the government to control banking. Theobjectives of this Act was to ensure more equitable distribution of the resources

    of the banking system. The priority sectors like agriculture, small-scaleindustry, public sector and self-employment were to receive their due share in

    obtaining bank finance. Apart from this the banks are required to reconstitutetheir board of directors .

    The government set up National credit council in1968. The Finance Minister was the chairman and the Governor of the ReserveBank was the vice chairman of the council. The main functions of the National

    credit council were:

    1. assessing the volume of credit required for the economy as a whole.

    2. providing guidelines for the distribution of credit to the priority sector.3. ensuring equitable distribution of credit in the economy.

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    Bank regulationsare a form of government regulation which subject banks to

    certain requirements, restrictions and guidelines. This regulatory structure

    creates transparency between banking institutions and the individuals and

    corporations with whom they conduct business, among other things. Given the

    inter connectedness of the banking industry and the reliance that the national

    (and global) economy hold on banks, It is important for regulatory agencies to

    maintain control over the standardized practices of these institutions. Supporters

    of such regulation often hinge their arguments on the "too big to fail" notion.

    This holds that many financial institutions(particularly investment banks with

    a commercial arm) hold too much control over the economy to fail without

    enormous consequences . This is the premise for government bailouts, in which

    government financial assistance is provided to banks or other financial

    institutions who appear to be on the brink of collapse. The belief is that withoutthis aid, the crippled banks would not only become bankrupt, but would create

    rippling effects throughout the economy leading to systemic failure.India has a

    long history of both public and private banking . Modern banking in India began

    in the 18th century, with the founding of the English Agency House in Calcutta

    and Bombay. In the first half of the 19th century, three Presidency banks were

    founded. After the 1860 introduction of limited liability, private banks began to

    appear, and foreign banks entered the market. The beginning of the 20th century

    saw the introduction of joint stock banks. In 1935, the presidency banks were

    merged together to form the Imperial Bank of India, which was subsequentlyrenamed the State Bank of India.

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    The post independence period witnessed

    massive growth in the Indian banking system. The first step taken in thisdirection was nationalization of the Reserve Bank of India in 1948. It changed

    the outlook of the Reserve Bank by giving them the status of monitoring

    authority to regulate and control the socio-economic activities laid down by thegovernment. In order to have sound and balanced growth of banking business

    in the country,

    The Reserve Bank of India Act, 1949 was passed

    to have control of the Reserve bank over the banking industry. In 1955, the

    Imperial Bank of India was nationalized under the name of State Bank of India.The scheme of social control was initiated by the government in the year 1967.Followed by it, the government nationalized 14 major banks which held a

    deposit of around Rs 50 crores on 19th July 1969 and 6 more banks which held

    deposit of around Rs 200 crores on 15th April 1980. This process was done toensure more equitable and purposeful distribution of the credit. Besides the

    above developments, financial institutions were established for meeting the

    specialized needs. These include Industrial Development Bank of India (IDBI),Industrial Credit and Investment Bank of India for meeting the long term

    financial needs of the large scale operations. Similarly for meeting the

    requirements of the Small Scale Industries (SSIs), State Financial Corporation(SFC), Small Industries Development (SIDC) and Small IndustriesDevelopment Bank of India (SIDBI) have been established. The National Bank

    for Agriculture and Rural Development (NABARD), Land Development Bank

    (LDB), Regional Rural Bank (RRB) etc. has been established for taking care of

    the credit needs in the agriculture sector.

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    NATIONALIZATION.

    Barely four months after the third meeting of the National Credit Council,on 9 July 1969, Indira Gandhi sent a note to the Congress Working Committee

    through Fakhruddin Ali Ahmed, who was the Minister for Industrial

    Development, suggesting the nationalization of major banks. This cameas a complete surprise, for the prevalent belief in Congress circles was that

    What was most disturbing for the Reserve Bank was the impression that wascreated in the media that it was opposed to nationalization. This perhaps had to

    do with the personality of Jha himself, and with the fact that the Bank had

    striven hard to make a success of the social control experiment. As Vice

    Chairman of the National Credit Council, Jha ensured that a large number ofdocuments were submitted on different aspects of social control.

    The Bank had substantial inputs in the work of the groups formed by theCouncil. It also helped to provide the secretariat for the Council, and to create in

    March 1969 a cell attached to the Banking Commission. These actions by

    themselves did not imply that Jha was opposed to nationalization of majorIndian banks. All the oral accounts point out that while Jha did not favour banknationalization, he did not openly articulate his personal view on the subject.

    The real issue was summed up by I.G. Patel in his book,

    Glimpses of Indian Economic Policy: An Insiders View: For me, oneconsequence of nationalization was controversy once again about my

    jurisdiction and that of my department. A new banking department was createdin the ministry under A. Bakshi from the RBI, an old leftist and acerbic friend

    of Haksar who could obviously be more relied upon to run nationalized banks

    than L.K. or I.G. (p. 137). As Patels quote shows, Jha was identified withforces that did not figure in the leftist groups that considered social control as an

    apology and a dilatory tactic to prevent the state from gaining the commanding

    heights of Indian finances. After the legal tangle over nationalization wastemporarily sorted out, Jha convened a Rural Credit Survey Committee

    commercial banks only provided 0.9% of the total volume of advances andloans to the agricultural sector (Reserve Bank of India 2008a). Rural Indiacontinued to rely mostly on moneylenders that charged them very high interestrates on their loans.

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    The government had to make some major changes

    to promote equal socio-economic development. The Government of Indianationalized the Imperial Bank of India, with the purpose of, extension ofbanking facilities on a large scale, more particularly in the rural and semi-urbanareas, and for diverse other public purposes. The State Bank of India Act

    (1955) renamed the Imperial Bank of India as the State Bank of India (SBI).

    However to prevent it from being under administrative pressure its ownership

    was vested with the RBI. SBI underwent rapid expansion and opened 416branches in 5 years all over the country (Reserve Bank of India2008a).

    The security that the government owned SBIhelped it compete against deposits in safe avenuessuch as the post offices and

    savings at home. Five years later in 1960 eight more banks were nationalizedand they formed the subsidiaries of the State Bank of India. With thenationalization of these eight banks one third of the banking sector was under

    the direct control of the government.

    The Indian banking system had made considerableprogress since independence: (1) bank failures had decreased,

    (2) bank presence in the country increased,(3) banking legislation had a stronger foundation,

    and(4) deposits had increased.

    However, the benefits had still not flowed in theirentirety to the general public, because credit was not reaching sectors that mostneeded it, and the banking industry did not have a national presence, because of

    its concentration in metropolitan and urban areas.On December 1967, through

    the Banking Laws Amendment Act (Reserve Bank of India 2008), the idea ofsocial control was introduced. The main objective of social control was to

    achieve:(1) bank credit allocation to the right sectors,

    (2) prevent misuse of bank funds, and

    (3) use banks to promote and help finance socio-

    economic development. The National Credit Council was established in 1968to help allocate credit according to the Five Year Plan priorities .In 1969 by

    putting into effect the Banking Companies (Acquisition and Transfer of

    Undertakings) Ordinance, fourteen banks were nationalized.

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    Nationalization led to major structural changes in

    the banking sector of India. Branch expansion was accompanied bydevelopment of priority sectors of the economy, with credit being directedtowards these sectors contrary to profit motives of the banks. The CreditGuarantee Corporation of India Ltd. was established for providing guarantees

    against the risk of default in payment, which increased the number of loans to

    smaller borrowers by the banks. .

    The interest rate paid by the banks on deposits.

    The nationalization phase was marked by stringent controls on the banking

    industry. As of September 22nd, 1990 the Cash Reserve Ratio was 15.00% and

    the Statutory Liquidity Ratio was 38.5% (Reserve Bank of India), combinedthey amounted to 53.5% of all demands and liabilities being saved in liquid

    government securities or as cash with the RBI. The banks were being used by

    the government to fund their projects for economic development. This led the

    banks to be unprofitable forcing the government to adopt changes and thus,

    came about the reforms of 1991 led by the Narasimham Committee.

    There are two main approaches to banking

    regulation. One endpoint is government. ownership of the banking industry and

    the other endpoint is free banking system. Barth, Caprio and Levine (2008)describe the two main approaches as the Public Interest Approach and the

    Private Interest View of Regulation. In India up until 1991 there was an

    increased amount of government regulation in the banking industry, and socialcontrol over the banks was mandated successful. Social control in banking

    would realize if the banks to manage to allocate resources efficiently whilemobilizing credit in all sectors including the marked out priority sectors.

    Barth,Caprio and Levine (2008) define socially efficient as, that the banking

    system allocates resources in a way that maximizes output,while minimizing

    variance, and is distributionally preferred.The government of India initially put in process the

    policy of social control to help regulate, stabilize and expand the banking

    system. The government had good intentions, and it led to a banking system that

    spanned across the nation and was undergoing fewer banking failures, andactually making profits while lending to priority sectors.

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    THE

    SECOND

    ROUND

    Nationalization that incorporated six more

    banks, and increased government regulation, made the banking system very

    inefficient and unprofitable; Joshi and Little (1997) said, By 1991, the countryhad erected an unprofitable, inefficient, and financially unsound banking

    sector.There are various ways a government can

    interfere with the banking system of an economy, and the Indian government,

    participated in all the below mentioned measures. Barth, rate of economicgrowth within those states accelerated and quality of bank lending improved.

    Caprio and Levine (2008)outline the main ones as:

    (1) restrictions on banks,

    (2) entry,(3) capital requirements,

    (4) supervisory powers,

    (5) safety net support the,(6) market monitoring and

    (7) government ownership.

    (1) Restrictions on Banks: It can be in the form of activity restrictions. It iscritical to impose activity restrictions on banks, and that helps define the term

    bank. Regulatory restrictions can decrease efficiency of the banks and reduces

    their ability to diversify their income streams and decrease overall risk ofoperations. A cross country data study by Barth, Caprio and Levine (2001) finds

    that greater regulatory restrictions lead to a higher probability of a country

    suffering from a major bank crisis and lower banking sector efficiency. TheIndian banks operated under many regulatory restrictions which limited their

    activities in off balance sheet activities.

    (2) Entry restriction:Governments have control over the banking system by

    regulating the entry of new private and foreign banks. Jayaratne and Strahan

    (1998) have performed studies that suggest when US created a morecompetitive environment by removing branching restrictions ,The Indian

    government had placed restrictions on entry of foreign banks and private banks.These banks required government licenses to operate in India.

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    In 1993 the RBI permitted private entry into the

    banking sector, but imposed restrictions on branch expansion. Various studieshave shown that entry restrictions are not favorable for the banking industry.

    (3) Capital Requirements: In addition to entry restrictions, governments canenforce regulations on minimum capital requirements. It can affect risk takingactivities and it helps create a pseudo overall economy.with the benefits derived

    from imposition of capital requirements by the government.

    (4) Supervisory Powers and Market Monitoring:It can be combined into onecategory and it refers to official supervision of banking activities in the country.

    Developing countries usually have directed credit programs and high reserveand liquidity requirements, this helps provide a cushion in times of crisis and as

    they liberalize these requirements, the banks need to have proper supervision oftheir activities. However, the private interest view argues otherwise. Howeverthere are not many studies on this that promote either view.

    The private interest view argues that excessive

    supervision can lead to corruption by government officials. It also says thatgovernment employees have no motivation to work in the government as the

    government pays them lesser than private banks and they would be willing totake bribes to produce a good report on a bank. India has instituted agencies that

    monitor banks performance. RBI also has supervisory powers and it placesthem in effect by looking at the financial statements of banks on a regular basis

    through the course of the year.

    (5) Safety Net Support:It has two main parts, one being the lender of the

    last resort and the other an explicit deposit insurance system. Proponents of

    the private interest view feel that it is a moral hazard and present several otherways to protect small depositors.

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    The objectives of bank regulation, and the emphasis, vary between

    jurisdictions. The most common objectives are:

    Prudentialto reduce the level of risk to which bank creditors are exposed (i.e.

    to protect depositors)

    1. Systemic risk reductionto reduce the risk of disruption resulting from

    adverse trading conditions for banks causing multiple or major bank failures

    1. Avoid misuse of banksto reduce the risk of banks being used for

    criminal purposes, e.g. laundering the proceeds of crime.

    2.To protect banking confidentiality.

    3.

    Credit allocationto direct credit to favored sectors.

    4.It may also include rules about treating customers fairly and

    having corporate social responsibility(CSR).

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    EVALUTION.

    PRIVATE OWNERSHIP,NATIONALIZATION AND

    DISINVESTMENT

    Effects of these reforms on the private and public banking

    system

    Credit structure and setting up of institutional framework

    for providing longterm finance to agriculture and industry. Banking sector, whichduring the preindependence India was catering to the needs of the government,

    rich individuals and traders, opened its door wider and set out for the first time tobring the entire productive sector of the economy large as well as small, in its

    fold. During this period number of commercial banks declined remarkably. Therewere 566 banks as on December, 1951; of this, number scheduled banks was 92 and

    the remaining 474 were non-scheduled banks.This number went down considerably to the level of

    281 at the close of the year 1968. The sharp decline in the number of banks was due

    to heavy fall in the number of non-scheduled banks which touched an all time low

    level of 210. The banking scenario prevalent in the country up-tothe year 1968depicted a strong stress on class banking based on security rather than on' purpose.

    Before 1968, only RBI and Associate Banks of SBI were mainly controlled byGovernment. Some associates were fully owned subsidiaries of SBI and in the rest,

    there was a very small shareholding by individuals and the rest by RBI.

    EXPANSION PHASE (1968-1984)

    The motto of bank nationalization was to make

    banking services reach the masses that can be attributed as "first- bankingrevolution". Commercial banks acted as vital instruments for this purpose by way

    of rapid branch expansion, deposits mobilization and credit creation. Penetratinginto rural areas and agenda for geographical expansion in the form of branch

    expansion continued. The second dose of nationalization of 6 more commercialbanks on April 15, 1980 further widened the phase of the public sector banks and

    therefore banks were to implement all the government sponsored programmes and

    change their attitude in favour of social banking, which was given the highestpriority.

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    This phase witnessed socialization of banking in

    1968. Commercial banks were viewed as agents of change and social control on

    banks.However, inadequacy of social control soon became

    apparent because all banks except the SBI and its seven associate banks were in theprivate sector and could not be influenced to serve social interests. Therefore, bankswere nationalized (14 banks in 1969 and 6 banks in 1980) in order to control the

    heights of the economy in conformity with national policy and objectives.

    This period saw the birth and the growth of what isnow termed as directed lending by banks.

    It also saw commercial banking spreading to far and

    wide areas in the country with great pace during which a number of poverty

    alleviation and employment generating schemes were sought to be implemented

    through commercial banks. Thus, this period was characterized by the death of

    private banking and the dominance of social banking over commercial banking. Itwas hardly realized that banks 'were organizations with social responsibilities butnot social organizations.

    This period also witnessed the birth of Regional Rural

    Bank (RRBS) in 1975 and NABARAD in 1982 which had priority sector as theirfocus of activity.

    Although number of commercial banks declined from

    281 in 1968 to 268 in 1984, number of scheduled banks shot up from 71 to 264during the corresponding period, number of non-scheduled banks having registered

    perceptible decline from 210 to 4 during the period under reference. The rise

    in the number of scheduled banks was, as stated above, due to theemergence of RRBS.

    The fifteen years following the banks nationalization in

    1969 were dominated by the Banks expansion at a path breaking pace. As many as

    50,000 bank branches were set up; three-fourths of these branches were opened in

    rural and semi-urban areas. Thus, during this period a distinct transformation of farreaching significance occurred in the Indian banking system as it assumed a broad

    mass base and emerged as an important instrument of socio-economic changes.Thus, with growth came inefficiency and loss of control over widely spread offices.

    Moreover, retail lending to more risk-prone areas at concessional interest rates had

    raised costs, affected the quality of assets of banks and put their profitability understrain.

    The competitive efficiency of the banks was at a low ebb.

    Customer service became least available commodity. Performance of a bank/bankerbegan to 61 be measured merely in terms of growth of deposits, advances and other

    such targets and quality became a casualty.

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    The progress of branch expansion is presented in the Table:

    BRANCH EXPANSION SINCE 1969 TO 1991

    Year Total No. of Branches Rural Branches Semi-urban Branches1969 8262 1833 33421980 32419 15105 8122

    1991 60,220 35206 11,344

    It can be seen from the Table 4.1 that the total number

    of bank branches increased eight-fold between 1969 to 1991.The bulk of the increase was on account of rural

    branches which increased from less than 2000 to over 35000 during the period.

    The percentage share of the rural and semi-urban branches rose from 22 and 4

    respectively in 1969 to 45 percent and 25 percent in 1980 and 58 per cent and 18percent in 1991.

    The impact of this phenomenal growth was to bring

    down the population per branch from 60,000 in 1969 to about 14,000. The banking

    system thus assumed a broad mass-base and emerged as an important instrument ofsocial-economic changes. However, this success was neither unqualified nor

    without costs.

    While the rapid branch expansion, wider geographicalcoverage 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 interest rates had raised costs, affected the qualityof assets of banks and put their profitability under strain.

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    PRIVATE OWNERSHIP

    The underprovision of credit to small-scale industry

    was one of the key reasons cited for nationalization in 1969: thus, it might in fact bethe case that while the public sector banks provide relatively little credit to SSI

    firms, private banks are even worse. In the next sub-section we examine the effectof bank ownership on bank allocation of credit.

    Bank Ownership and Sectoral Allocation of Credit As

    mentioned above, an important rationale for the Indian bank nationalizations was to

    direct credit towards sectors the government thought were underserved, includingsmall scale industry, as well as agriculture and backward areas.

    Ownership was not the only means of directing credit:

    the Reserve Bank of India issued guidelines in 1974, indicating that both public and

    private sector banks must provide at least one-third of their aggregate advances to

    the priority sector by March 1979. In 1980, it was announced that this quota would

    be increased to 40 percent by March 1985. Sub-targets were also specified forlending to agriculture and weaker sectors within the priority sector. Since publicand private banks faced the same regulation, in this section we focus on how

    ownership affected credit allocation.

    The comparison of nationalized and private banks isnever easy: banks that fail are often merged with healthy nationalized banks, which

    makes the comparison of nationalized banks and non-nationalized banks close to

    meaningless.The Indian nationalization experience of 1980

    represents a unique chance to learn about the relationship between bank ownership

    and bank lending behavior. The 1980 nationalization took place according to astrict policy rule: all private banks whose deposits were above a certain cutoff werenationalized.18 After 1980, the nationalized banks remained corporate entities,

    retaining most of their staff, though the board of directors was replaced by

    nominees of the Government of India.

    Both the banks that got nationalized under this rule andthe banks that missed being nationalized, continued to operate in the same

    environment, and face the same regulations and therefore ought to be directlycomparable .Even this comparison between banks just nationalized and just not

    nationalized may be invalid, because policy rule means that banks nationalized in

    1980 are larger than the banks that. remained private. If size influences bankbehavior, it would be incorrect to attribute all differencesbetween nationalized and

    private sector banks to nationalization. In this section, based on Cole, we adopt an

    approach in the spirit of regression discontinuity design, and compare banksthat were just above the 1980 cut off to those that were just below the 1980 cutoff,

    while control- 18While the 1969 was larger, and also induced a discontinuity,

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    We do not use it because many of the banks just below the cut-off in 1969 were

    nationalized in 1980.

    One policy option that is being discussed isprivatization. The evidence from Cole, discussed above, suggests that privatization

    would lead to an infusion of dynamism in to the banking sector: private bankshave been growing faster than comparable public banks in terms of credit, depositsand number of branches, including rural branches, though it should be noted thatin our empirical analysis, the comparison group of private banks were the

    relatively small old private banks.48 It is not clear that we can extrapolate from

    this to what we could expect when the State Bank of India, which is more than an

    order of magnitude greater in size than the largest old private sector banks. Thenew private banks are bigger and in some ways would have been a better group

    to compare with.However while this group is also growing very fast,

    they have been favored by regulators in some specific ways, which, combinedwith their relatively short track record, makes the comparison difficult.Privatization will also free the loan officers from the fear of the CVC and make

    them somewhat more willing to lend aggressively where the prospects are good,

    though, as will be discussed. Later, better regulation of public banks may alsoachieve similar goals.

    Historically, a crucial difference between public andprivate sector banks has been their willingness to lend to the priority sector. The

    recent broadening of the definition of priority sector has mechanically increasedthe share of credit from both public and private sector banks that qualify as

    priority sector. The share of priority sector lending from public sector banks was42.5 percent in 2003, up from 36.6 percent in 1995.

    Private sector lending has shown a similar increase

    from its 1995 level of 30 percent. In 2003 it may have surpassed for the first time

    ever public sector banks, with a share of net bank credit to the priority sector at44.4 percent to the priority sector.49 Still, there are substantial differences

    between the public and private sector banks.Most notable is the consistent failure of private

    sector banks to meet the agricultural lending subtarget, though they also lend

    substantially less in rural areas. Our evidence suggests that privatization will make

    it harder for the government to get the private banks to comply with what it wantsthem to do.

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    However it is not clear that this reflects the greater

    sensitivity of the public banks to this particular social goal. It could also be thatcredit to agriculture, being particularly politically salient, is the one place where

    the nationalized banks are subject to political pressures to make imprudent loans.

    Finally, one potential disadvantage of privatization comes from the risk of bankfailure.

    In the past there have been cases where the owner of theprivate bank stripped its assets, and declared that it cannot honor its deposit

    liabilities.

    The government is, understandably, reluctant to letbanks fail, since one of the achievements of the last forty years has been to

    persuade people that their money is safe in the banks.Therefore, it has tended to take over the failed bank,

    with the resultant pressure on the fiscal deficit. Of course, this is in part a result of

    poor regulationthe regulator should be able to spot a private bank that is strippingits assets. Better enforced prudential regulations would considerably strengthen

    the case for privatization. On the other hand, public banks have also been failing

    the problem seems to be part corruption and part inertia/laziness on the part of thelenders.

    As we saw above, the cost of bailing out the public

    banks may well be larger (appropriately scaled) than the total losses incurred fromevery bank failure since 1969 All numbers are from various issues of Report onTrends and Progress of banking in India.

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    PROTECTION OF DEPOSITORS

    As stated earlier, financial intermediation by commercial banks has played a

    key role in India in supporting the economic growth process. An efficient

    financial intermediation process, as is well known, has two components:effective mobilization of savings and their allocation to the most productive

    uses. In this chapter, we will discuss one part of the financial intermediation

    by banks: mobilization of savings. When banks mobilize savings, they do it inthe form of deposits, which are the money accepted by banks from customers to

    be held under stipulated terms and conditions. Deposits are thus an instrument

    of savings.Since the first episode of bank nationalization

    in 1969, banks have been at the core of the financial intermediation process inIndia. They have mobilized a sizeable share of savings of the household sector,

    the major surplus sector of the economy.

    This in turn has raised the financial savings ofthe household sector and hence the overall savings rate. Notwithstanding the

    liberalization of the financial sector and increased competition from variousother saving instruments, bank deposits continue to be the dominant instrument

    of savings in India. provides a description of the most standard instruments of

    bank regulation: deposit insurance, capital adequacy requirements and lender oflast resort.

    These three policies are linked one with the other.Deposit insurance protects the smallest depositors from a bank bankruptcy andprevents bank runs. Capital adequacy requirements are necessary in order to

    make sure that bank managers follow a responsible credit policy, in the absenceof an effective control on the part of depositors. Lender of last resort policies

    further reduce the risk of banks bankruptcies providing banks with Emergency

    Liquidity Assistance facilities that are designed to avoid that temporarysituations

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    Safety of deposits

    At the time of depositing money with the bank, a

    depositor would want to be certain that his her money is safe with the bank andat the same time, wants to earn a reasonable return.The safety of depositors'

    funds, therefore, forms a key area of the regulatory framework for banking. InIndia, this aspect is taken care of in the Banking Regulation Act, 1949 (BR

    Act).

    The RBI is empowered to issue directives/advices onseveral aspects regarding the conduct of deposit accounts from time to time.

    Further, the establishment of the Deposit Insurance Corporation in 1962(against the backdrop of failure of banks) offered protection to bank depositors,

    particularly small-account holders. This aspect has been discussed later in the

    Chapter.

    Deregulation of interest rates

    The process of deregulation of interest rates started inApril 1992. Until then, all interest rates were regulated; that is, they were fixed

    by the RBI. In other words, banks had no freedom to fix interest rates on their

    deposits. With liberalization in the financial system, nearly all the interest rateshave now been deregulated.

    Now, banks have the freedom to fix their own

    deposit rates with only a very few exceptions. The RBI prescribes interest rates

    only in respect of savings deposits and NRI deposits, leaving others forindividual banks to determine.

    Deposit policy

    The Board of Directors of a bank, along with its top

    management, formulates policies relating

    to the types of deposit the bank should have, rates of interest payable on eachtype, special deposit schemes to be introduced, types of customers to be targeted

    by the bank, etc. Of course, depending on the changing economic environment,

    the policy of a bank towards deposit mobilization, undergoes changes.

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    Types of Deposit Accounts

    The bank deposits can also be classified into(i) demand deposits and

    (ii) time deposits.

    (i) Demand deposits are defined as deposits payable on demand through cheque

    or otherwise. Demand deposits serve as a medium of exchange, for theirownership can be transferred from one person to another through cheques and

    clearing arrangements provided by banks. They have no fixed term to maturity.

    (ii) Time deposits are defined as those deposits which are not payable on

    demand and on which cheques cannot be drawn. They have a fixed term tomaturity. A certificate of deposit (CD), for example, is a time deposit

    Certificate of DepositA Certificate of Deposit (CD) is a negotiable money

    market instrument and is issued in dematerialized form or as a Usance

    Promissory Note, for funds deposited at a bank or other eligible financialinstitution for a specified time period. Guidelines for issue of CDs are currently

    governed by various directives issued by the RBI, as amended from time to

    time. CDs can be issued by(i) scheduled commercial banks (SCBs) excluding

    Regional Rural Banks (RRBs) and Local Area Banks (LABs); and

    (ii) select all-India Financial Institutions

    that have been permitted by the RBI to raise short-term resources within theumbrella limit fixed by RBI. Deposit amounts for CDs are a minimum of Rs.1lakh, and multiples thereof. Demand and time deposits are two broad categories

    of deposits. Note that these are only categories of deposits; there are no depositaccounts available in the banks by the names 'demand deposits' or 'time

    deposits'. Different deposit accounts offered by a bank, depending on their

    characteristics, fall into one of these two categories.There are several deposit accounts offered by banks in India; but they can be

    classified into three main categories:

    1.Current account

    2.Savings bank account3.Term deposit account

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    Deposit Insurance:

    Deposit insurance helps sustain public confidence

    in the banking system through the protection of depositors, especially small

    depositors, against loss of deposit to a significant extent. In India, bank depositsare covered under the insurance scheme offered by Deposit Insurance and

    Credit Guarantee Corporation of India (DICGC), which was established withfunding from the Reserve Bank of India.

    The scheme is subject to certain limits and

    conditions. DICGC is a wholly-owned subsidiary of the RBI.1. Banks insured by the DICGCAll commercial banks including branches of

    foreign banks functioning in India, local area banks and regional rural banks areinsured by the DICGC.22

    Further, all State, Central and Primary cooperative banks

    functioning in States/Union Territories which have amended the localCooperative Societies Act empowering RBI suitably are insured by the DICGC.

    Primary cooperative societies are not insured by the DICGC.

    2 Features of the scheme

    When is DICGC liable to pay?

    In the event of a bank failure, DICGC protects bank deposits that are payable inIndia. DICGC is liable to pay if (a) a bank goes into liquidation or (b) if a bankis amalgamated/ merged with another bank.

    Methods of protecting depositors' interestThere are two methods of protecting depositors' interest when

    an insured bank fails:

    (i) by transferring business of the failed bank to another sound bank23(in case of merger or amalgamation) and

    (ii) where the DICGC pays insurance proceeds to depositors (insurance

    pay-out method).

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    Types of deposit covered by DICGC

    The DICGC insures all deposits such as savings, fixed, current, recurring, etc.

    except the following types of deposits:A). Deposits of foreign Governments;

    B). Deposits of Central/State Governments;

    C). Inter-bank deposits;

    D). Deposits of the State Land Development Banks with the State

    co-operative bank;

    E). Any amount due on account of any deposit received outside India;

    F). Any amount, which has been specifically exempted by the corporation

    with the previous approval of RBI.

    Maximum deposit amount insured by the DICGC

    Each depositor in a bank is insured up to amaximum of Rs100,000 for both principal and interest amount held by him in

    the same capacity and same right.For example, if an individual had a deposit with principal amount of Rs.90,000

    plus accrued interest of Rs.7,000, the total amount insured by the DICGC would

    be Rs.97,000. If, however, the principal amount were Rs. 99,000 and accruedinterest of Rs 6,000, the total amount insured by the DICGC would be Rs 1

    lakh.

    The deposits kept in different branches of a bank areaggregated for the purpose of insurance cover and a maximum amount up to Rs

    1 lakh is paid. Also, all funds held in the same type of ownership at the samebank are added together before deposit insurance is determined. If the funds are

    in different types of ownership (say as individual, partner of firm, director of

    company, etc.) or are deposited into separate banks they would then beseparately insured.

    Also, note that where a depositor is the sole proprietorand holds deposits in the name of the proprietary concern as well as in hisindividual capacity, the two deposits are to be aggregated and the insurance

    cover is available up to rupees one lakh maximum. Cost of deposit insuranceDeposit insurance premium is borne entirely by the insured bank. Banks are

    required to pay the insurance premium for the eligible amount to the DICGC ona semi-annual basis.

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    The cost of the insurance premium cannot be passed on

    to the custom. Withdrawal of insurance coverThe deposit insurance scheme is compulsory and no

    bank can withdraw from it. The DICGC, on the other hand, can withdraw the

    deposit insurance cover for a bank if it fails to pay the premium for threeconsecutive half year periods. In the event of the DICGC withdrawing its

    cover from any bank for default in the payment of premium, the public will benotified through the newspapers.

    .

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    Basics of Bank Lending

    Banks extend credit to different categories ofborrowers for a wide variety of purposes. For many borrowers, bank credit is

    the easiest to access at reasonable interest rates. Bank credit is provided to

    households, retail traders, small and medium enterprises (SMEs), corporates,the Government undertakings etc. in the economy.

    Retail banking loans are accessed by consumersof goods and services for financing the purchaseof consumer durables, housing

    or even for day-to-day consumption. In contrast, the need forcapital investment,

    and day-to-day operations of private corporates and the Governmentundertakings are met through wholesale lending.

    Loans for capital expenditure are usually extendedwith medium and long-term maturities, while day-to-day finance requirementsare provided through short-term credit (working capital loans). Meeting the

    financing needs of the agriculture sector is also an important role that Indianbanks play.

    1. Principles of Lending and Loan policy

    Principles of lending

    To lend, banks depend largely on depositsfrom the public. Banks act as custodian of public deposits. Since the depositorsrequire safety and security of their deposits, want to withdraw deposits

    whenever they need and also adequate return, bank lending must necessarilyBe based on principles that reflect these concerns of the depositors.

    These principles include:

    1). safety

    2). liquidity

    3). profitability4). and risk diversion.

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    Safety:

    Banks need to ensure that advances are safe and money lent out by

    them will come back. Since the repayment of loans depends on the borrowers'capacity to pay, the banker must be satisfied before lending that the business for

    which money is sought is a sound one. In addition, bankers many times insist onsecurity against the loan, which they fall back on if things go wrong for thebusiness.

    The security must be adequate, readily marketable and free

    of encumbrances.

    Liquidity:

    To maintain liquidity, banks have to ensure that money lent out bythem is not locked up for long time by designing the loan maturity period

    appropriately. Further, money must come back as per the repayment schedule. Ifloans become excessively illiquid, it may not be possible for bankers to meet

    their obligations vis--vis depositors.

    Profitability:

    To remain viable, a bank must earn adequate profit on its investment.

    This calls for adequate margin between deposit rates and lending rates. In thisrespect, appropriate fixing of interests rates on both advances and deposits is

    critical. Unless interest rates are competitively fixed and margins are adequate,banks may lose customers to their competitors and become unprofitable.

    Risk diversification:

    To mitigate risk, banks should lend to a diversified customer base.Diversification should be in terms of geographic location, nature of businessetc. If, for example, all the borrowers of a bank are concentrated in one region

    and that region gets affected by a natural disaster, the bank's profitability can be

    seriously affected.

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    Loan Policy

    Based on the general principles of lending stated

    above, the Credit Policy Committee (CPC) of individual banks prepares thebasic credit policy of the Bank, which has to be approved by the Bank's Board

    of Directors.The loan policy outlines lending guidelines and

    establishes operating procedures in all aspects of credit management including

    standards for presentation of credit proposals, financial covenants, ratingstandards and benchmarks, delegation of credit approving powers, prudential

    limits on large credit exposures, asset concentrations, portfolio management,loan review mechanism, risk monitoring and evaluation, pricing of loans,

    provisioning for bad debts, regulatory/ legal compliance etc.

    The lending guidelines reflect the specific bank's

    lending strategy (both at the macro level and individual borrower level) and

    have to be in conformity with RBI guidelines.

    The loan policy typically lays down lending guidelines in the following areas:

    1). Level of credit-deposit ratio2).Targeted portfolio mix3). Hurdle ratings

    4). Loan pricing

    5). Collateral security

    Credit Deposit (CD) Ratio Lending Rates

    Banks are free to determine their own lending rates onall kinds of advances except a few such as export finance; interest rates on theseexceptional categories of advances are regulated by the RBI. It may be noted

    that the Section 21A of the BR Act provides that the rate of interest charged

    by a bank shall not be reopened by any court on the ground that the rate ofinterest charged is excessive.

    The concept of benchmark prime lending rate (BPLR)was however introduced in November 2003 for pricing of loans by commercial

    banks with the objective of enhancing transparency in the pricing of their loanproducts. Each bank must declare its benchmark prime lending rate (BPLR) as

    approved by its Board of Directors. A bank's BPLR is the Interest rate to becharged to its best clients; that is, clients with the lowest credit risk. Each bankis also required to indicate the maximum spread over the BPLR for various

    credit exposures.

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    However, BPLR lost its relevance over time as a

    meaningful reference rate, as the bulk of loans were advanced below BPLR.

    Further, this also impedes the smooth transmission of monetary signals by theRBI. The RBI therefore set up a Working Group on Benchmark Prime Lending

    Rate (BPLR) in June 2009 to go into the issues relating to the concept of BPLRand suggest measures to make credit pricing more transparent.

    Guidelines on Fair Practices Code for Lenders

    RBI has been encouraging banks to introduce a

    fair practices code for bank loans. Loan application forms in respect of allcategories of loans irrespective of the amount of loan sought by the borrower

    should be comprehensive. It should include information about the fees/ charges,

    if any, payable for processing the loan, the amount of such fees refundable inthe case of non acceptance of application, prepayment options and any other

    matter which affects the interest of the borrower, so that a meaningful

    comparison with the fees charged by other banks can be made and informeddecision can be taken by the borrower. Further, the banks must inform 'all-in

    cost' to the customer to enable him to compare the rates charged with othersources of finance.

    Regulations relating to providing loans

    The provisions of the Banking Regulation Act, 1949(BR Act) govern the making of loans by banks in India. RBI issues directions

    covering the loan activities of banks. Some of the major guidelines of RBI,

    which are now in effect, are as follows:

    1).Advances against bank's own shares: a bank cannot grant any loans andadvances against the security of its own shares.

    2).Advances to bank's Directors: The BR Act lays down the restrictions on

    loans and advances to the directors and the firms in which they hold substantialinterest.

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    3).Restrictions on Holding Shares in Companies: In terms of Section 19(2) ofthe BR Act, banks should not hold shares in any company except as provided in

    sub-section

    (A)whether as pledgee, mortgagee or absolute owner, of an amount exceeding

    30% of the paid-up share capital of that company or 30% of its own paid-upshare capital and reserves, whichever is less.

    Following the recommendations of the Group, the ReserveBank has issued guidelines in February 2010. According to these guidelines, the

    'Base Rate system' will replace the BPLR system with effect from July 01,

    2010.All categories of loans should henceforth be priced only with reference to

    the Base Rate. Each bank will decide its own Base Rate.The actual lending rates charged to borrowers would be the

    Base Rate plus borrower-specific charges, which will include product specificoperating costs, credit risk premium and tenor premium.

    Since transparency in the pricing of loans is a key objective,banks are required to exhibit the information on their Base Rate at all branchesand also on their websites. Changes in the Base Rate should also be conveyed to

    the general public from time to time through appropriate channels.

    Apart from transparency, banks should ensure that interest ratescharged to customers in the above arrangement are non-discriminatory in

    nature. Guidelines on Fair Practices Code for Lenders RBI has beenencouraging banks to introduce a fair practices code for bank loans.

    Loan application forms in respect of all categories of loansirrespective of the amount of loan sought by the borrower should be

    comprehensive. It should include information about the fees/ charges, if any,payable for processing the loan, the amount of such fees refundable in the caseof non-acceptance of application, prepayment options and any other matter

    which affects the interest of the borrower, so that a meaningful comparison with

    the fees charged by other banks can be made and informed decision can betaken by the borrower. Further, the banks must inform 'all-in-cost' to the

    customer to enable him to compare the rates charged with other sources offinance.

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    PROMOTION OF UNDER PRIVILEGED CLASSES

    General principles of bank regulation

    Banking regulations can vary widely across nations and

    jurisdictions. This section of the article describes general principles of bank

    regulation throughout the world.

    Minimum requirements

    Requirements are imposed on banks in order to promote the objectives of the

    regulator. Often, these requirements are closely tied to the level of risk exposure

    for a certain sector of the bank. The most important minimum requirement in

    banking regulation is maintaining minimum capital ratios. To some extent, U.S.

    banks have some leeway in determining who will supervise and regulate them.

    Supervisory review

    Banks are required to be issued with a bank license by the regulator in order to

    carry on business as a bank, and the regulator supervises licensed banks for

    compliance with the requirements and responds to breaches of the requirements

    through obtaining undertakings, giving directions, imposing penalties or

    revoking the bank's license.

    Market discipline

    The regulator requires banks to publicly disclose financial and other

    information, and depositors and other creditors are able to use this information

    to assess the level of risk and to make investment decisions. As a result of this,

    the bank is subject to market discipline and the regulator can also use market

    pricing information as an indicator of the bank's financial health.

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    Instruments and requirements of bank regulation

    Capital requirement

    The capital requirement sets a framework on how banks must handletheir capital in relation to their assets. Internationally, the Bank for International

    Settlements' Basel Committee on Banking Supervision influences each

    country's capital requirements. In 1988, the Committee decided to introduce a

    capital measurement system commonly referred to as the Basel Capital Accords.

    The latest capital adequacy framework is commonly known as Basel III.[5]

    This

    updated framework is intended to be more risk sensitive than the original one,

    but is also a lot more complex.

    Reserve requirementThe reserve requirement sets the minimum reserves each bank must hold to

    demand deposits and banknotes. This type of regulation has lost the role it once

    had, as the emphasis has moved toward capital adequacy, and in many countries

    there is no minimum reserve ratio. The purpose of minimum reserve ratios is

    liquidity rather than safety. An example of a country with a contemporary

    minimum reserve ratio is Hong Kong, where banks are required to maintain

    25% of their liabilities that are due on demand or within 1 month as qualifying

    liquefiable assets.

    Reserve requirements have also been used in the past tocontrol the stock of banknotes and/or bank deposits. Required reserves have at

    times been gold coin, central bank banknotes or deposits, and foreign currency.

    Corporate governance

    Corporate governance requirements are intended to encourage the bank to be

    well managed, and is an indirect way of achieving other objectives. As many

    banks are relatively large, with many divisions, it is important for management

    to maintain a close watch on all operations. Investors and clients will often hold

    higher management accountable for missteps, as these individuals are expectedto be aware of all activities of the institution. Some of these requirements may

    include:

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    1.To be a body corporate (i.e. not an individual, a partnership, trust or other

    unincorporated entity)

    2.To be incorporated locally, and/or to be incorporated under as a particular

    type of body corporate, rather than being incorporated in a foreign

    jurisdiction.

    3.To have a minimum Securities and Exchange Commission (SEC)

    financial reporting standard Quarterly Disclosure Statements Sarbanes-

    Oxley Act of 2002

    Out of the 637 commercial banks in India in

    1947, 200 were in Madras, 106 were in West Bengal and 40 were in Mumbai.This left only 291 banks to cover all the rest of India (Reserve Bank of India2008a).

    However, before expansion of the banking system,

    the government had to ensure a stable financial system. This led to the creationof the Banking Regulations Act (1949), which came into effect on March 16th,

    1949 (Banking Regulation Act 1949). The act formed separate legislation forcompanies operating as banks. It also vested the RBI with further powers such

    as:

    (1) control over opening new banks and branches,

    (2) power to inspect books of the companies that qualified as banks

    under this act,

    (3) prevent voluntary winding up of licensed banking companies,

    (4) regularly reporting financial statements to the Reserve Bank of

    India.