Banking Sector Reforms in India: A Survey

After assuming office in June 1991, the then Cong (I) Government, headed by P.V. Narsimha Rao, introduced major changes in economic policies consequent upon terrific macroeconomic imbalances developed in the Indian economy over the last 1 or 2 years.

Such economic policies came to be known as structural reforms.

Devaluation of the Indian rupee, liberalised new EXIM Policy, new Industrial Policy were the critical elements in structural reforms. Following these reforms, the Indian economy became more free and competitive. Successful implementation of trade and industrial policies demanded that the resource allocation needed to be market- driven.

In other words, these two reforms needed another prop—the financial sector reforms—so that scarce investible funds could be channelised in the productive sectors. It is not enough, however, to change the rules of monetary management; what is needed is the comprehensive reform of the banking system, the capital market and their regulations. This is because the financial sector is at the centre of economic activity; its health affects the entire economy.

1. Narasimham Committee’s Recommendations:

Against this backdrop, a Committee under the chairmanship of M. Narasimham was set up by the Government of India to examine the country’s financial system and its various components and to make recommendations for reforming and improving the country’s financial sector. The report was placed before the Parliament in December 1991.

Its major recommendations were:

(a) Establishment of a four-tier hierarchy for the banking sector:

(i) 4 to 5 large commercial banks which could be of international character. One such bank is the State Bank of India;

(ii) 8 to 10 national banks having nation­wide branches engaged in universal banking;

(iii) Small banks where business would be confined to specific regions; and

(iv) Rural banks whose operation would be confined to rural areas only.

(b) Abolition of branch licensing system. Banks themselves would be allowed to open or close branches.

(c) Entry of private banks, easing of restric­tions on foreign banks and full stop on further nationalisation of banks.

(d) Allowing nationalised banks to issue fresh capital to the public through the capital market.

(e) Phased reduction of statutory liquidity ratio (SLR) from 38.5 p.c. to 25 p.c. over 5 years, reduction of cash reserve ratio (CRR), from 15 p.c. to 3 to 5 p.c. over the next five years, and payment of interest on CRR to commercial banks.

(f) Phasing out of directed credit to priority sectors down to 10 p.c. of the aggregate bank credit.

(g) Deregulation of interest rates and bringing them on government borrow­ing in line with the market-determined rates.

(h) Tightening of prudential norms and strengthening of banking supervision.

(i) Issue of prudential guidelines governing the financing of financial institutions.

(j) Proper classification of assets and full disclosure and transparency of accounts of banks and other financial institutions.

(k) Attainment of a minimum 4 p.c. capital adequacy ratio in relation to risk weigh­ted assets within three years.

(l) Increased competition in lending between ‘development financial institu­tions’ and banks.

(m) Setting up of an institution to be called Asset Reconstruction Fund with a view to taking over a portion of the loan portfolio of banks which has become bad and doubtful and whose recovery is not easy.

2. Measures Taken So Far:

The Government of India has taken a series of measures follow­ing the recommendations of the Narasimham Committee. At the outset, a strategy was mapped out to reverse the financial repres­sions and too much interference and interven­tions that characterised the country’s banking sector almost from the late 1960s was required to be removed. After 1991, the ‘liberalisation’ approach gave the ‘market’ a greater role in price-setting and assigned a bigger role to the private sector in the country’s development.

There has been significant progress in sev­eral areas of the banking sector. In fact, the banking sector has undergone several signifi­cant structural reforms, the capital markets are deeper and more liquid and equity markets are zooming up. In 2003, it was said by the Standard Poor that the Indian banking sector had moved from ‘negative’ to ‘stable’. Fitch Ratings assessed that the economic reforms carried out so far have considerably ‘strength­ened’ the fundamentals of the entire financial sector of India.

As a result of reforms made in the finan­cial sector we now see very ‘limited’ market- based decision-making. For instance—deposit and lending rates—which had been mostly ‘administered prices’—have now been liber­alised and are being mostly determined by market forces, of course, subject to a ceiling stipulated by the RBI.

CRR and SLR—which were hiked to 15 p.c. and 38.5 p.c., respectively, prior to economic reforms—have now been reduced to 5 p.c. (January 2009) and 24 p.c. (November 2008).

Following the recommendations of the Narasimham Committee, prudential norms for income recognition, classification of assets and provisioning of bad debts have been in­troduced. Earlier, no uniform practices for in­come recognition, asset classification into per­forming and non-performing ones, provision­ing for non-performing assets (NPAs), valua­tion for securities held in the banks’ portfolio had been followed by the Indian banking in­dustry. Even capital adequacy requirements (i.e., the capital base of the banks need to be promoted to lend more) had not been uniform.

Against this backdrop, the Committee rec­ommended uniform prudential norms and standards (in accordance with the lines rec­ommended by the Basle Committee on bank­ing supervision). Because of the implemen­tation of these measures, the asset quality of banks has considerably improved. This was corroborated by the raising of capital ad­equacy ratio (CAR) over the years.

The con­cept of CAR or capital to risk weighted assets ratio (CRAR) has been developed to ensure that banks can absorb a reasonable level of losses. Such ratio helps to protect the interest of depositors and promotes stability and effi­ciency of the financial system. (CAR has now been increased to 12.3 much above the stipu­lated minimum level of 9 p.c.)

Further, it is because of the improvement in the asset quality of banks there has been a significant reduction in the level of NPAs con­sequent upon the recovery of their dues. The setting up of the Asset Reconstruction Com­pany (India) Ltd. has also provided a great boost to banks’ efforts to recover dues from the defaulting borrowers.

One of the landmark developments in the reform of the financial sector is the enactment of the securitisation and reconstruction of Fi­nancial Assets and Enforcement of Securities Interest (SARFAES1) Act of June 2002. This Act is meant to facilitate foreclosures and enforce­ment of securities in cases of default and to employer banks and other financial institu­tions to recover their dues, even without court/tribunals’ intervention. This Act actu­ally paved the way for the creation of ARCI Ltd.

It may be recalled here that one of the ma­jor contributing factors for NPA reduction is the change in the policy of directed and prior­ity sector lending. The commitment of directed credit to priority sector to the tune of 40 p.c. had been considered as huge and that too needed to be cut drastically to 10 p.c. as rec­ommended by the Narasimham Committee.

Such directed or priority sector lending by the public sector banks after bank nationalisation created a ‘loan-mela, loan-mafia political cul­ture’ in the country. By putting a cap on such lending requirements, reduction of interest rate, subsidy on loans, etc. have now improved the financial health of the banking industry quite significantly in the reform era and, hence, reduction of NPAs.

In the name of structural reforms, the Government of India has been allowing the entry of private sector banks and foreign banks. However, the licensing requirements of the RBI suggest that these private bankers would open branches in the rural areas too, after a moratorium period of three years. This requirement, thus, allows private banks to fulfil some sort of’ social banking service’ goal.

3. Impact of Reforms:

Thus, reforms in the banking sector have made an indelible mark on it. It is now experiencing increased efficiency (measured in terms of profitability or reduction of NPAs, etc), systematic stability, and financial deepening with greater access.

The basic objectives of financial sector reforms, that is efficiency, stability and financial deepening, have been largely fulfilled because of priority sector lending liberalisation, prudential framework and increased competi­tion between nationalised banks and other banks. It is said that in some areas the banking sector is inching towards world standards (in terms of prudential norms and systems).

According to T.T. Ram Mohan; “It is not just that Indian banks have achieved a turn­around. They have gone on to become among the most profitable in the world. Internation­ally, a return of 1 per cent on assets is considered a benchmark of excellence.” India’s PSBs’ profitability, measured by net return on assets, rose to a height of 1.12 p.c. in 2003-04.

However, it declined to 0.8 p.c. in 2006-07 and remained unchanged from the previous year. Non-performing assets of PSBs have been showing a decelerating trend. It declined from Rs. 53,174 crore in 2001 to Rs. 38,602 crore in 2007. Gross NPAs as proportion of total assets has declined from 1.8 p.c. in 2005-06 to 1.5 p.c. in 2006-07.

Meanwhile, in view of the rising NPAs for the first time in 2007-08 since 2001-02, the RBI has cautioned banks not to make any compromise in the quality of lending. This is because of the policy stance of the commercial banks relating to the aggressive lending to the real estate and housing sectors, particularly by private and foreign-owned banks. Gross NPAs of all scheduled commercial banks shot up by Rs. 6,126 crore to touch Rs. 56,345 crore during 2007-08.

Unless corrective actions are not taken to prevent ‘undue asset-liability mismatches’ following mainly defaults and non-payments by borrowers, the banking industry may experience severe liquidity crunch against the backdrop of economic recession of 2008-09. Further, capital adequacy ratio has gone up to 12.7 p.c. in recent years (2006-08), well above the regulatory minimum of 9 p.c.

Seeing the remarkable performances of banking sector in the reform era, the London Economist remarked in May 2006: “Earlier, it used to be argued that the government should get out of PSBs because they were doing badly. Now it is contended that the government should get out because they are doing well!”

Despite these progresses and achieve­ments, systemic weaknesses still remain in the banking sector. Even today, the financial system has not been able to come out of the ‘government-serving syndrome’. As far as conduct and allocation of resources are concerned, the financial system, in effect, tends to serve the government in its objectives. Secondly, NPAs are declining and profits of banks are rising. This is definitely a healthy sign.

But it is said that the rise in profitability of banks in India is attributed to non-interest income (roughly two-thirds of the sub- Standard assets of scheduled commercial banks). Coming to the composition of loans, it is observed that bad loans of Indian banks tend to be concentrated largely on ‘priority sectors’ like heavy industries, infrastructure projects, etc. instead of stock market or real estate (sensitive sector). However, profit per employee for the nationalised banks has shown an accelerating trend. It rose from Rs. 2.23 lakh per employee in 2005-06 to Rs. 2.87 lakh in 2006-07.

The RBI, in its Annual Report 2007-08 presented in August 2008, says; “As a result of various reforms, the financial markets have transited to a regime characterised by market- determined interest and exchange rates, price based instruments of monetary policy— current account convertibility, phased capital account liberalisation and an auction-based system in the government securities market…The vulnerability of financial intermediates can be addressed through prudential regulations and supervision.”