Banking Sector Reforms in India UPSC

The article Banking Sector Reforms in India UPSC will highlight major steps taken in the Indian banking sector to bring efficiency, transparency, and greater autonomy to banks in order to prevent them from financial risk. So let us understand the impact of Banking Reforms in India and how Banking Reforms in India can help boost the nation’s economy...

Presented by Aakriti Yadav

The development of banking reforms in India can be classified into two phases:

1. Pre-Independence Banking Reforms
2. Post-Independence Banking Reforms

Pre-Independence Banking Reforms-

Timeline:

• 1770: Bank of Hindustan and Calcutta (European owned)
• 1806- 42: Three Presidency banks at Bengal, Bombay, and Madras. All three were given the right to issue currency. Later they were combined into the Imperial Bank of India and named as State Bank of India (SBI).
• 1865: Allahabad Bank was owned by the Europeans.
• 1894: Lala Lajpat Rai founded Punjab National Bank (PNB).
• 1908: Bank of Baroda by Mharaja Sayajrao Gaekwad III
• 1913-1930s: The rise and collapse of the banking industry in India led to the birth of RBI.
• 1926: Royal Commission on Indian currency, Hilton Young Commission recommends setting up a Central Bank named RBI.
• 1929:  Great Depression in the USA resulted in the collapse of 450+  banks in India which forced the British Indian government more serious about setting up RBI.
• 1934: RBI Act enacted. It started functioning as- Banker to Bank, government bank, and currency printing bank.
• 1935 April: RBI becomes operational. Sir Osborne Smith was its first Governor.
• 1935 July: Commercial banks full filling certain conditions were listed in the Second Schedule of the RBI Act and known as A Grade Banks or Scheduled Commercial Banks.
• 1943-49: C.D. Deshmukh became the second Finance Minister of India and the first Governor of RBI.

 

  Post-Independence Banking Reforms-

• 1948-49: Under the RBI Transfer of Ownership Act 1948, the government of India now owns all private bank shares. As a result, the RBI Governor is accountable to Parliament and required to distribute dividends to the government from the organization’s profits.
• 1949: Banking Regulation Act empowered the RBI to (a) give licenses to companies to open banks and new branches, (b) Prescribe auditing and liquidity norms for banks such as SLR, (c) protect the interest of depositors, (d) force elimination and Merger of weak banks, etc.
• 1951: Consolidation period of Banks due to fragile banking system, poor penetration of banking networks, financial instability, etc.
• 1955: Merger of Banks into State Bank of India (SBI).

Other Reforms of India-

1. To Solve the Problem of Lending-

In 1969, two reforms were taken-

(a) Priority Sector Lending (PSL)

Directed Credit, also known as Credit Rationing, involves assigning credit to specific sectors of society such as agriculture, exports, MSMEs, etc. Indian banks are required to meet the criteria of 40%, while foreign banks must adhere to PSL norms of 35%.

(b) Preferential Interest Rates (PIR)

Certain sectors, including manufacturing, small-scale units, and agriculture, are given preferential treatment with an exemption in interest rates ranging from 6-9%.

However, the main challenge confronting the above scheme is to assign credit to those who don’t have credit worthiness i.e. ‘credit without worthiness’.

To solve this problem, three rules were made-

• Change in Guarantee Laws– Credit was provided without the need for collateral.
• Difference in Margin– zero margins were decided for preferential sectors.
• Banking Penetration in Rural Areas– To improve the banking penetration in unbanked rural areas, new bank branches were opened.

2. To Fulfill the Liquidity Crunch of Banks–

To solve the liquidity crunch of banks, Refinance Corporations were opened. They refinance the priority sector lending banks. They are-

• To support India’s exports and imports, the Export-Import Bank of India (EXIM) was established in 1982.
• National Bank for Agriculture and Rural Development (NABARD) established in 1982 is an apex regulating body in the field of credit for agriculture and other economic activities in rural areas of India.
• Small Industries Development Bank of India (SIDBI) was formed on 2nd April 1990, is the apex regulating body for licensing and regulation of micro small and medium enterprises in India.
• UTI Bank was set up as a Sarkari mutual fund company through Unit Trust of India Act 1963. In 1993 it obtained the license to open UTI Bank. Now it is privatized into Axis Bank.

3. Committees For Interbank Participation-

– Nakul Vahan committee

It recommended a method for companies to borrow money from the market by introducing Commercial Papers. Reputable companies can utilize these papers to obtain credit from the market. The committee also introduced a Certificate of Deposits as a means for banks to borrow money.

– Khan committee

Khan committee introduced the concept of Universal banks. It increased the work space of banks by adding mutual funds, insurance companies, loans, etc.

– Vohra committee

This committee granted greater autonomy to banks in their day-to-day banking operations.

– Narasimham committee I (1991) 

This committee solved the problem of ‘crowd out credit’ through provisions of CRR and SLR.  Some major recommendations of the Narasimham committee I were-

• Solution to crowd out credit by reducing SLR to 25% and CRR to 6% in order to provide liquidity to banks.
• No lending to the government by commercial banks instead Central Bank will provide loans to the government.
• Define the method of Non-Performing Assets (NPA) and their recovery mode.
• Market determinant interest rates, and deposit rates to prime candidates. The government was barred from interfering in this situation.
• It provides greater autonomy to banks.

– Narasimham committee II (1998) 

It paved the way for second-generation banking reforms in India. Some of the recommendations of Narasimham Committee II are as follows:

• Open competition in banks- It involves market-determined price of government securities, entry of new commercial banks to increase competition for efficiency of banking sector, etc. 
• Supervision regulation- The committee suggested Financial Sector Code for the supervision of bank loans and assets, etc.
• Prudential Norms- To prevent failure of banks, adequate liquidity must be maintained as per Capital Adequacy Ratio (CAR). This norm provides a safety wall for the banks.
• Institutional Changes- Banking Lok Adalat for dispute settlement in banks was established. SARFAISHI Act was enacted. The Insolvency and Bankruptcy Code (IBC) was introduced to resolve financial disputes between corporates and banks.
• Banking Ombudsman- A grievance redressal mechanism to solve the problem of financial fraud and complaints.
• Credit Rating System- To solve the problem of asymmetric information and moral hazard, a credit rating mechanism was suggested for both customers and banks.
• Technology Norms- Technology plays a crucial role in bringing transparency and efficiency in banking sector. Major technological reforms such as Real Time Gross Settlement (RTGS), core banking solution, etc. are initiated.

4. International Banking Institution-

Basel Norms are the international banking regulations developed by the Basel Committee on Banking Supervision (BCBS). The suggestions of the Basel Committee are crucial amid rising financial risks and globalization of banks.

– Basel Norms I 

In 1988, Basel Norms I was introduced with the following recommendations-

• Standardization of Assets- It assigned credit risk on the basis of default such as 0% for safer assets and 150% for risky assets.
• Defined Asset to Risk Ratio- The minimum capital requirement was fixed at 8% of risk weighted assets.

– Basel Norms II 

BCBS published Basel II guidelines in 2004. The guidelines were based on three parameters.

• Capital Adequacy Requirement- Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
• Supervisory Review-Banks are now required to undergo auditing within three months. The internal auditor will not be allowed to audit. It can be done only through the person of central authority or by foreign auditors.
• Transparency- Every bank needs to submit its report to the Central Bank. It assigned accountability provisions for defaulters and other stakeholders.

– Basel Norms III

In 2010, Basel III guidelines were released. It was developed in response to the global financial crisis of 2007-08. 

• The objective of Basel Norms III is to increase the liquidity of banks and decrease bank leverage. 

5. Miscellaneous Reforms-

– CAMELs

 

India added ‘s’ in the international CAMEL step i.e. 

C refers to Capital Adequacy

A= Asset Quality

M= Management such as audit, inspecting, report, accountability, etc.

E= Efficiency in case of per bank employee, per branch, etc. with the help of technology.

L= Liquidity

s= Sovereignty or autonomy of banks.

– Buckting System

The matching of assets and liabilities within a given time period (usually 2/7/15 days or 3 months/1 year) with the help of RBI and other institutions is known as Asset-Liability Management (ALM) or Bucket System.

 

Thank you.

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