Commercial Banking Reforms


The Indian government decided to amend new economic reforms. Earlier, the banking industry was highly dominated by the public sector. This lead to profitability and poor asset quality. The country was undergoing deep economic crisis. The main aim of the banking sector reforms was to build a diversified, efficient and competitive financial system. The ultimate goal of this system was to properly allocate resources through functional flexibility, improved financial viability and institutional strengthening.

The reforms are mainly focused towards eradicating financial repression through minimizations in statutory preemptions, while concurrently stepping up prudential regulations. In addition to this, interest rates on deposits and the loans lent by banks had been progressively denationalized.

By the year 1991, India had nationalized banks in two phases in 1969 and 1980. The public sector banks (PSBs) controlled the credit supply. The post-1991 period saw three different chronological phases. The first phase was roughly between 1991 to 1998. The second phase started in 1998 and continued until the beginning of global financial crisis. The third phase is the ongoing one.

Phase 1

As we know post-1991 was a period of structural reforms in the financial sector. There was unprecedented development in various areas such as banking and capital markets. These reforms were based on the recommendations put forward by the Narasimham Committee in their report in November 1991.

After the first phase of banking sector reforms under the guidance of Narasimham Committee the following measures were undertaken by government −

Lowering SLR and CRR

The high SLR and CRR minimized the profits of the banks. The SLR was minimized from 38.5% in 1991 to 25% in 1997. As a result, banks were left with more funds that could be allocated to agriculture, industry, trade etc.

The Cash Reserve Ratio (CRR) is a bank’s cash ratio of total deposits to be maintained with RBI. The CRR has been lowered from 15% in 1991 to 4.1% in June 2003. The aim is to release the funds locked up with RBI.

Prudential Norms

These norms were initiated by RBI in order to bring in professionalism in commercial banks. The main objective of these norms were proper disclosure of income, classification of assets and provision for bad debts so as to assure that the books of commercial banks mirrored the accurate and correct picture of financial position.

Prudential norms ensured the banks made 100% provision for all non-performing assets (NPAs). For this purpose, sponsoring was placed at Rs.10,000 crores phased over 2 years.

Capital Adequacy Norms (CAN)

It is the ratio of minimum capital to risk asset ratio. In April 1992, RBI fixed CAN at 8%. By March 1996, all public sector banks had attained the ratio of 8%.

Deregulation of Interest Rates

The Narasimham Committee recommended that interest rates should be determined by market forces. From 1992, determining interest rates has become more simple and easy.

Recovery of Debts

The government of India issued the “Recovery of debts due to Banks and Financial Institutions Act 1993” in order to support and speed up the recovery of the dues of banks and financial institutions. Six Special Recovery Tribunals have been established to work on the same. An Appellate Tribunal was also established in Mumbai.

Competition from New Private-Sector Banks

Today banking is open to private-sector. New private-sector banks have already started functioning well in the banking industry. These new private-sector banks are permitted to hike capital contribution from foreign institutional investors up to 20% and from NRIs up to 40%. As a result, there is an increase in competition.

Phasing Out of Directed Credit

The committee recommended phasing out of the directed credit plans. A recommendation was made to lower the credit target for the priority sector from 40% to 10%. It would be very difficult for the government as farmers, small industrialists and transporters have powerful lobbies.

Access to Capital Market

The Banking Companies (Accusation and Transfer of Undertakings Act) was enhanced to allow the banks to increase capital through public issues. This is subject to a provision that the holding of central government would not decrease below 51% of paid-up-capital. The State Bank of India has already increased substantial amount of funds through equity and bonds.

Freedom of Operation

Scheduled commercial banks are given freedom to open new branches and upgrade extension counters, after attaining capital adequacy ratio and prudential accounting norms. The banks are also permitted to close non-viable branches other than in rural areas.

Local Area banks (LABs)

In 1996, RBI issued guidelines for establishing Local Area Banks and it approved to build 7 LABs in private-sector. LABs provide support in mobilizing rural savings and in converting them to investment in local areas.

Supervision of Commercial Banks

The RBI formed a Board of financial Supervision with an advisory Council to empower the supervision of banks and financial institutions. In 1993, RBI established a new department, the Department of Supervision, as an independent unit for supervision of commercial banks.

Measures were taken to empower capital infusion by the government to approximately Rs. 20,000 Crore. Along with this, public sector banks were permitted to access the capital markets for infusion of equity capital subject to the condition that government ownership would remain at least at 51 percent.

Also, necessary measures were taken to develop the fragile health and low profitability. This called for adherence to internationally acceptable prudential norms, asset classification and provisioning and capital adequacy. Many measures were also started, the prominent one being the enactment of The Recovery of Debts Due to Banks and Financial Institutions Act in 1993. Following this, 29 debt recovery tribunals (DRTs) and five debt recovery appellate tribunals (DRATs) were established at a number of places in the country.

All these measures minimized the percentage of NPAs to gross advances from 23.2 percent in March 1993 to 16 percent in March 1998. Later rationalization and deregulation of interest rates was also undertaken.

Concurrently, in order to build competition within the banking sphere, different measures were undertaken. These comprised of opening private-sector banks, greater freedom to open branches and installation of ATMs, and full functional freedom to banks to evaluate working capital requirements.

Phase 2

The second phase of reforms begun with another Narasimham Committee report in April 1998, which succeeded the East Asian Crisis. Post 1998, a need was felt to restructure debt as the DRTs process was very slow because of many legal and other hurdles.

An important feature in this phase was the growing competition between banks. Though 21 new banks including four private-sector banks, one public sector bank and 16 foreign entities enrolled, the overall scheduled commercial banks (SCB) decreased approximately four-fifths to 82 by 2007. In addition to this, FDI in the banking sector was brought under the automatic route, and the limit in private-sector banks was increased from 49 percent to 74 percent in 2004.

In order to make banking sector stronger, the government delegated a Committee on banking sector reforms under the Chairmanship of M. Narasimham. It endured its report in April 1998. The Committee focused mainly on structural measures and development in standards of disclosure and levels of transparency.

The following reforms were undertaken on the recommendations made by the committee

  • New Areas − New areas for bank financing have been unclosed like Insurance, credit cards, asset management, leasing, gold banking, investment banking etc.

  • New Instruments − For more flexibility and better risk management new tools and technologies have been introduced. These instruments include interest rate swaps, cross currency forward contracts, forward rate agreements, liquidity adjustment facility for meeting day-to-day liquidity mismatch.

  • Risk Management − Banks have initialized specialized committees to assess various risks. Their Skills and systems are upgraded on a regular basis.

  • Strengthening Technology − Technology infrastructure has been reinforced for payment and settlement with services such as electronic funds transfer, centralized fund management system, etc.

  • Increase Inflow of Credit − Measures are taken to boost up the flow of credit to priority sector by focusing on Micro Credit and Self Help Groups.

  • Increase in FDI Limit − The limit for FDI has been increased in private-sector banks from 49% to 74%.

  • Universal banking − It refers to the merging of commercial banking and investment banking. There are a few guidelines for the expansion of universal banking.

  • Adoption of Global Standards − The RBI recently introduced risk based supervision of banks. Best international exercises in accounting systems, corporate governance, payment and settlement systems etc. are being endorsed.

  • Information Technology − Banks have proposed online banking, E-banking, Internet banking, telephone banking etc. Measures have been taken to support delivery of banking services via electronic channels.

  • Management of NPAs − Measures were taken by RBI and central government for management of non-performing assets (NPAs), like corporate Debt Restructuring (CDR), Debt Recovery Tribunals (DRTs) and Lok Adalats.

  • Mergers and Amalgamation − In May 2005, RBI issued guidelines for merger and Amalgamation of private-sector banks.

  • Guidelines for Anti-Money Laundering − Recently, prevention of money laundering was given importance in international financial relationships. In 2004, RBI updated the guidelines on know your customer (KYC) principles.

  • Managerial Autonomy − In February 2005, the Government of India circulated a managerial autonomy package for public sector banks to supply them a level playing field with private-sector banks in India.

  • Customer Service − Past years witnessed improvement in customer service. The RBI advanced its services with credit card facilities, banking ombudsman, settlement of claims of deceased depositors etc.

  • Base Rate System of Interest Rates − The system of Benchmark Prime Lending Rate (BPLR) was introduced in 2003 to ensure true reflection of the actual costs. The RBI proposed the system of Base Rate on 1st July, 2010. The base rate can be defined as the minimum rate for all loans. If we take banking system as a whole, the base rates were in the range of 5.50% - 9.00% as on 13th October, 2010.

The Banking Sector Reform Committee further recommended that presence of a healthy competition between public sector banks and private-sector banks was important. The report showed flow of capital to meet higher and unspecified levels of capital adequacy and minimization of targeted credit.

The government focused with the help of reform process on improving the role of market forces by making sharp reduction in preemption through reserve requirement, market determined pricing for government securities, disbanding of administered interest rates with a few exceptions and improved transparency and disclosure norms to support market discipline.