Notes Indian Banking System Part 1 PDF

# Notes Indian Banking System Part 1 ## History of Banking System in India ### 1.0 Introduction - The history of banking in India dates to the 17th century, when the Madras Bank was founded in the year 1683, in British India. - The bank was founded and largely managed by European traders, who wor...

# Notes Indian Banking System Part 1 ## History of Banking System in India ### 1.0 Introduction - The history of banking in India dates to the 17th century, when the Madras Bank was founded in the year 1683, in British India. - The bank was founded and largely managed by European traders, who worked closely with the East India Company. ## 2.0 Evolution ### 2.1 Phase I: Pre-Independence (Before 1947) #### 2.1.1 Bank of Hindustan - Modern banking in India originated in the mid-18th century. - The Bank of Hindustan was one of the first banks in India, which was established in 1770. - The first paper notes were issued by the private banks such as Bank of Hindustan, during late 18th century. - Via the Paper Currency Act of 1861, the British Government of India was conferred the monopoly to issue paper notes in India. - The Bank of Hindustan was liquidated in 1832. #### 2.1.2 Imperial Bank of India - During the British rule in India, the East India Company established three banks known as the Presidency Banks: - Bank of Calcutta (1806) - Bank of Bombay (1840) - Bank of Madras (1843) - The Imperial Bank of India came into existence on 27 January 1921 through the reorganisation and amalgamation of the three Presidency Banks into a single banking entity. - The Imperial Bank of India was later nationalized, and on 1 July 1955, the Imperial Bank of India was transformed into the State Bank of India. #### 2.1.3 Other Pre-Independence Banks Some of the other banks that were established during the pre-independence period were: - Oudh Commercial Bank (1881) - First commercial bank in India - Allahabad Bank (1865) - Oldest still running joint stock bank in India until it's merger in 2020 - Punjab National Bank (1894) - Second largest government-owned bank in India - Bank of India (1906) - Bank of Baroda (1908) - Central Bank of India (1911) - Reserve Bank of India (1935) ### 2.2 Phase II: Post-Independence (1947 – 1990) #### 2.2.1 Pre-Nationalization Phase (1947 – 1968) 1950s - Post-independence - After independence, commercial banks were limited to urban, industrializing areas and catered to the needs of only the rich and the industrial class. - The reason for this was the nexus between banks and industrial houses. - Banks had a board of directors, which was composed mainly of the industrial class. - This board of directors had the power to make policy decisions and appoint a CEO for day-to-day administration. - Policies were made to favour business houses and day-to-day administration was made to support this objective. - Banking for the poor did not exist due to the control of business houses. 1958 - Refinance Corporation for Industry Ltd. (RCI) - Since banks needed to be refinanced for term loans forwarded by them for industrial development, a new scheme was developed in 1958, whereby Refinance Corporation for Industry Ltd. (RCI) was set up to refinance banks for industrial lending. - RCI was later merged with IDBI. 1960s - Shift from Traditional Role - Banks were traditionally involved in orthodox deposit banking and short-term credit. - Industrial financing for the long term accounted for a small fraction of total bank credit. - Since the mid-1960s, there has been a departure from this traditional role towards term lending and underwriting of securities. - As per the recommendations of the Shroff Committee, in 1953, banks undertook the underwriting of new corporate securities. 1962-63 - Small-scale Industries and Agriculture - Banks were also encouraged to forward credit to small-scale industries and agriculture. - Regarding SSI, RBI introduced a new policy in 1962, whereby banks could take credit at concessional rates from RBI if they would forward more credit to SSI. - Agricultural Refinance Corporation (ARC) was set up as a subsidiary of RBI in 1963 to provide medium- and long-term finance to financial institutions and banks to promote credit in agriculture by refinancing. #### 2.2.2 Nationalization of Banks (1969 – 1990) Nationalization in 1969 - The nexus of industrial houses in banks survived till 1969 when it was broken through the nationalization of banks whereby majority shareholding passed to the hands of government. - This was done under the radical ideology which had developed in that decade, to target inequality and poverty directly by state policy. - The following banks were nationalized in 1969: - Allahabad Bank (now Indian Bank) - Bank of Baroda - Bank of India - Bank of Maharashtra - Central Bank of India - Canara Bank - Dena Bank (now Bank of Baroda) - Indian Bank - Indian Overseas Bank - Punjab National Bank - Syndicate Bank (now Canara Bank) - UCO Bank - Union Bank of India - United Bank of India (now Punjab National Bank) - At present, there are 12 nationalized banks in India. Nationalization in 1980 - A second round of nationalizations of six more commercial banks followed in 1980. - The stated reason for the nationalization was to give the government more control over credit delivery. - The following banks were nationalized in 1980: - Punjab and Sind Bank - Vijaya Bank (Now Bank of Baroda) - Oriental Bank of Commerce (now Punjab National Bank) - Corporation Bank (now Union Bank of India) - Andhra Bank (now Union Bank of India) - New Bank of India (now Punjab National Bank) ### 2.3 Phase III: Liberalization (1991 – Present) #### 2.3.1 Problems in the Indian Banking System - In order to increase its control over the banking sector, the Government nationalized 14 major private-sector banks in 1969. - This raised the number of scheduled bank branches under Government control. - However, the poor performance of the public sector banks was increasingly becoming an area of concern. - The continuous rise of non-performing assets (NPAs) of banks posed a significant threat to the stability of the financial system. - Hence, banking reforms were made an integral part of the liberalization process. - The financial sector reforms started in 1991 provided the necessary platform for the banking sector to operate on the basis of operational flexibility and functional autonomy enhancing productivity, efficiency, and profitability. #### 2.3.2 Indian Economic Crisis (1991) - The 1991 Indian economic crisis resulted from a balance of payments deficit due to excess reliance on imports and other external factors. - The 1990-91 Gulf War led to a sharp increase in oil prices and a fall in remittances from the Indian workers working overseas. - This led to a sharp depletion of India's forex reserves. - The Chandra Shekhar government could not pass the budget in February 1991 after Moody downgraded India's bond ratings. - The ratings further deteriorated due to the unsuccessful passage of the budget. - This made it impossible for the country to seek short-term loans and exacerbated the existing economic crisis. - The World Bank and IMF also stopped their assistance, leaving the government with no option except to mortgage the country's gold to avoid defaulting on payments. - The crisis, in turn, paved the way for the liberalization of the Indian economy, since one of the conditions stipulated in the World Bank and IMF loan, required India to open itself up to participation from foreign entities in its industries, including its state-owned enterprises. - In the light of these events, two expert Committees were set up in 1990s under the chairmanship of M. Narasimham, former RBI Governor, which are widely credited for spearheading the financial sector reforms in India. #### 2.3.3 Narasimham Committee I (1991) **Purpose** - The first Narasimhan Committee (Committee on the Financial System – CFS) was appointed by then Finance Minister, Manmohan Singh, on 14 August 1991. - The purpose of the Committee was to study all aspects relating to the structure, organization, functions, and procedures of the financial systems and to recommend improvements in their efficiency and productivity. **Recommendations** Some major recommendations of the Narasimham Committee I were - 1. **Reduction in CRR and SLR:** - Since both, CRR and SLR were extremely high, the Committee recommended that the CRR and SLR should be reduced. - Accordingly, CRR was brought down to 3-5%, from 15%, and SLR was brought down to 25% from 38.5%. 2. **Deregulation of Interest Rates:** - The Committee believed that interest rates in India were regulated and controlled by the Government. - The Committee was of the view that the existing structure of administered interest rates was highly complex and rigid. - The Committee advocated allowing market forces to determine interest rates. 3. **Phasing out Directed Credit Programmes:** - Directed credit programs compelled banks to set aside funds for the needy and poor sectors at concessional interest rates. - Since they were reducing bank profitability, the Committee recommended that these programs must be discontinued. - The Committee also proposed that the priority sector must be redefined, and the credit target for the redefined sector must be fixed at 10% of aggregate credit. 4. **Establishment of Special Tribunals:** - The proportion of bad debts and NPAs of public sector banks and development financial institutions was very concerning. - The Committee proposed the establishment of an Assets Reconstruction Fund (ARF) to assist banks in getting rid of bad debts. - Debt Recovery Tribunal (DRT) was established in 1993 to facilitate the recovery of loans by banks and financial institutions. 5. **Structural Reorganization of the Banking Sector:** - The Committee proposed a significant reduction in the number of public sector banks through mergers and acquisitions to increase efficiency in banking operations. - The Committee recommended that the banking system must evolve towards a broad pattern consisting of: - 3 or 4 large banks (including SBI), with international presence; - 8 to 10 national banks; - A large number of local banks and rural banks - The Committee also proposed that there should be no further nationalization of banks. 6. **Freedom to Banks:** - The Committee believed that the Indian banking system was over-regulated and over-administered. - It said that supervision should be based on evolved prudential norms and regulations. - The Committee proposed that there must be greater emphasis on internal audit and internal inspection systems of banks. 7. **Elimination of Dual Control:** - Banks were under the dual control of the RBI and the Banking Division of the Ministry of Finance. - The Committee recommended that the RBI must be the primary agency for the regulation of the banking system. - It also recommended that a quasi-autonomous body must be set up under RBI to supervise banks and financial institutions. #### 2.3.4 Narasimham Committee II (1998) - The second Narasimhan Committee (Committee on Banking Sector Reforms) was appointed by then Finance Minister, P. Chidambaram, in December 1997. - The Committee was tasked with the progress review of the implementation of the banking reforms since 1992, with the aim of further strengthening the financial institutions of India. **Recommendations** Some major recommendations of the Narasimham Committee II were - 1. **Stronger Banking System:** - The Committee recommended for merger of large Indian banks to make them strong enough to support international trade. - However, it cautioned that large banks should merge only with banks of equivalent size and not with weaker banks, which should be closed down if unable to revitalize themselves. 2. **Narrow Banking:** - Some of the public sector banks at that time had accumulated a high percentage of NPAs. - For successful rehabilitation of such banks, the Committee recommended "narrow banking", wherein banks were allowed to place their funds in short-term, risk-free assets. 3. **Autonomy in Banking:** - Greater autonomy was proposed for the public sector banks in order for them to function with equivalent professionalism as their international counterparts. - The Committee recommended a review of the functions of bank boards with a view to making them responsible for enhancing shareholder value through the formulation of corporate strategy and reduction of government equity. 4. **Reform in the Role of RBI:** - The Committee recommended that the RBI withdraw from the 91-day treasury bills market and that interbank call money and term money markets be restricted to banks and primary dealers. - The Committee also proposed a segregation of the roles of RBI as a regulator of banks and owner of banks, as it could lead to a possible conflict of interest. 5. **Non-performing Assets (NPAs):** - The Committee highlighted the need for 'zero' NPAs for all Indian banks with international presence. - The Committee recommended the creation of Asset Reconstruction Funds or Asset Reconstruction Companies to take over the bad debts of banks, allowing them to start on a clean slate. - The Committee wanted banks to bring down their NPAs to 3% by 2002. - The recommendations led to the introduction of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. 6. **Capital Adequacy Norms:** - To improve the inherent strength of the Indian banking system the Committee recommended that the Government should raise the prescribed capital adequacy norms. - The Committee targeted raising the capital adequacy ratio to 9% by 2000 and 10% by 2002 and has penal provisions for banks that fail to meet these requirements. 7. **Entry of Foreign Banks:** - The Committee suggested that the foreign banks seeking to set up business in India should have a minimum start-up capital of $25 million as against the existing requirement of $10 million. - It said that foreign banks can be allowed to set up subsidiaries and joint ventures that should be treated on a par with private banks. #### 2.3.5 Major Committees on Financial System - Pre and Post-1991 Reforms **Tandon Committee** - The Tandon Committee was formed in 1974 with the objective of framing guidelines for commercial banks for follow-up and supervision of bank credit to ensure proper end-use of funds. - There was an urgent need to direct bank credit to the newly developed 'priority sector' in 1968, and also to ration credit due to its scarcity. - The Committee submitted its report in August 1975. - The Tandon Committee Report emphasized the need to correlate bank credit to the business/ production plans and own resources of borrowers. - Entailed a shift from a 'security-based' to a 'need-based' approach to bank credit. - The new norms formed the basis of bank lending for working capital requirements. **Khan Committee** - Khan Committee was formed by RBI in 1997 to examine the role and operations of Development Financial Institutions (DFIs). **The Committee made the following recommendations -** - Gradually move towards Universal Banking - Developing a function-based regulatory framework and risk-based supervisory framework - A super-regulator to coordinate and supervise multiple regulators - Phasing out SLR and reducing CRR to international standards. **Bimal Jalan Committee** - The RBI constituted a committee under the chairmanship of Bimal Jalan in October 2013, to examine the criteria, business plans, and corporate governance practices of applicants applying for new bank licenses. - The Committee submitted its report to the RBI on 25 February 2014. Accordingly, two companies were granted licenses - Bandhan Financial Services Private Limited (now Bandhan Bank), a microfinance institution (MFI), founded by Chandra Shekhar Ghosh - Infrastructure Development Finance Company Limited (now IDFC First Bank), is a finance company under the Department of Financial Services, Government of India. #### 2.3.6 Lead Bank Scheme **What is LBS?** - The RBI launched the Lead Bank Scheme (LBS) in December 1969 to mobilize deposits and step up lending to weaker sections of the economy. - The genesis of this scheme can be traced back to the Prof. D.R. Gadgil Study Group. - The Study Group drew attention to the fact that commercial banks did not have adequate presence in rural areas and also lacked the required rural orientation. **Area Approach** - The Gadgil Study Group recommended the adoption of an 'Area Approach' to evolve plans and programs for the development of an adequate banking and credit structure in rural areas. - The Nariman Committee, set up by the RBI in 1969 endorsed the idea of the 'Area Approach', recommending that in order to enable the Public Sector Banks to discharge their social responsibilities, each bank should concentrate on certain districts where it should act as a 'Lead Bank'. - Under this scheme, a Lead Bank is designated for a district to identify and address bottlenecks in the provision of financial services, and to conduct public outreach programs such as financial literacy camps in the district. - The Lead Bank is expected to assume a leadership role in coordinating the efforts of the credit institutions and the Government. **Committees under LBS** - The performance of the credit plans is reviewed in the various fora created under the Lead Bank Scheme as shown below: - At Block Level : Block Level Bankers' Committee (BLBC) - At District Level: District Consultative Committee (DCC) & District Level Review Committee (DLRC) - At State Level: State Level Bankers' Committee (SLBC) - Under nationalization, 14 major banks were purchased by the government and brought under its control. **High-Level Committee on Lead Bank Scheme** - In view of the several changes that had taken place in the financial sector, the Lead Bank Scheme was last reviewed by the High-Level Committee headed by Smt. Usha Thorat, the then Deputy Governor of the Reserve Bank of India in 2009. - The Committee recommended increasing the scope and coverage of the scheme and also suggested a sharper focus on financial inclusion.