Banking Sector Reforms in India: An Overview

 | June 17,2010 03:36 pm IST

Governor Ishrat Husain and distinguished bankers


At the outset, let me express my gratitude to Governor Husain for inviting me to visit Karachi and meet with you. I consider it an honour to be here amidst the banking fraternity.

I would like to congratulate Pakistan for its impressive economic performance. Governor Husain, in his address at the Seminar on Management of Pakistan Economy in Lahore, a few weeks ago, had this to say about recent economic performance of Pakistan and challenges ahead, in his characteristically candid fashion:


"Economic growth rate has reached a solid 6 per cent plus, inflation has been contained to 5 per cent which has only recently started rising, exchange rate has been stabilized, fiscal deficit has been drastically reduced, domestic interest rates have declined dramatically, international reserves have jumped twelve times their 2000 level, debt ratios have fallen significantly and investment is booming."


He further added that, "Pakistan has achieved macroeconomic stability, introduced structural reforms, improved economic governance and resumed the path for high growth rates. But there is no room for complacency."


Taking account of the nature of audience here and following the example of Governor Husain, who spoke eloquently on the banking sector reforms in Pakistan in January this year, I have chosen to present an overview of banking sector reforms in India.


It is useful to very briefly recall the nature of the Indian banking sector at the time of initiation of financial sector reforms in India in the early 1990s. The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991), essentially catered to the needs of planned development in a mixed-economy framework where the public sector had a dominant role in economic activity.

The strategy of planned economic development required huge development expenditure, which was met through Government's dominance of ownership of banks, automatic monetization of fiscal deficit and subjecting the banking sector to large pre-emptions - both in terms of the statutory holding of Government securities (statutory liquidity ratio, or SLR) and cash reserve ratio (CRR).

Besides, there was a complex structure of administered interest rates guided by the social concerns, resulting in cross-subsidization. These not only distorted the interest rate mechanism but also adversely affected the viability and profitability of banks by the end of 1980s. There is perhaps an element of commonality of such a 'repressed' regime in the financial sector of many emerging market economies. It follows that the process of reform of financial sector in most emerging economies also has significant commonalities while being specific to the circumstances of each country. A narration of the broad contours of reform in India would be helpful in appreciating both the commonalities and the differences in our paths of reforms.


Contours of Banking Reforms in India

First, reform measures were initiated and sequenced to create an enabling environment for banks to overcome the external constraints - these were related to administered structure of interest rates, high levels of pre-emption in the form of reserve requirements, and credit allocation to certain sectors.


Sequencing of interest rate deregulation has been an important component of the reform process, which has imparted greater efficiency to resource allocation. The process has been gradual and predicated upon the institution of prudential regulation for the banking system, market behaviour, financial opening and, above all, the underlying macroeconomic conditions. The interest rates in the banking system have been largely deregulated except for certain specific classes; these are: savings deposit accounts, non-resident Indian (NRI) deposits, small loans up to Rs.2 lakh and export credit. The need for continuance of these prescriptions as well as those relating to priority sector lending have been flagged for wider debate in the latest annual policy of

the RBI. However, administered interest rates still prevail in small savings schemes of the Government.


Second, as regards the policy environment of public ownership, it must be recognised that the lion's share of financial intermediation was accounted for by the public sector during the pre-reform period. As part of the reforms programme, initially, there was infusion of capital by the Government in public sector banks, which was followed by expanding the capital base with equity participation by the private investors.

The share of the public sector banks in the aggregate assets of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in 2004.


The share of wholly Government-owned public sector banks (i.e., where no diversification of ownership has taken place) sharply declined from about 90 per cent to 10 per cent of aggregate assets of all scheduled commercial banks during the same period. Diversification of ownership has led to greater market accountability and improved efficiency. Since the initiation of reforms, infusion of funds by the Government into the public sector banks for the purpose of recapitalisation amounted, on a cumulative basis, to less than one per cent of India's GDP, a figure much lower than that for many other countries. Even after accounting for the reduction in the Government's shareholding on account of losses set off, the current market value of the share capital of the

Government in public sector banks has increased manifold and as such what was perceived to be a bail-out of public sector banks by Government seems to be turning out to be a profitable investment for the Government.



Third, one of the major objectives of banking sector reforms has been to enhance efficiency and productivity through competition. Guidelines have been laid down for establishment of new banks in the private sector and the foreign banks have been allowed more liberal entry. Since 1993, twelve new private sector banks have been set up. As already mentioned, an element of private shareholding in public sector banks has been injected by enabling a reduction in the Government shareholding in public sector banks to 51 per cent. As a major step towards enhancing competition in the banking sector, foreign direct investment in the private sector banks is now allowed up to 74 per cent, subject to conformity with the guidelines issued from time to time.