The first bank in India, though conservative, was established in 1786.

From 1786 till today,

the journey of Indian Banking System can be segregated into three distinct phases. They are
as mentioned below:

 Early phase from 1786 to 1969 of Indian Banks

 Nationalisation of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
 New phase of Indian Banking System with the advent of Indian Financial & Banking
Sector Reforms after 1991.

To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II and Phase
III.

Phase I

The General Bank of India was set up in the year 1786. Next came Bank of Hindustan and
Bengal Bank. The East India Company established Bank of Bengal (1809), Bank of Bombay
(1840) and Bank of Madras (1843) as independent units and called it Presidency Banks.
These three banks were amalgamated in 1920 and Imperial Bank of India was established
which started as private shareholders banks, mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab
National Bank Ltd. was set up in 1894 with headquarters at Lahore. Between 1906 and 1913,
Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank
of Mysore were set up. Reserve Bank of India came in 1935.

During the first phase the growth was very slow and banks also experienced periodic failures
between 1913 and 1948. There were approximately 1100 banks, mostly small. To streamline
the functioning and activities of commercial banks, the Government of India came up with
The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949
as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank of India was vested with
extensive powers for the supervision of banking in india as the Central Banking Authority.

During those days public has lesser confidence in the banks. As an aftermath deposit
mobilisation was slow. Abreast of it the savings bank facility provided by the Postal
department was comparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after independence. In
1955, it nationalised Imperial Bank of India with extensive banking facilities on a large scale
specially in rural and semi-urban areas. It formed State Bank of india to act as the principal
agent of RBI and to handle banking transactions of the Union and State Governments all over
the country.

Seven banks forming subsidiary of State Bank of India was nationalised in 1960 on 19th July,
1969, major process of nationalisation was carried out. It was the effort of the then Prime
Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in the country were
nationalised.

Second phase of nationalisation Indian Banking Sector Reform was carried out in 1980 with
seven more banks. This step brought 80% of the banking segment in India under Government
ownership. 

The following are the steps taken by the Government of India to Regulate Banking
Institutions in the Country:

 1949 : Enactment of Banking Regulation Act.

 1955 : Nationalisation of State Bank of India.
 1959 : Nationalisation of SBI subsidiaries.
 1961 : Insurance cover extended to deposits.
 1969 : Nationalisation of 14 major banks.
 1971 : Creation of credit guarantee corporation.
 1975 : Creation of regional rural banks.
 1980 : Nationalisation of seven banks with deposits over 200 crore.

After the nationalisation of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%.
Banking in the sunshine of Government ownership gave the public implicit faith and
immense confidence about the sustainability of these institutions.

Phase III

This phase has introduced many more products and facilities in the banking sector in its
reforms measure. In 1991, under the chairmanship of M Narasimham, a committee was set up
by his name which worked for the liberalisation of banking practices.

The country is flooded with foreign banks and their ATM stations. Efforts are being put to
give a satisfactory service to customers. Phone banking and net banking is introduced. The
entire system became more convenient and swift. Time is given more importance than
money.

The financial system of India has shown a great deal of resilience. It is sheltered from any
crisis triggered by any external macroeconomics shock as other East Asian Countries
suffered. This is all due to a flexible exchange rate regime, the foreign reserves are high, the
capital account is not yet fully convertible, and banks and their customers have
limited foreign exchange exposure.

The nationalisation of banks in India took place in 1969 by Mrs. Indira Gandhi the then prime
minister. It nationalised 14 banks then. These banks were mostly owned by businessmen and
even managed by them.

• Central Bank of India

• Bank of Maharashtra
• Dena Bank
• Punjab National Bank
• Syndicate Bank
• Canara Bank
• Indian Bank
• Indian Overseas Bank
• Bank of Baroda
• Union Bank
• Allahabad Bank
• United Bank of India
• UCO Bank
• Bank of India

Before the steps of nationalisation of Indian banks, only State Bank of India (SBI) was
nationalised. It took place in July 1955 under the SBI Act of 1955. Nationalisation of Seven
State Banks of India (formed subsidiary) took place on 19th July, 1960. The State Bank of
India is India's largest commercial bank and is ranked one of the top five banks worldwide. It
serves 90 million customers through a network of 9,000 branches and it offers -- either
directly or through subsidiaries -- a wide range of banking services. The second phase of
nationalisation of Indian banks took place in the year 1980. Seven more banks were
nationalised with deposits over 200 crores. Till this year, approximately 80% of the banking
segment in India were under Government ownership. After the nationalisation of banks in
India, the branches of the public sector banks rose to approximately 800% in deposits and
advances took a huge jump by 11,000%. • 1955 : Nationalisation of State Bank of India. •
1959 : Nationalisation of SBI subsidiaries. • 1969 : Nationalisation of 14 major banks. •
1980 : Nationalisation of seven banks with deposits over 200 crores. Scheduled Commercial
Banks In India The commercial banking structure in India consists of: • Scheduled
Commercial Banks in India • Unscheduled Banks in India Scheduled Banks in India
constitute those banks which have been included in the Second Schedule of Reserve Bank of
India(RBI) Act, 1934. RBI in turn includes only those banks in this schedule which satisfy
the criteria laid down vide section 42 (6) (a) of the Act. As on 30th June, 1999, there were
300 scheduled banks in India having a total network of 64,918 branches.The scheduled
commercial banks in India comprise of State bank of India and its associates (, nationalised
banks (19), foreign banks (45), private sector banks (32), co-operative banks and regional
rural banks. "Scheduled banks in India" means the State Bank of India constituted under the
State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bank of
India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constituted
under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act,
1970 (5 of 1970), or under section 3 of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the Second
Schedule to the Reserve Bank of India Act, 1934 (2 of 1934), but does not include a co-
 operative bank". "Non-scheduled bank in India" means a banking company as defined in
clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a
scheduled bank".

By the beginning of 1990, the social banking goals set for the banking industry made most of
the public sector resulted in the presumption that there was no need to look at the
fundamental financial strength of this bank. Consequently they remained undercapitalized.
Revamping this structure of the banking industry was of extreme importance, as the health of
the financial sector in particular and the economy was a whole would be reflected by its
performance.
The need for restructuring the banking industry was felt greater with the initiation of the real
sector reform process in 1992. the reforms have enhanced the opportunities and challenges
for the real sector making them operate in a borderless global market place. However, to
harness the benefits of globalization, there should be an efficient financial sector to support
the structural reforms taking place in the real economy. Hence, along with the reforms of the
real sector, the banking sector reformation was also addressed.
The route causes for the lackluster performance of banks, formed the elements of the banking
sector reforms. Some of the factors that led to the dismal performance of banks were.
 Regulated interest rate structure.
 Lack of focus on profitability.
 Lack of transparency in the bank’s balance sheet.
 Lack of competition.
 Excessive regulation on organization structure and  managerial resource.
 Excessive support from government.
Against this background, the financial sector reforms were initiated to bring about a paradigm
shift in the banking industry, by addressing the factors for its dismal performance.
In this context, the recommendations made by a high level committee  on financial sector,
chaired by M. Narasimham, laid the foundation for the banking sector reforms. These reforms
tried to enhance the viability and efficiency of the banking sector. The Narasimham
Committee suggested that there should be functional autonomy, flexibility in operations,
dilution of banking strangulations, reduction in reserve requirements and adequate financial
infrastructure in terms of supervision, audit and technology. The committee further advocated
introduction of prudential forms, transparency in operations and improvement in productivity,
only aimed at liberalizing the regulatory framework, but also to keep them in time with
international standards. The emphasis shifted to efficient and prudential banking linked to
better customer care and customer services.

A credit bureau is a repository of credit information of all customers of its members, which
comprises banks and financial institutions. CIBIL (Credit Information Bureau of India
Limited) is one such organization that collates credit information contributed by its members
and disseminates it to lenders, helping them in their credit-decision-making and lending
process. CIBIL houses only credit information i.e. information on loans and credit cards. It
does not have any details of customers’ savings accounts or fixed deposit accounts.
Members share this credit information of their customers with CIBIL month on month so
that CIBIL’s database is updated. This information is then used by credit underwriters to
make effective credit decisions.
Therefore, with proper financial planning and by maintaining a good track record of
repayment of dues for loans / credit cards, you will be able to build a good credit history for
yourself. This, in turn, may help you in getting future loans / credit cards easily or on better
terms.

The establishment of Credit Information Bureau (India) Limited (CIBIL), India's first Credit
Information Bureau, is an effort made by the Government of India and the Reserve Bank of
India to improve the functionality and stability of the Indian financial system by containing
NPAs while improving credit grantors' portfolio quality.

CIBIL was promoted by State Bank of India (SBI), Housing Development Finance

Corporation (HDFC), Dun & Bradstreet Information Services India Private Limited (D&B)
and TransUnion International Inc.

India lives in its villages, and the founding fathers deemed it imperative to enable financial
inclusion for the rural population. The Regional Rural Bank (RRB) emerged from India’s
early aspirations for a stronger institutional arrangement to develop a savings culture in the
rural eco-system, provide rural credit and agriculture finance, while enabling poverty
elevation. The formation of the Narasimham Committee in 1975, and eventually the passing
of the RRB Act in 1976 were key milestones in this journey. Legislation mandated joint
ownership of RRBs by the Central Government, State Government and a sponsor commercial
bank, in the ratio of 50%: 35%: 15%, respectively.
From a modest beginning of just 6 RRBs with 17 branches covering 12 districts in 1975, the
numbers grew to 196 RRBs with 14,446 branches working in 518 districts across the country,
in 2004. However, given the multiagency shareholding and entailed restrictions, several
RRBs failed to sustain viable operations and others merged vertically or horizontally,
resulting in the total number of RRBs stabilizing at 91, in 2007, with over 14,000 branches,
spread across 585 of the 622 identified districts.

Thus, history has clearly established that the original mandate of promoting profitable
banking with a rural focus will be an enduring phenomenon, only when the RRB is able to
deliver customer-relevant products with optimal operational efficiency and ensure the
functioning of a sustainable and viable business. With 80% of RRBs in rural India, it serves
the larger cause of financial inclusion as well.

The Challenges

This, however, is easier said than done. RRBs today continue to traverse an increasingly
rocky path, facing significant economic, infrastructural and business hurdles that heighten in
complexity with every passing year.

Lack of a Robust Governance Structure

While other rural financial services providers like Scheduled Commercial Banks and private
banking entrants have robust processes for functions ranging from HR to product
development, RRBs are largely insulated in operation and lag behind their commercial
counterparts in efficiency and rationalization of process as well as governance mandates.

Manual Operations 
While automation of operations at RRBs is the vision of The Reserve Bank of India (RBI),
even mechanization remains a challenge for several of these banks. Basic automation, like the
Advanced Ledger Posting Machine (ALPM), for end-of-day (EOD) reporting, is yet to reach
a significant number of RRBs. Lack of automation also hampers reporting and MIS, which in
turn results in poor visibility into business and operational parameters, critical for
management-driven business decisions.
 Inadequate Infrastructure 
Lack of sufficient infrastructure and consequently the inability of most RRBs to retain
qualified managers affect the growth and the discharge of their operations. Inadequate
infrastructure support also translates into high project preparation costs, and risk aversion
amongst sponsor entities.

Dynamic Market Conditions

Few RRBs are up to the rigours of channel expansion and customer segmentation mandated
to conduct business in today’s fast changing times. Even the otherwise ubiquitous ATM, is
ever so often a channel not supported by RRBs.
Most RRBs also lack a robust product innovation agenda to deliver relevant offerings,
factoring in the need for customer convenience and flexibility – increasingly critical in
today’s highly competitive and dynamic rural marketplace.

Undefined Roadmap
The RRBs’ share of woes also includes budgetary constraints, mounting over-dues, lack of
adequate infrastructure facilities, and limited channels of investment. Owing to these
problems, some RRBs are not able to achieve financial viability. In addition, they have little
visibility into operational and business imperatives. Working for growth in very challenging
conditions, sustenance is possible only when RRBs have a clear roadmap for:
 Abiding relationships with customers through customer data analysis
 Operations with clear cost-efficiency and productivity
 Unified 360-degree view of the business
 Relevant and timely product innovation

Technology can Transform

The RBI’s diktat is for RRBs to achieve automation before the dawn of 2011. In fact, for
RRBs established after September 2009, automation will be a clear mandate right from day
one of inception.

Rightly so - since, a robust technology solution can enable RRBs to confront several current
market and business challenges. As an ideal solution, it can help RRBs break through the
insular mould, share information, reuse data and business logic, deliver one view of the
customer, and sustain fruitful relationships in the long term.

Knowledge Repository
RRBs can leverage technology to build a knowledge repository by consolidating knowledge
about products, customers, systems, processes, revenue and practices. This provides them
with an integrated, 360-degree view of the entity. Such consolidated knowledge is intellectual
capital which can be realized by proactively sharing it with all stakeholders – both within and
outside the bank. Employees will thus be empowered with the knowledge necessary to
sustain and grow business. They will also have the wide-ranging information to match
customers with products and enable mapping of process to the business challenge.

Customer-centricity
RRBs can no longer adopt the one-size-fits-all approach restricting their offerings to a
skeletal spread of microfinance for Self Help Groups (SHG), and small loans and deposits.
They must cater to the market’s need for a comprehensive range of banking and insurance
products arising from diverse customer segments ranging from the agri-based sector, the
cottage and small scale industry and artisans. A primary route through which an RRB can
address all these requirements is by having an integrated back office environment. It provides
them with a holistic and actionable view of customers, their interactions, accounts,
transactions, and products, from a single integrated hub. This can enable the RRB to mine
customer data and leverage the information to offer customers tailored financial services that
fulfill their needs. Capitalizing on already existing data will help the RRB save money and
seize cross-sell opportunities.

Process-centricity
RRBs must migrate to an IT environment that comprises an integrated suite of core
functionenabling systems that make it easy for the RRB to standardize processes for all
services. Such an environment introduces much needed intelligence into the RRB
organization and empowers it to chart a successful and sustainable future road-map, which in
turn can strengthen profitability.

Regulation Compliance 
Like every strong player in the banking domain, mitigating compliance risk would be a clear
mandate for RRBs as well. To play a meaningful role in the financial eco-system of the
country, it will be imperative that RRBs comply with regulations like AML and KYC.

To enable regulatory compliance, RRBs can leverage technology for effective data mining
techniques to improve systems that detect violations or outlying risk factors, consolidate
processing for data-intensive jobs and factor in compliance requirements at the product
development level too. Above all, the technology platform can enable complete visibility into
customer transactions. It can also form the basis of information sharing between RRBs for
mutual risk-mitigation from poor credit and eventual gains.

It’s the Way the World Works

Worldwide, the mandate for ‘social and development banks’ like credit unions, cooperative
societies and micro-finance institutions, has been to extend financial inclusion. This includes
services to under-banked rural areas, credit for agriculture and small scale-industry related
businesses, as opposed to the traditional approach to business from a pure-profit perspective.

The most successful among these institutions have been the ones that have adopted
appropriate technology platforms to achieve customer-centricity, break down silos, reuse data
and business logic, while accessing an enterprisewide view of operations. They have driven
their service agenda successfully, while also creating enough profits to ensure sustenance and
viability in the long term.

SARFAESI Act

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security

Interest Act, 2002 (SARFAESI) empowers Banks / Financial Institutions to recover their
non-performing assets without the intervention of the Court. The Act provides three
alternative methods for recovery of non-performing assets, namely: -

 Securitisation
 
  Asset Reconstruction
 
 Enforcement of Security without the intervention of the Court

The provisions of this Act are applicable only for NPA loans with outstanding above Rs. 1.00
lac. NPA loan accounts where the amount is less than 20% of the principal and interest are
not eligible to be dealt with under this Act.

Non-performing assets should be backed by securities charged to the Bank by way of

hypothecation or mortgage or assignment. Security Interest by way of Lien, pledge, hire
purchase and lease not liable for attachment under sec.60 of CPC, are not covered under this
Act

The Act empowers the Bank:

 To issue demand notice to the defaulting borrower and guarantor, calling upon them
to discharge their dues in full within 60 days from the date of the notice. 
 
 To give notice to any person who has acquired any of the secured assets from the
borrower to surrender the same to the Bank. 
 
 To ask any debtor of the borrower to pay any sum due or becoming due to the
borrower. 
 
 Any Security Interest created over Agricultural Land cannot be proceeded with.

If on receipt of demand notice, the borrower makes any representation or raises any
objection, Authorised Officer shall consider such representation or objection carefully and if
he comes to the conclusion that such representation or objection is not acceptable or tenable,
he shall communicate the reasons for non acceptance WITHIN ONE WEEK of receipt of
such representation or objection.

A borrower / guarantor aggrieved by the action of the Bank can file an appeal with DRT and
then with DRAT, but not with any civil court. The borrower / guarantor has to deposit 50% of
the dues before an appeal with DRAT.
If the borrower fails to comply with the notice, the Bank may take recourse to one or more of
the following measures:

 Take possession of the security

 Sale or lease or assign the right over the security
 Manage the same or appoint any person to manage the same

In 1991, the RBI had proposed to from the committee chaired by M.

Narasimham, former RBI Governor in order to review the Financial System
viz. aspects relating to the Structure,Organisations and Functioning of the
financial system. The Narasimham Committee report, submitted to the
then finance minister, Manmohan
Singh, on the banking sector reforms highlighted the weaknesses in the
Indian banking system and suggested reform measures based on the
Basle norms. The guidelines that were issued subsequently laid the
foundation for the reformation of Indian banking sector.

The main recommendations of the Committee were: -

i. Reduction of Statutory Liquidity Ratio (SLR) to 25 per cent over a
period of five years
ii. Progressive reduction in Cash Reserve Ratio (CRR)
iii. Phasing out of directed credit programmes and redefinition of the
priority sector
iv. Deregulation of interest rates so as to reflect emerging market
conditions
v. Stipulation of minimum capital adequacy ratio of 4 per cent to risk
weighted assets by March 1993, 8 per cent by March 1996, and 8
per cent by those banks having international operations by March
1994
vi. Adoption of uniform accounting practices in regard to income
recognition, asset classification and provisioning against bad and
doubtful debts
vii. Imparting transparency to bank balance sheets and making more
disclosures
viii. Setting up of special tribunals to speed up the process of recovery
of loans
ix. Setting up of Asset Reconstruction Funds (ARFs) to take over from
banks a portion of their bad and doubtful advances at a discount
x. Restructuring of the banking system, so as to have 3 or 4 large
banks, which could become international in character, 8 to 10
national banks and local banks confined to specific regions. Rural
banks, including RRBs, confined to rural areas
xi. Abolition of branch licensing
xii. Liberalising the policy with regard to allowing foreign banks to open
offices in India
xiii. Rationalisation of foreign operations of Indian banks
xiv. Giving freedom to individual banks to recruit officers
xv. Inspection by supervisory authorities based essentially on the
internal audit and inspection reports
xvi. Ending duality of control over banking system by Banking Division
and RBI
xvii. A separate authority for supervision of banks and financial
institutions which would be a semi-autonomous body under RBI
xviii. Revised procedure for selection of Chief Executives and Directors
of Boards of public sector banks
xix. Obtaining resources from the market on competitive terms by DFIs
xx. Speedy liberalisation of capital market

Several recommendations have been accepted and are being

implemented in a phased manner. Among these are the reductions in
SLR/CRR, adoption of prudential norms for asset classification and
provisions, introduction of capital adequacy norms, and deregulation of
most of the interest rates, allowing entry to new entrants in private sector
banking sector, etc.

India’s pre-reform period and financial reform

Since 1991, India has been engaged in banking sector reforms aimed at increasing the
profitability and efficiency of the then 27 public-sector banks that controlled about 90 per
cent of all deposits, assets and credit. The reforms were initiated in the middle of a “current
account” crisis that occurred in early 1991. The crisis was caused by poor macroeconomic
performance, characterized by a public deficit of 10 per cent of GDP, a current account
deficit of 3 per cent of GDP, an inflation rate of 10 per cent, and growing domestic and
foreign debt, and was triggered by a temporary oil price boom following the Iraqi invasion of
Kuwait in 1990. Prior to the reforms, India’s financial sector had long been characterized as
highly regulated and financially repressed. The prevalence of reserve requirements, interest
rate controls, and allocation of financial resources to priority sectors increased the degree of
financial repression and adversely affected the country’s financial resource mobilization and
allocation. After Independence in 1947, the government took the view that loans extended by
colonial banks were biased toward working capital for trade and large firms (Joshi and Little
1996). Moreover, it was perceived that banks should be utilized to assist India’s planned
development strategy by mobilizing financial resources to strategically important sectors.
Reflecting these views, all large private banks were nationalized in two stages: the first in
1969 and the second in 1980. Subsequently, quantitative loan targets were imposed on these
banks to expand their networks in rural areas and they were directed to extend credit to
priority sectors. These nationalized banks were then increasingly used to finance fiscal
deficits. Although non-nationalized private banks and foreign banks were allowed to coexist
with public-sector banks at that time, their activities were highly restricted through entry
regulations and strict branch licensing policies. In the period 1969-1991, the number of banks
increased slightly, but savings were successfully mobilized in part because relatively low
inflation kept negative real interest rates at a mild level and in part because the number of
branches was encouraged to expand rapidly. Nevertheless, many banks remained
unprofitable, inefficient, and unsound owing to their poor lending strategy and lack of
internal risk management under government ownership. The major factors that contributed to
deteriorating bank performance included (a) too stringent regulatory requirements (i.e., a cash
reserve requirement [CRR] and statutory liquidity requirement [SLR] that required banks to
hold a certain amount of government and eligible securities); (b) low interest rates charged on
government bonds (as compared with those on commercial advances); (c) directed and
concessional lending; (d) administered interest rates; and (e) lack of competition. These
factors not only reduced incentives to operate properly, but also undermined regulators’
incentives to prevent banks from taking risks via incentive-compatible prudential regulations
and protect depositors with a well-designed deposit insurance system. While government
involvement in the financial sector can be justified at the initial stage of economic
development, the prolonged presence of excessively large public-sector banks often results in
inefficient resource allocation and concentration of power in a few banks. Further, once entry
deregulation takes place, it will put newly established private banks as well as foreign banks
in an extremely disadvantageous position.

Reduction of CRR and SLR

The CRR is considered an effective instrument for monetary regulation and inflation control.
The SLR is used to impose financial discipline on the banks, provide protection to deposit-
holders, allocate bank credit between the government and the private sectors, and also help in
monetary regulation. The CRR requires banks to hold a certain portion of deposits in the form
of cash balances with the Reserve Bank of India. In the 1960s and 1970s, the CRR was 5 per
cent, but then rose steadily to its legal upper limit of 15 per cent in early 1991. The statutory
liquidity requirement requires banks to hold a certain amount of deposits in the form of
government and other approved securities. It was 25 per cent in 1970 and then increased to
38.5 per cent in 1991 – nearly to the level of its legal upper limit of 40 per cent. With respect
to direct lending, the priority sector target of 33 per cent of total advances was introduced in
1974, and the ratio was gradually raised to 40 per cent in 1985. As a part of the financial
sector reforms, the SLR requirement for banks was gradually reduced to 25 per cent by

.
October 1997 from its peak of 38.5 per cent in February 1992 Presently the CRR and SLR
are 6% and 25% respectively.

Diversification of banking activities

The second unique feature of India’s banking sector is that the Reserve Bank of
India has permitted commercial banks to engage in diverse activities such as securitiesrelated
transactions (for example, underwriting, dealing and brokerage), foreign
exchange transactions and leasing activities. The 1991 reforms lowered the CRR and
SLR, enabling banks to diversify their activities. Diversification of banks’ activities
can be justified for at least five reasons. First, entry deregulation and the resulting
intensified competition may leave banks with no choice but to engage in risk-taking
activities in the fight for their market share or profit margins. As a result, risk-taking
would reduce the value of banks’ future earnings and associated incentives to avoid
bankruptcy (Allen and Gale 2000).
Second, banks need to obtain implicit rents in order to provide discretionary,
repetitive and flexible loans.6 In addition, banks attempt to reduce the extent of information
asymmetry by processing inside information on their clients and monitoring
their performance. Such roles are unique to the banking system and important
particularly for SMEs since information on them tends to be highly idiosyncratic.
Without sufficient rents, however, banks are likely to cease providing these services and
the implication for SMEs and economic development can be enormous. Thus, it is
important for bank regulators to ensure adequate implicit rents to banks in order to
encourage them to provide such unique services. Moreover, banks may lose an
opportunity to collect implicit rents if their clients switch to capital markets once they
become larger and profitable.7
Diversification of banking activities helps banks to mitigate the two problems
raised above by providing them with an opportunity to gain non-interest income and
thereby sustain profitability. This enables banks to maintain long-term relationships
with clients throughout their life cycles and gives them an incentive to process inside
information and monitor their clients.
Third, banks can stabilize their income by engaging in activities whose returns
are imperfectly correlated, thereby reducing the costs of funds and thus lending and
underwriting costs.
Fourth, diversification promotes efficiency by allowing banks to utilize inside
information arising out of long-term lending relationships. 8 Thanks to this advantage,
banks are able to underwrite securities at lower costs than non-bank underwriters.
Firms may also obtain higher prices on their securities underwritten by banks because
of their perceived monitoring advantages. Further, banks can exploit economies of
scope from the production of various financial services since they can spread fixed
physical (i.e., branches and distribution channels) and human capital costs (Steinherr
and Huveneers 1990).
Fifth, diversification may improve bank performance by diluting the impact of
direct lending (through requiring banks to allocate credit to priority sectors). Direct
lending reduces the banks’ incentives to conduct information processing and monitoring
functions. As a result, this not only lowers banks’ profitability by limiting financial
resources available to more productive usages, but also results in a deterioration of
efficiency and soundness by discouraging banks from functioning properly.
These five advantages, however, can be offset by the following disadvantages.
First, public-sector banks’ engagement in the securities business may promote a
concentration of power in the banking sector since the asset size of banks expands. This
is partly because banks have a natural tendency to promote lending over securities, thereby indirectly
deterring the development of capital markets. Further, the reputation
and informational advantages enjoyed by public-sector banks put them in an even more
favourable position, preventing other banks and investment firms from competing on a
level playing field.
Second, the engagement of banks in underwriting services may lead to conflicts of
interest between banks and investors. Banks may decide to underwrite securities for
troubled borrowers so that the proceeds of the issue of securities can be used to pay off
these banks’ own claims to the companies. Banks may dump into the trust accounts they
manage the unsold part of the securities they underwrite. Further, banks may impose
tie-in deals on customers by using their lending relationships with firms to pressure
them to purchase their underwriting services (for example, using the threat of increased
credit costs or non-renewal of credit lines). Banks may also use the confidential inside
information that they possess when they underwrite firms’ securities in a way that the
firms do not contemplate, such as disclosing the information directly or indirectly to the
firms’ competitors.9
Third, diversification may expose banks to various new risks. For example, banks
may end up buying the securities they underwrite. They may also face greater market
risks as they increase their share of securities holdings and market-making activities.
Further, derivatives involve higher speed and greater complexity, which may reduce the
solvency and transparency of banking operations.
The presence of these three potential disadvantages suggests that measures are
needed to balance the advantages and disadvantages. The Reserve Bank of India tries to
cope with the disadvantages by encouraging banks to engage in securities business
through subsidiaries, thereby putting in place firewalls between traditional banking and
securities services.10 The Reserve Bank of India also prohibits cross-holdings with
industrial groups to minimize “connected lending” – one of the causes of the East Asian
crisis.
To assess the overall impact of banks’ activities, this chapter examines whether
diversification improves bank performance. In particular, the impact of disadvantages
can be assessed indirectly by examining how soundness is associated with diversification.
It is also important to examine whether diversification has led to even greater
dominance of public-sector banks by examining whether banks’ asset portfolios differ
between public-sector and private banks.
Interest rate deregulation
Looking at the history of interest rates policy in India since 1950, we observe three distinct
phases. The first phase lasting for a decade (1950 – 1960) was characterized by more or less
free rates of interest. The second phase lasted for a quarter century (1961-85) and it has been
characterized as the phase of “administered” or regulated interest rates system. The third
phase of gradual and progressive deregulation of interest rates began in 1985, received a big
push in 1991 and is still continuing. The process of interest rate liberalization began in the
mid 1980s with the submission of the report of the committee to review the working of the
monetary system (popularly referred to as Chakravarty Committee Report, submitted in
April, 1985). The first step in this direction was taken in September 1991 with the
discontinuation of sector-specific and programme – specific prescriptions excepting for a few
areas like agriculture and small industries, the Differential Rate of Interest scheme and export
credit.Loans above Rs.2 lakh were freed from various prescriptions, subject to the minimum-
lending rate prescribed by the Reserve Bank. In October 1994 the minimum lending rate was
withdrawn and the banks were given full freedom to determine lending rates for loans above
Rs.2 lakh. They were only required to announce their Prime Lending Rates (PLR);
subsequently, in October 1996, in view of the high spreads over the PLR and to impart a
degree of transparency, banks were advised to announce the maximum spread over PLR. In
1998 RBI decided that interest rates on loans below Rs.2 lakh would not exceed the PLR of
the concerned bank. It was also decided that interest rates on all advances against term
deposits would be equal to PLR or less. Banks were later permitted to operate different PLRs
for different maturities and lend at sub-PLR to creditworthy borrowers. The process of
deposit rate deregulation began in April 1992 by replacing the existing maturitywise
prescription by a single ceiling rate of 13 per cent for all deposits above 46 days of maturities.
The ceiling rate was revised in November 1994 and April 1995. In October 1995, deposits of
maturity of over two years were exempted from ceiling and later in July 1996 deposits of
maturity of over one year were exempted from the ceiling. The ceiling rate for deposits of ‘30
days up to one year’ was linked to Bank Rate less 200 basis points in April 1997. The linkage
to the Bank Rate was removed and thus deposit rates were fully deregulated in October 1997.
In April 1998 banks were allowed to offer differential rates of interest depending upon the
size of the deposit. The minimum period of maturity of term deposits was reduced from 30
days to 15 days. The deposit rates in respect of non-resident rupee deposits were also
deregulated on broadly similar lines while that on foreign currency deposits are subject to a
ceiling rate linked to London Inter Bank Offer Rate (LIBOR).