Financial Reforms

Indian Financial Sector from 1950 to 1990: From
Laisseze Faire to Government Controlled

• At the time of independence in 1947, India had 97 scheduled1 private banks, 557
“non-scheduled” (small) private banks organized as joint stock companies, and
395 cooperative banks. So mainly three major types of players, viz., the Imperial
Bank of India, joint-stock banks and the foreign owned exchange banks.
• The decade of 1950s and 1960s was characterized by limited access to finance of
the productive sector and a large number of banking failures.
• Such dissatisfaction led the government of left-leaning Prime Minister (and then
Finance Minister) Mrs. Indira Gandhi to nationalize fourteen private sector banks
on 20 July 1969; and later six more commercial banks in 1980.
• Thus, by the early 1980's the Indian banking sector was substantially nationalized,
and exhibited classical symptoms of financial repression.
05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

• Besides the commercial banks, there were four other types of financial
institutions in the Indian financial sector: development finance
institutions (DFIs), co-operative banks, regional rural banks and post-
offices.
• Over the 1950s and 1960, in the absence of effective capital markets, a
network of DFIs was established over much of the developing world,
usually encouraged by external aid agencies.
• The sources of funds of these DFIs were diverse but raised primarily
from the domestic bond market, from multilateral institutions like the
World Bank, refinance window of the RBI, and government budgetary
provisions.
• Thus, by the end of the 1980s, the financial sector in India was
virtually owned by the government with nationalized banks and
insurance companies and a single public sector mutual fund.
• Consequently, reforming the financial sector was a very important
part of Indian economic reforms initiated in the early 1990s.
• Thus, over the years, the Indian financial sector has emerged as a
substantial segment of the economy comprising diverse financial
institutions and various markets.

Philosophy of Financial Sector Reforms
• The philosophy of financial liberalisation originates from the analysis
of financially repressed economies by McKinnon (1973) and Shaw
(1973).
• They argue that financial repression reduces the real rate of growth
and the real size of the financial system relative to non-financial
magnitudes.
• The financial repression is defined as by McKinnon and Shaw as
indiscriminate distortion of financial prices including interest rates by
the government through the central bank.
• Financial Repression also constraint the private sector expansion.
Objective of Financial sector reforms
• To develop market oriented, competitive, world integrated, diversified, autonomous
and transparent system.
• To increase the allocative efficiency of limited financial resources (savings) and
promote economic growth.
• To create level-playing fields and facilitate free entry and exit for institutions and
market players.
• To rationalize the interest rates structures as per market principles.
• To allow the global capital to freely move in and out to generate growth momentum in
the country.
• Providing various avenues of financial resources for business expansion.
• To modernize the functioning of the financial institutions including the central bank’s
monetary policy making.
Reasons for financial sector reforms in
India
• India met the BOP crisis/currency crisis in 1991 and had to take
assistance from the IMF which imposed the conditionalities
(Macroeconomic Stabilization and Structural Adjustment Programs) on
India.
• There was too much state intervention on the allocation of financial
resources through SLR and lending provisions.
• Private and public sector financial institutions did not have level playing
field.
• Exchange rate was operating as per the fixed exchange rate regime,
which was considered the impediment in efficiency of trade oriented
sectors.
Components of financial sector reforms
• Financial sector reforms in India are based on primarily: 1.

Narasimham Committee (1991) and Narasimham Committee
(1997).
• The committees’ recommendations can be explained in the
following categories:
• 1. Systemic Policy Reforms
• 2. Banking Sector Reforms
• 3. Primary and Secondary Market Reforms

Systemic Policy Reforms
• Deregulation of interest rates
• Reduction of SLR from 38.5 percent in 1991 to 18.75% now.
• Reduction of CRR from 15% in 1991 to 4% now.
• Capital Adequacy norms were introduced for banking sector under the framework
of Basel Norms.
• To regulate the banks and all India financial Institutions a Board of Financial
Supervision was crated in 1994.
• To minimize the monetization of fiscal deficit, a ceiling on the ad hoc treasury bills
was introduced and gradually it aimed to do away the ad hoc treasury bills by 1997.
• Consolidation of banking sector to ensure that there exist only 5 to 6 large banks.

• Ways and means advances (WMA) is a mechanism used by RBI to
provide to governments to help them to tide over temporary
mismatches in the cash flow of their receipts and payments. The
advances are repayable in each case not later than three months from
the date of making that advance.
• Umbrella banking/Universal banking was introduced to increase the
efficiency in banking services and introduction of financial
instruments.
• SEBI was made an official body 1992 to regulate and reforms the
capital market.

• RBI was entrusted with monetary control with open market operation.
• Repo Market was introduced as part of Liquidity Adjustment Facility
(LAF). Repo rate has turned out to be important policy rate to controle
the interest rate in the economy.
• Money Market has turned out to be deep and diverse in operation.
• Auction of government securities have been introduced to inculcate
market elements in the determination of interest rate.
• The Clearing Corporation of India Limited (CCIL) has been established
as a central counterparty to provide guaranteed clearing and
settlement functions for transactions in money, G-Secs, foreign
exchange and derivative markets. It has led to significant improvement
in the market efficiency, transparency, liquidity and risk management.
Banking Reforms
• Interest rates on deposits and advances of all cooperative banks and commercial
banks have been deregulated.
• The number of administered interest rates have been reduced from 20 in 1989-90 to
2 in 1994-95 and that is further reduced to 1 in 2010. Now no lending rate is
regulated.
• Since 1994 RBI introduced the Prime Lending Rate (PLR) system for banks then
converted into Benchmark Prime Lending Rate (BPLR) in 2003. However, the RBI
discarded the Benchmark Prime Lending Rate (BPLR) and introduced Base Rate
system to decide lending interest rates in 2010 and further Marginal Cost of Funds
based Lending Rate (MCLR) was introduced in 2016.
• Prudential norms for income recognition, classification of assets: Standard, Sub-
starndard, Doubtful and Loss asstes; and provisioning for bad assets have been
introduced.
Banking Reforms
• Transparency in the Banks’ balance sheets have been emphasized.
• Conversion of DFIs into Commercial Banks.
• Alignment of Indian banking regulation as per the international standard and
therefore adoption of Basel Norms.
• Allowance of FDI in the banking sector and insurance sector with joint
venture or independent venture.
• Introduction of automation in the banking sector and core banking solution.
• Core banking is a banking service provided by a group of
networked bank branches where customers may access their bank account
and perform basic transactions from any of the member branch offices.

Banking Reforms
• Introduction of Indian Financial Network (INFINET) and Real Time Gross
Settlement (RTGS) made the payment system more efficient and cost
cutting.
• Setting up of Institute for Development and Research in Banking
Technology (IDRBT) by RBI in 1996 to impliment information and
technology inputs in banks’ functioning.
• Towards inculcating a credit culture through enforcement of creditors'
rights, and hastening the process of credit recovery. The Securitization
and Reconstruction of Financial Assets and Enforcement of Securities
Interest (SARFAESI) Act was passed in 2002, enabling the setting up of
debt-recovery tribunals and asset-reconstruction companies.
Aggregate Deposit and Credit (as % of GDP)

Select Indicators of Scheduled Commercial Banks
(excluding Regional Rural Banks)

Gross and Net NPAs of all Commercial Banks and Capital Adequacy
Ratio

Some Emerging Issues in Indian Banking Sector
• The Indian banking sector continued to remain predominantly public in nature, with
the public sector banks still accounting for more than 70% of total banking sector
assets.
• However, the performance of public sector banks has been less impressive as
compared to private sector banks in terms of profitability and other financial ratios.
• However, there has been decline of NPAs since 1998 but it picked up again after 2014-
15 as shown in next table on NPAs.
• However, during
• 2014-15 , despite their substantive share in total assets, public sector banks
accounted for
• Public Sector banks constitute only 42% in total profits in 2014-15, which is down
from 74% in 2003-04.
Gross of Different Types of Banks

Trend of NPAs as % of Gross Advances
Foreign Banks
Private sector banks 3.8
Pulic Sector banks 3

4
4.7 2.3
3.6
4.2 4.1 5.3
5.5 2.9
4.8
2.8
3.2 3.8
3.9
3 14.6
2.7 2.1 11.7
1.8 11.6
1.8 9.3 10.3
1.9 9.1
7.3
4.4 5
3 3.6
2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22
Pulic Sector banks 3 3.6 4.4 5 9.3 11.7 14.6 11.6 10.3 9.1 7.3
Private sector banks 1.9 1.8 1.8 2.1 2.8 4.1 4.7 5.3 5.5 4.8 3.8
Foreign Banks 2.7 3 3.9 3.2 4.2 4 3.8 3 2.3 3.6 2.9

Some Emerging Issues in Indian Banking Sector
• Taking a wider definition, the stressed assets (NPAs and Restructured

Assets) for the banking system as a whole increased from 9.8% in
2012 to 14.5% in 2015. But the stressed assets in public sector banks
increased from 11.0% to 17.7% during the same period.
• Interestingly, in recent years, small industries as well as agricultural
loans do not seem to have contributed the lion’s share of this
formation of NPAs, as they used too in the past. It is the industrial
sector - primarily the infrastructure and steel sectors that have
experienced greater deterioration in asset quality.

Reasons for Rise in NPAs of Public Sector Banks
• First, in the aftermath of the North Atlantic Financial Crisis-2008 the RBI relaxed credit
norms in order to encourage bank lending – a phenomenon that is called “regulatory
forbearance” in Central Bank’s language.
• Second, during the post-NAFC, the sharp fall in commodity prices has led to sharp
declines in the profitability of sectors such as steel; this could have caused the problem
of unpaid debt to banks from these and associated sectors.
• Third, the government thrust on infrastructure investment through public-private-
partnerships (PPP) led to huge new debt being contracted by highly leveraged Indian
corporate entities investing in infrastructure. Government pressure combined with
private sector enthusiasm for PPP infrastructure projects may have led banks to deviate
from the rigorous discipline of credit appraisal and due diligence.
• Fourth, there are allegations of governance issues with the management of select public
sector banks and cases of political interference.
Some Social Issues in Indian Banking
Sector
• Despite all the decades of social
sector banking and success in
spreading the banking network,
there has been evidence that poorer
sections of the society have not been
able to access financial services
adequately from the organized
financial system (NABARD, 2008).
This led to start of Jan-Dhan Yojna for
zero balance banking with an
objective of digitization of welfare
funds transfer to the poorer sections.
Note: 55.59% (25.71 crore) Jan-Dhan account holders are women
and 66.79% (30.89 crore) Jan Dhan accounts are in rural and semi-
urban areas
Sector
Avg. Deposit per account has increased over 2.9 times over Aug’15, which means average deposit per account
increased from Rs. 1279 in August 2015 to Rs. 3761 in August, 2022.
Sector
• Indian commercial banks are required to lend 40 percent of
their credit to the priority sector.
• There are sub-targets within this overall 40 per cent target.
Illustratively, 18 per cent has to be disbursed to agriculture
while 7.5 per cent has to be disbursed to the small and
medium enterprises.
• Further, commercial banks can also invest the amount of
their shortfalls in the Rural Infrastructure Development Fund
(RIDF) run by NABARD.
Outstanding Debt of Rural Household: Institutional
versus Non-Institutional Sources (%)

New Banking Intitiatives
• After long time licenses were granted in 2015 to two existing financial institutions to become
universal commercial banks: IDFC Ltd (an integrated infrastructure finance company) and
Bandhan Financial Services (a large micro finance organization).
• Payments banks and small finance banks have also emerged as the newest entrants in the
Indian banking sector.
• Payments banks are essentially narrow banks (i.e., without any lending activity) which can
raise deposits of up to Rs. 100,000 and pay interest on these balances just like a savings bank
account does.
• Their basic business model is geared towards utilizing newer mobile technology and payment
gateways whereby they can enable transfers and remittances through a mobile phone.
• Since August 2015 when the RBI issued licenses to 11 entities17 to establish payments banks.
• At the same time, small finance banks are being licensed to further financial inclusion
primarily through mobilization of savings as well as supply of credit to small business units.

Primary and Secondary Stock Market
Reforms
• Establishment of SEBI : The Securities and Exchange Board of India
(SEBI) was established in 1988. It got a legal status in 1992. It was
meant to:
• Regulate the business of the stock market and other securities market.
• Prohibit fraudulent and unfair trade practices in securities market.
• Promote awareness among investors and training of intermediaries
about safety of market.
• Prohibit insider trading in securities market.
• Regulate huge acquisition of shares and takeover of companies.

Reforms
• Establishment of Creditors Rating Agencies : Three creditors rating agencies viz.
The Credit Rating Information Services of India Limited (CRISIL - 1988), the
Investment Information and Credit Rating Agency of India Limited (ICRA - 1991)
and Credit Analysis and Research Limited (CARE) were set up in order to assess
the financial health of different financial institutions and agencies related to the
stock market activities.
• Increasing of Merchant Banking Activities : Many Indian and foreign commercial
banks have set up their merchant banking divisions in the last few years. These
divisions provide financial services such as underwriting facilities,
issue organising, consultancy services, etc. It has proved as a helping hand to
factors related to the capital market.
• Factoring is a financial service in which the business entity sells its bill
receivables to a third party at a discount in order to raise funds
Reforms
• Rising Electronic Transactions : Due to technological development in the
last few years. The physical transaction with more paper work is reduced.
Now paperless transactions are increasing at a rapid rate.
• Investor's Protection : Under the purview of the SEBI the Central
Government of India has set up the Investors Education and Protection
Fund (IEPF) in 2001. It works in educating and guiding investors.
• Growth of Derivative Transactions : Since June 2000, the NSE has
introduced the derivatives trading in the equities. In November 2001 it
also introduced the future and options transactions. These innovative
products have given variety for the investment leading to the expansion
of the capital market.
Indicators of impact of financial sector reforms
1990-91 2007-08 2011-12 2016-17

Gross Domestic Savings 22.9 36.8 30.8 29.2
Gross Domestic Investments 26.0 38.1 35.0 29.6
Bank Credit/GDP(%) 20.4 47.4 50.60 75
Broad Money/GDP (%) 46.7 82.9 83.21 75.56
Spread (%) 2.9 3.62 2.0
Net Interest Income to total assets(%) 1.95 3.0 2.9 3
ROA(%) 1.13 1.08 .99

BSE Market Capitalization(%) 16 103 70.2 151.7
Primary Market Resource Mobilization (Rs. 43.1 636.4 3087.5 2500
Billion)
05/03/2024 Copyright@ Dr. Santosh Kumar, SRCC

Financial Reforms

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Financial Reforms

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Indian Financial Sector from 1950 to 1990: From

Laisseze Faire to Government Controlled

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

• Financial sector reforms in India are based on primarily: 1.

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

Private sector banks 3.8

Pulic Sector banks 3

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

• Taking a wider definition, the stressed assets (NPAs and Restructured

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

05/03/2024 Copyright of Dr. Santosh Kumar, SRCC

1990-91 2007-08 2011-12 2016-17

ROA(%) 1.13 1.08 .99

05/03/2024 Copyright@ Dr. Santosh Kumar, SRCC

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