Impact of

Banking
Sector
Reforms In
India
Gangadharam Siddili
Kaushik Nagarajan
Ashwin Paldano
Leoprabhu Ekambaram

Table of Contents
1. Introduction to Banking and Pre-reform era...........................................2
2. Necessity for Banking sector Reforms.....................................................2
3. First Phase of Reforms(Narasimhan committee, 1991)........................3
Recommendations of Narasimhan Committee...........................................3
Banking reforms brought in by the Government and their impact........3
4. Second phase of reforms (Narasimhan committee, 1998)....................5
Recommendations of Narasimhan Committee...........................................5
Banking reforms brought in by the Government and their impact........6
5. Impact of Banking sector reforms.............................................................8
Productivity of Commercial Banks...............................................................8
Profitability of Commercial Banks................................................................9
Asset Quality.................................................................................................... 9
Customer Services........................................................................................ 10
6. Impact on Corporate Sector:....................................................................10
7. Conclusion and Recommendation...........................................................12
8. References.................................................................................................. 12

1. Introduction to Banking and Pre-reform era

A bank is an institution, which provides fundamental financial
transactions such as accepting the deposits and providing loans. Basically,
banks are a subset of the Financial Services Industry. After a series of
reforms in the Indian banking industry, the Indian banks were able to
compete with the modern banks of the world.
Banking in India originated in 18 th century with the establishment of The
General Bank of India and Bank of Hindustan in 1786. The East India
Company then established three presidency banks in India namely The
Bank of Bengal (1809), The Bank of Bombay (1840) and The Bank of
Madras (1843). These three banks were amalgamated in 1921 to form
The Imperial Bank of India (IBI) under the Imperial Bank of India Act,
1920 which is now The State Bank of India.
Until 1935, all the banks were set up by individuals and/or industrial
houses. Though consolidation in banking was building trust among
investors yet a central regulatory and authority was much needed. The
establishment of The Reserve Bank of India in 1935 brought an end to the
quasi-central bank role of Imperial Bank of India and transformed it into a
purely commercial bank over a period of time.
Before reforms the Indian banking sector was characterised by high
reserve requirements, low productivity/ efficiency in PSU banks, stringent
regulations by RBI, quantitative restrictions on credit flows and an ever
increasing Non Performing Assets, Inferior work technology and poor
customer service. The Indian Banks were not in a position to handle the
stiff competition from Foreign Banks. The private banks were not fulfilling
the social and developing goals of banking.
2. Necessity for Banking sector Reforms
In 1991, India faced a severe macroeconomic crisis. This crisis opened the
chinks in the armour of the Indian Banking Sector. The foreign exchange
reserves were at a seemingly low level. The country faced the risk of
defaulting with payments and the economic growth was at very low rate.
This called for the government to bring measures on the paths of
liberalization and globalization in the economy. A series of reforms had to
be brought about in the Financial Sector. Between 1947 and 1990, there
was a tremendous expansion of our banking system which played a major
part in the development of the Financial Sector. However, by the end of
1990 it was felt that banking system wasnt as developed and robust as it
should have been. Some of the Public Sector banks had become loss
making entities with its high level of nonperforming Assets. The hidden
NPAs had the potential to trigger a huge financial crisis. Compared to
International Banks, Indian Banks were nowhere near with respect to

capital adequacy and accounting standards etc. This served as a great

threat to the progress of Indian economy.

3. First Phase of Reforms(Narasimhan committee, 1991)

To overcome the 1991 financial crisis, the Government of India appointed
a special committee headed by Shri. M. Narasimhan, ex-governor of the
RBI to address the problem and to suggest corrective measures. The
recommendations of this committee became the basis for the financial
and banking sector reforms.
Recommendations of Narasimhan Committee
A new 4 tier hierarchy was to be established by the incorporation
of a couple of large banks to be at the top level and a number of
rural service providers to handle the activities pertaining to
agriculture.
The monitoring of the financial institutions and banks by separate
entities that were set up by the RBI.
Proposed phases of reduction in the SLR rate.
A target level of 8% in terms of the Capital Adequacy Ratio.
Elimination of the License raj.
Full account disclosure and the correct organization of the banks
assets and financial entities.
Lower levels of regulation on Interest rates.
Directing the lending activities of the IDBI to a separate corporate
body.
Banking reforms brought in by the Government and their impact
Since 1991 the Narasimhan committee had recommended a series of
measures which were incorporated by the Indian government

Lowering SLR and CRR

The reduction in the levels of SLR and CRR impacted the profits of the
banks. The SLR was brought down to 25% from 38.5%. This helped in
increased funding to the industry & Trading, agriculture. The Cash Reserve
Ratio was reduced to 4.1% from the earlier rates of 15%. The primary
reason behind the move was to liquidate the funds that were locked with
the RBI.It is in use till date and serves as toll for regulating the monetary
policy.

Prudential Norms
RBI had launched prudential norms for commercial banks. The primary
motive behind this was the disclosure of the asset classification, bad debts
provisioning, income to make that the financial records reflected the
accurate data with respect to its financial position. It was necessary for
the banks to ensure a 100% provisioning for all the NPAs which are at
international standards.
Capital Adequacy Norms
RBI had placed a slab for CAN at 8% and this was achieved the public
sector banks by 1996.
Deregulation of Interest rates
The Narasimhan Committee proposed the interest rates to be decided by
the market forces.

Scheduled Commercial banks were permitted to determine the fix

the interest rates depending on the deposits taking into
consideration the maximum ceiling rates & the minimum floor rates.
The interest rates of termed domestic deposit was controlled.
SBI along with the other players in the market had reduced the
lending rates for advances that were more than 2 lakhs
For the loans that were in excess of Rs. 2 lakhs the Interest rates
were deregulated.
The interest rates for the Co-operative banks for advances and
deposits we reduced to a minimum level of 13%.

Recovery of Debts
Recovery of debts due to Banks and Financial Institutions Act 1993 was
passed by the government to facilitate the speeding up of the recovery of
debts by the banks and financial institutions.6 special recovery tribunals
and an Appellate Tribunal was set up in the city of Mumbai.
Competition from new private sector Banks
Banking was opened up to bring in private sector players and many
private sector banks began operations. The new entrants were permitted
to raise capital to the extent of up to 20% from the FIIs and about 40%
from NRIs, which brought in high levels of competition. The new market
players were armoured with the latest technology and services that had
increased the expectations of the customers.

Phasing out of Direct Credit

The committee proposed the reduction in the credit target from 40% to
10% for the primary sectors. The task was however hectic for the
government as those sectors involved powerful lobbies.
Access to Capital Market
The Banking Companies Act was reviewed to enable the banks to raise
capital through issues. This however came with a clause that the central
governments stake of the paid up capital would not fall below 51%.
4. Second phase of reforms (Narasimhan committee, 1998)
A committee was again appointed by the government of India, as a part of
the second phase of reforms, to make the banking sector of the country
stronger
under
the
guidance
of
Mr.
M.
Narasimhan.
The
report/recommendations were submitted to the Government on April,
1998. The major focus and objective of the committee was to improve the
principles of disclosure and the levels of transparency.
Below are the
government.

recommendations

and

corresponding

measures

by

Recommendations of Narasimhan Committee

The committee suggested a resolute banking system entirely in
the context of CAC (Capital Account Convertibility). The
committee provided warning against the merging of small and
weak banks with the strong players, as this might bring in a
negative effect on the performance of stronger banks.
The committee suggested that 2-3 large banks be given
international positioning and global character.
Capital inadequacy was tackled with new improved norms.
It recommended the formation of an Asset Reconstruction Fund
to take possession of bad debts of the banks and financial
institutions.
The committee suggested a Board for Financial Regulation and
Supervision (BFRS) to organize the achievements of financial
institutions and banks.

 To be at par with the current demands of the industry, there is an

urgent need to evaluate and alter the provisions of the RBI Act,
Banking Regulation Act, etc.
By 2002,Net NPAs of all the banks to be reduced to 3%.
The rearrangement of bank branches and staffs was
emphasised. The committee was willing to continue with the
licensing policy of new private banks.
Foreign banks were permitted to set up their joint ventures and
subsidiaries.

Banking reforms brought in by the Government and their impact

New Instruments
New instruments were introduced to facilitate better risk management
and greater flexibility. The new instruments were interest swaps, cross
currency forward contracts, forward rate agreements, Liquidity
Adjustment Facility(LAF) for meeting everyday liquidity mismatch.
Risk Management
Banks created dedicated committees to measure, monitor and track the
various risks. These committees upgrade their skills and systems on a
regular basis in order to sustain the risk management.
Strengthening the technology
New and advanced technology was introduced across banks to strengthen
the payment and settlement systems through centralized fund
management system, core banking solutions, electronic funds transfer,
etc.
Increased Foreign Direct Investment (FDI) Limit
Foreign Direct Investment(FDI) cap in private banks was raised to 74%
from 49%.
Increased inflow of Credit
Flow of credit to priority sector was improved by giving more importance
to Self Help and Micro Credit groups.

Adoption of Global Standards

RBI has introduced Risk Based Supervision of banks. The best
international practices are being adopted in accounting systems, payment
and settlement systems, corporate governance, etc.
Information Technology
Over the counter banking was replaced with the introduction of E-banking,
telephonic banking etc. Focus was on the delivery of banking services
through electronic medium.
Management of NPAs
Non-performing Assets had been the major cause of trouble for the Indian
Banking Sector. The committee wanted a robust system to identify and
classify NPAs. Asset Reconstruction Company or Asset Reconstruction
Funds were created to take possession of the bad debt of banks. These
recommendations led to the introduction of a new legislation which was
subsequently implemented as the SARFAESAI(Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest
Act), 2002 and came into effect from 21 June 2002.
Mergers and Amalgamation
In May 2005,RBI issued procedures for merger and acquisition of private
banks.
Anti-Money Laundering guidelines
KYC(Know Your Customer) norms were reformed to prevent money
laundering. Huge attention has been given to prevent money laundering
in international financial relationships in recent times.
Revamping the rural credit system
To bridge the gap between demand and supply of agricultural credit.
Managerial Autonomy
From February 2005, public sector banks were given greater managerial
autonomy to provide them equal opportunity to compete with private
sector banks and international banks. This was achieved by

 Bringing recruitment process, training and remuneration policies of

public sector banks in line with the private and international banks.
Reducing GOI equity to 33% in nationalized banks.
Customer Service
RBI has introduced many new facilities such as Credit Cards, settlement of
claims of deceased depositors, banking ombudsman etc. to improve the
customer service.
Base Rate System for fixing Interest Rates
The Benchmark Prime Lending Rate (BPLR) introduced in 2003, fell short
of its purpose to bring transparency to lending rates. The main reason for
this was that under the BPLR system, banks had the freedom to lend
below BPLR. To overcome this failure of BPLR, RBI introduced the system
of Base Rate. This new system is in use from July 2010.The base rate is
nothing but the minimum interest rate for all loans.
5. Impact of Banking sector reforms
The performance of both public and private sector banks improved in
terms of profit per employee, productivity per employee, assets value etc.
The improvement in the performance can be explained in the below 5
categories.
i.
ii.
iii.
iv.

Productivity of Commercial Banks

Profitability of Commercial Banks
Asset Quality
Customer Services
Productivity of Commercial Banks
Analyses in terms of profit per employee, business per employee, and
business per branch provides the improvement in the productivity of
Commercial Banks.
Business per employee
The business per employee for Public Sector Banks, Private Sector
Banks and Foreign Banks are tabulated below, though the business per
employee for Public sector banks is very low compared to New Private
sector banks and foreign banks it had increased rapidly compared to
others. A growth rate of 216% was witnessed in Public Sector Banks. By
the year
Business per employee (in lakhs)

Year
1997-98
2005-06
2012-13

Public Sector
Banks
88.5
324.1
1274.7

New Private Sector

Banks
785.9
728.9
930.3

Foreign
Banks
529.4
1012.8
2173.3

Profit per employee

Between the period 1997-98 and 2005-06, the profit per employee of
Public sector banks had a increased by 314%, whereas the New private
sector banks and Foreign banks had increased their profit by 350% and
489% respectively. The absolute value of profit per employee is tabulated,
Profit per employee In lakhs)
Year
1997-98
2005-06
2012-13

Public Sector
banks
0.7
2.9
6.3

New Private Sector

Banks
1.4
6.3
11.8

Foreign
Banks
4.5
26.5
45.6

Business per Branch

The Business per Branch had an average growth rate 14% when our
economic growth rate was 6.2% between 1999-2000 and 2004-05, During
this period the Foreign banks had increased their business per branch by
109% followed by nationalised bank and new private sector banks with
their business per branch increased by 97% and 44% respectively,
Business per Branch (in Lakhs)
Year
1999-2000
2004-05

Nationalized
Banks
2152
4242

New Sector Private

banks
14989
21656

Foreign
Banks
54800
114768

Profitability of Commercial Banks

Profitability of Commercial banks can be shown using below indicators.
a. Net/Spread interest margin
Net/Spread interest rate is the difference between the interest income
generated by bank to the interest paid by bank in relation to the amount
of their assets. For public sector, private sector banks and foreign banks
the spread interest margin was 2.9%, 2.1% and 3.6% respectively in 200001. In the year 2012-13 it was 2.78%, 3.24% and 3.89% for public, private
and foreign banks respectively.
b. Return on Assets(ROA)
The ROA of all banks has been risen after reforms. For public and private
sector banks, it increased from 0.4%, 0.8%in 2000-01 to 0.88% and 1.22%

in 2009-2010 and by the year 2012-13 it is 0.78% and 1.74% respectively.

For foreign banks, the rise has been from 0.9% to 1.09% and 1.94% for
the same period.
Asset Quality
Asset quality of a bank in the terms of Non-performing Assets (NPA) have
been increased
Average NPA in %
GNPA
NNPA

1997-2001
12.8
8.4

2009-2013
2.6
1.2

The NPA raised initially after reforms during early 1990s however it
declined by mid 90s due to increased risk management, abundant
liquidity condition, increased write off and increased restructuring.
Customer Services
After the banking reforms, the Indian banks have begun to offer different
kind of services to the clients/customers. Core Banking Solutions (CBS)
has increased very fast. Under CBS, there are many services that has
been provided to the customers/clients such as anywhere banking,
everywhere access and quick and effecting fund transfer at reasonable
cost. The number of branches implemented the CBS has increased from
79.4% in March 2009 to 90% at the end of March 2010.
6. Impact on Corporate Sector:
Corporate governance
Capital markets always had the prospective to implement discipline
among the marketers and management .However, it was the structural
changes constituted by the financial reforms that unleashed this power.
Smaller stakeholders would be able to carry out the discipline of
capital markets by polling with their wallets. They have the powers vested
on them to vote in the primary market and to reject the subscription to
new issues by a firm. They would also be able to trade their stocks in the
secondary markets by decreasing the stock price.
Deregulation
Financial reforms not only helped in increasing the development visions,
but they have also made the markets more competitive. This forced
companies to invest on a large scale continuously, to survive. The
essential impact of the voting on companies is that the need to approach
the market for the additional funds.

Disintermediation
The financial sector reforms made it vital for the firms to depend on the
capital markets more for their needs of additional capital. As long as the
companies were dependant on the direct credit, the ability to handle
administrative and political process was all that mattered. This implied
that the capital markets demanded performance.
Globalization
Globalization of the Indian Financial markets has showed the issuers,
shareholders and intermediaries the higher standards of disclosures and
corporate governance that succeed in more developed capital markets.
Tax reforms
The tax reforms together with deregulation and competition have made
the market free from black money transaction. It is not often realized that
when an organization makes profits in black money, it is cheating not only
the government, but also the smaller investors. Profits made by black
money do not enter the accounts of the organization at all, but will go into
the pockets of the promoters.
Risk management
Unlike the stable interest rate before banking sector reforms during
1980s, interest rate are highly volatile post reform, which made the
short term funding new projects very difficult to Corporates. Several
companies that borrowed for acquisitions and expansion defaulted.
Capital stricter
At the earlier stage after reform the corporates were increasing their
debt to equity ratio due to the availability of the subsidized institution
finance, the corporates were able to take more financial risks as there
were less business risk in the protected economy before liberalisation
Cash flow discipline:
The equity has no fixed service cost and the fluctuations in income
every year dont have much impact as long as overall enough is earned
to provide a decent return to the investor. On the other hand, the debt
has a fixed repayment schedule and interest irrespective of the
fluctuations. A company which enables the generation of enough cash
flow to meet the requirement faces a painful reformation of liability.
Bonds are rescheduled typically only as a part of insolvency proceeding
or a BIFR reform.
Group Structure:
Indian business groups have been into serious self-assessment about
their business portfolio and group structure. Under the guidance of

many academicians, business groups which are involved in to an array

of business are anticipating a move to a more intensive approach. Also,
they are trying to create a structure of organizations which would enable
the construction and execution of group wide corporate strategy.
Working capital management:
Numerous developments discussed above, reforms in the areas of credit
assessment and delivery, interest deregulation, and transformation in
the competitive structure have impacted the working capital
management.
In the cash credit system, the cast management has played key role.
The companies should now decide on the optimum amount of cash they
have to hold and should know about the ways to organise the cash,
which corresponds to the decisions on maturity and credit risk liquidity.

7. Conclusion and Recommendation

Since the reforms in the financial sector in 1991, there had been
significant changes to Indias Banking sector. This paper tries to assess
the impact of reforms in our economy.
It is understood that the reforms have had a positive impact to an
extent in terms of reducing the concentration of the banking sector and by
improving performance.
The empirical estimation also gave us an estimation which reveals
that the reforms reduced profitability and decreased the efficiency of
public-sector banks during the initial phase, However the decline
overturned to accommodate a new environment
Further reduction in the SLR rate could serve as a motivation for
non-traditional activities and would make our banking sector resilient to
adverse shocks.
To maintain a steady growth of the economy it is imperative that the
reforms continue to serve as a critical factor.
The banking sectors response to the reforms has been significant
and the sectors has adjusted well to the new environment

8. References
1.
2.
3.
4.
5.

www.ijmra.us/project%20doc/IJMT-234.pdf
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