Banking Sector Reform in India – Since 1990

(Reference: Based on a paper from IMF)

The banking regulatory that was put in place in many countries following the Great Depression of 1930s had two broad goals: first to reduce the risk inherent in banking by imposing restrictions on the way the banks operated and controlling the cost of deposits, and the second was to protect the depositors from bank failures.

Prior to 1991, the system of licensing was prevalent in India which protected the borrowers from meaningful economic competition and even the possibility of run was remote on a bank due to the nationalization of the bulk of banking sector in 1969 meant an implicit guarantee from the government.
Banking regulation followed the classical path under which the regulator specified detailed guidelines on each aspect of the banking business, there were fixed borrowing and lending rates and a completely fixed set of interest rates and slowly moving exchange rates in the larger economy. Lending was directed towards certain priority sectors such as agriculture and small scale industries.

The economic liberalization of 1991 under Prime Minister P V Narsimha Rao demolished Industrial licensing and entrepreneurs were free to set up any capacity by obtaining minimal clearances. However because there were very few business houses and even they had very little capital, the only real constraint became the availability of finance from the DFIs (Development Finance Institutions).
DFIs are established and funded by the government to develop and promote certain strategic sectors of the economy, and to achieve social goals. They are expected to fill in the gaps which the banks do not enter.

In particular on the lending side of non priority sector debt, commercial banks and DFIs were given complete freedom to lend money at the rates of interest that they could freely determine. However the rates of interest in Savings and Current bank account were regulated across the banking system and only commercial banks (not NBFCs and DFIs) were allowed to access these low-cost funds. Commercial banks were required to maintain a part of their liabilities (deposits) as SLR, CRR and invest heavily in government securities.

Neither the bankers nor industrialists had any experience operating in liberalized environments; almost every project that was submitted for financing was accepted. As a consequence, the system created excessive capacity in all industries mainly steel, man made fiber, paper, cement, textiles, hotels, and automobiles which received a major share of the loan given by the DFIs and partly by Commercial banks.


The yield on 10 year government bond fell from 13.9% in April 1996 to a low 5.15% in April 2004. Banks continued to invest heavily in government securities even though interest rates on these securities fell steadily because interest rates on savings account and current accounts were tightly regulated and kept well below risk free rate.
This helped in maintaining solvency in the system; however the poor understanding of risk management and maturity profile produced excess capacity as stated earlier.


The factors responsible for the current healthy banking system in our country are namely:
1) The implied government guarantee ensured that the public never lost confidence in the banks and hence there was never a run on a bank.
2) The large difference between the cost of demand deposits (current and savings) and the rate of return on the government of India securities helped banks to maintain profit..
3) High level of explicit capital injection into DFIs and banks helped these banks to remain liquid.


There have been a lot of changes since the liberalization of the economy such as:
• A rapid buildup of retail finance since 1996 due to the strong demand for retail loans.
• Increase in commodity prices since 2000 due to the Chinese demand and the domestic retail financing boom.
• The volatility level in financial assets have increased (interest rates in government securities have started to rise)
• There has been increased level of volatility in commodity prices due to the global shocks
• Demand for credit from manufacturing, infrastructure and agriculture has surged
• Enhanced levels of competition from Insurance companies and Asset Management companies for Bank deposits


However, the Indian Banking system still has a long way to go and needs reforms which focus on banking outcomes for the banking system as a whole. The various reforms which need to be implemented include:
• Shifting focus from detailed processes that banks use to monitoring outcomes which would help banks to standardize their processes and also result in more timely and accurate disclosures which would be beneficial for the customer as well as regulator
• Lower the cost of intermediation by increasing the penetration of electronic payments on a nationwide basis and move towards national settlement in payment systems.
• Improve access to financial services:- In over 600,000 villages in the country the total number of rural bank branches of Scheduled Commercial Banks (SCB) does not exceed 30,000. The distance from a bank branch can be many more kilometers for some residents. Both regional rural banks (RRBs) and cooperative credit institutions suffer from poor access for customers, low levels of capitalization, and high default rates. We need to develop more number of Micro Finance Institutions which are more potent and committed to the goal of their inception.
• Banks need to be provided more freedom in terms of building outreach models (franchisee, branch, correspondent) with a focus on outcomes and not on uniform processes across banks, the way it happens in Brazil where banking services are offered from retail outlets such as drugstore, superstore, petrol stations which include deposits & withdrawals, bill payment services, and insurance products with the formally licensed bank taking complete responsibility for the correspondents business conduct.