Financial Sector Reforms: Part 2

In the last part , i have gone through the history of banking sector in India. Now, we will continue towards the reforms in the financial sector.

As discussed previously, the financial sector consists of the entities which engage in the channelization of capital from the surplus sector to the deficit sector. Broadly speaking, there are 3 such entities:

• Banks and NBFCs
• Capital Markets 
• Money Market 

Reforms in Banking sector

As discussed in the earlier post, due to government directed irrational expansion of the banking sector, the banking sector was in desperate need of an overhaul. Fortunately the crisis of 1991, opened the window for reforms in the banking sector.

Due to the opening of economy, the banking structure has also to be changed to keep pace with the changes. Thus, Government of India constituted Narsimhan committee to suggest progressive changes in the banking sector. This was followed by another Narsimhan Committee on Banking sector reforms in 1998 ( Also known as Narsimhan-II committee). Key recommendations were:

a) Autonomy in Banking

Greater autonomy was proposed for the public sector banks in order for them to function with equivalent professionalism as their international counterparts. For this the panel recommended that recruitment procedures, training and remuneration policies of public sector banks be brought in line with the best-market-practices of professional bank management. Secondly, the committee recommended GOI equity in nationalized banks be reduced to 33% for increased autonomy. It also recommended the RBI relinquish its seats on the board of directors of these banks.

b) Reform in the Role of RBI

The Committee proposed a segregation of the roles of RBI as a regulator of banks and owner of bank. It observed that "The Reserve Bank as a regulator of the monetary system should not be the owner of a bank in view of a possible conflict of interest”. Pursuant to the recommendations, the RBI introduced a Liquidity Adjustment Facility (LAF) operated through repo and reverse repos to set a corridor for money market interest rates. RBI decided to transfer its respective shareholdings of public banks like State Bank of India (SBI), National Housing Bank (NHB) and National Bank for Agriculture and Rural Development (NABARD) to GOI. Subsequently, in 2007–08, GOI decided to acquire entire stake of RBI in SBI, NHB and NABARD. Of these, the terms of sale for SBI were finalized in 2007–08 .

c) Stronger Banking System

The committee wanted to rationalize the banking sector by means of mergers and consolidation, so as to create financial institutions capable of handling international transactions. It suggested 3 –tier banking structure i.e. top tier with 2-3 large scale banks competent of catering to international financial requirements, middle tier with nationalized banks which can deal with domestic requirement, and the bottom tier of RRBs to cater the priority sector of the economy. It was opposed by RBI at that stage, but now RBI has itself came out with guidelines regarding restructuring of banking sector in August, 2013.

d) Managing NPAs

The greatest scourge of the PSBs was the ever-increasing burden of Non-Performing Assets. Most of this was due to directed credit lending directions by the mechanism of priority sector lending. There were also instances of behest lending to fulfill political motives. Narsimhan-II committee recommended the reduction of priority sector lending target to 10% from 40% ( Which was not accepted by government). He also, recommended for setting up of Asset Reconstruction Firms (ARFs) to ease the burden on banks and clean their balance sheets. He was strictly against the recapitalization of the banks by government. The recommendations of committee led to path breaking legislation of SARFAESI Act, 2002.

e) Capital Adequacy and Tightening of Provisioning

To improve the inherent strength of the Indian Banking sector, he suggested capital adequacy norms of 9% of the risk weighted assets (following the norms of BCFS, Basel Norms). For asset classification, the Committee recommended a mandatory 1% in case of standard assets and for the accrual of interest income to be done every 90 days instead of 180 day.

Further Reforms in Banking Sector

The 2 Narsimhan committees on banking sector reforms, raised very vital points and led to many structural changes in the banking sector and enabling legislations. Since then, Banking sector is constanly reforming itself, with the able guidance of Reserve Bank of India. Some of the recent reforms in the banking structure are :

·       Decontrolling of the interest rates on Saving Accounts

·       Scrapping of BPLR system and setting Base rate Regime

·       Giving banks autonomy to open branches as per their business requirement

·       Technological revolution: CBS, NEFT, RTGS and CTS-2010

·       Allowing bank to participate in capital markets for investment and raising capital

·       Concept of Universal banking: tie up of various financial institutions to provide integrated financial services under one umbrella brand

·       Valuation of the securities of Banks on Mark-to-Market basis for the right assessment of the assets of banks

·       Establishment of Board-level Asset-Liability committees (ALCO) to monitor the Asset Liability management in banks to maintain solvency of banks.

·       Introduction of Daily-basis interest calculation in place of standard first 10 days min balance calculation to increase profit for depositors.

Thus, we can observe that reforms in the banking sector have been in 2 dimensions. First is the increase in the profitability and the autonomy of banks, and second is the protection of interests of small depositors in the Bank.

The new thrust to reforms in the banking sector is coming from the increased focus on Financial Inclusion. RBI is mulling over giving additional banking licenses and making it a continuous process. Models like Banking correspondents, M-Banking are creating new paradigms for the evolution of the banking sector. Due to increasing impetus on leveraging technological prowess, there is integration of various financial services in the Banking function. Thus, we will have to brace ourselves for more reforms in the banking structure in the near future.

Capital Markets and Money Markets

Capital Markets: Markets for long-term investment of funds

Money-Markets: Markets for short term investment of funds ( generally <1 year)

<< will dwell on it in the next document>>

P.S> Few points are taken from Wikipedia.