Paper 3: Finance and Management: Financial Sector reforms: Part 1

Financial Sector Reforms

Before moving into the reforms side, let us first understand what the financial sector of an economy means. Actually, the primary purpose of the financial sector in an economy is resource allocation. That is, to channelize the funds from the portion of population which have idle surplus money to the productive sector which need money for investment. Therefore, the role of financial sector is to act as an agent of capital formation in an economy. Now you must appreciate, that for an economy to move forwards, we need a robust financial sector with efficient means and ways of resource allocation.

So, broadly speaking, financial sector has following players:

• Supplier of Funds
• Demander of Funds
• Financial Intermediaries
• Financial Markets

Phases of reforms in Indian Financial Sector

In over five decades since dependence, banking system in India has 

passed through five distinct phase, viz. 

(1) Evolutionary Phase (prior to 1950) 

(2) Foundation phase (1950-1968) 

(3) Expansion phase (1968-1984) 

(4) Consolidation phase (1984-1990) 

(5) Reformatory phase (since 1990) 

Evolutionary Phase

First set of significant banks appeared in late 19th century, when the financial system was dominated by presidency banks known as Imperial bank of India ( Later SBI). Some new banks also arrived in the scene viz Allahabad Bank and PNB became the first Indian managed bank of the nascent Indian financial sector.

Foundation Phase

The banking scenario prevalent in the country during the period 1948- 1968 presented a strong focus on class banking on security rather than on  purpose. The emphasis of the banking system during this period was on  laying the foundation for a sound banking system in the country. Banking  Regulating Act was passed in 1949 to conduct and control operations of the commercial banks in India. Another major step taken during this period was the transformation of Imperial Bank of India into State Bank of India and a  redefinition of its role in the Indian economy, strengthening of the co-operative credit structure and setting up of institutional framework for providing long term finance to agriculture and industry. Banking sector, which during the  pre—independence India was catering to the needs of the government, rich  individuals and traders, opened its door wider and set out for the first time to  bring the entire productive sector of the economy – large as well as small, in  its fold.

Expansion Phase

The motto of bank nationalization was to make banking services reach  the masses that can be attributed as "first- banking revolution". Commercial  banks acted as vital instruments for this purpose by way of rapid branch  expansion, deposits mobilization and credit creation. Penetrating into rural  areas and agenda for geographical expansion in the form of branch  expansion continued. The second dose of nationalization of 6 more  commercial banks on April 15, 1980 further widened the phase of the public  sector banks and therefore banks were to implement all the government  sponsored programmes and change their attitude in favour of social banking,  which was given the highest priority.

This period also witnessed the birth of Regional  Rural Bank (RRBS) in 1975 and NABARAD in 1982 which had priority sector  as their focus of activity.

The fifteen years following the banks’ nationalization in 1969 were dominated by the Banks’ expansion at a path breaking pace. As many as  50,000 bank branches were set up; three-fourths of these branches were 

opened in rural and semi-urban areas. Thus, during this period a distinct transformation of far reaching significance occurred in the Indian banking system as it assumed a broad mass base and emerged as an important instrument of socio-economic changes. Thus, with growth came inefficiency and loss of control over widely spread offices. Moreover, retail lending to more risk-prone areas at concessional interest rates had raised costs, affected the quality of assets of banks and put their profitability under strain. The competitive efficiency of the banks was at a low ebb. Customer service became least available commodity. Performance of a bank/banker began to be measured merely in terms of growth of deposits, advances and other such  targets and quality became a casualty.

Consolidation Phase

By this time about 90% of commercial banks were in the public sector  and closely regulated in all its facets. Prices of assets liability were fixed by  the RBI; prices of service were fixed uniformly by the Indian Banking 

Association (IBA); composition of assets was also somewhat fixed in as much  as 63.5% of bank funds were mopped up by CRR and SLR and the remained  was to directed towards priority sector leading and small loaning; salary  structure was negotiated by the IBA and validated by the Government. Thus,  there was no autonomy in vital decisions Government. Thus, there was no  autonomy in vital decisions. Commercial approach in operations and drive  towards efficiency was almost nonexistent. The result was that during this period, the banks ended up consolidating their losses rather than the gains

Over-interference of government in banking sector led to decline in productivity and efficiency and erosion of the  profitability of the banking sector. The squeeze on profitability has emanated  both from the factors operating on the side of income and on the side of  expenditure. The Narasimham Committee-I identified the following factors as  responsible for decline in income earnings:

i. Directed investment in terms of minimum Statutory Liquidity Ratios  which together with variable Cash Reserve Ratio, preempting well 64 over half of the total resources mobilized by banks.

ii. Directed credit program of deploying 40 per cent of bank credit to the priority sectors 

iii. Low capital base.

iv. Low technology. 

v. Phenomenal branch expansion. 

vi. Political interference in loan disbursal and poverty eradication program

<< We will see the reformist and the revolution in Finacial sector after GPL in 1991 in next part>>

Regards

Rahul