RECENT HISTORY OF INDIAN BANKING

BRIEF HISTORY AND PRESENT STRUCTURE OF INDIAN BANKING

Indian Banking Upto 1947 :

The history of Banking in India can be traced back to the establishment of the first joint stock
bank, The General Bank of India in the year 1786. However, following this there was not much
progress in this field. Later on in 1870, Bank of Hindustan was set up. It was followed by
establishment of Bengal Bank.

However, the banking on modern lines in India started only with the establishment of three
presidency banks under Presidency Bank’s Act 1876. During the first half of nineteenth
century, East India Company established three banks in India, namely The Bank of Bengal in
1809, The Bank of Bombay in 1840, and bank of Madras in 1843. These banks were
independent units and called Presidency banks. All these institutions started as private
shareholders banks and the shareholders were mostly Europeans.

Later on in 1920, these three banks were amalgamated in and a new bank, Imperial Bank of
India was established. This Bank was also assigned the role of Central Bank.

In the meantime, number of private Bank started to function. Among the surviving Banks,
Allahabad Bank is the oldest Bank established in 1865. The next important bank to be set up
during this period was the Punjab National Bank Ltd. with its headquarters at Lahore in 1894. It
was the first time Bank exclusively established by Indians in which Lala Lajpat Rai played an
important role. Most of the household names of Indian commercial banks, owe their origin to
the first half of 20th century. Some of these include, Bank of India, Central Bank of India,
Bank of Baroda, the Canara Bank, the Indian Bank, United Commercial Bank. However, this
period also witnessed failure of large number of small joint stock Banks.

In the meantime, Reserve Bank of India was established in 1935 as the Central Bank of the
country.
Indian Banking after 1947 :

In 1947, India got independence, but banking sector at that time was not only quite small but
was also extremely weak. The banks were mostly confined to urban areas, and loans were
mostly extended to trading sector dealing with agricultural produce etc. There was hardly any
penetration of the commercial banks in rural and semi-urban areas.

After independence, with the advent of Five Year Plans, it was felt that the private banks are not
extending the kind of cooperation needed for upliftment of the rural economy. Based on the
recommendations of All India Rural Credit Survey Committee’s report submitted in 1954, the
first Pubic Sector Bank under the banner of State Bank of India was established on 1st July, 1955,
by acquiring the substantial part of the share capital by RBI, of the then Imperial Bank of India.
It was established with the objective of "extension of banking facilities on a large scale, more
particularly in the rural and semi-urban areas, and for diverse other public purposes". Later on
during the period 1956-59, the seven associate banks of State Bank of India came into existence
as a result of the re-organisation of princely States.

With Mrs. Indira Gandhi coming to power in 1966, started the Scheme of Social Control of
Banks in Febraury, 1966. It was felt that private Banks are a mere tool in the hands of leading
industrial houses and were not extending the credit facilities to the farmers, small entrepreneurs,
transporters, professionals and self employed etc. However, this scheme could not deliver the
desired results and thus on 19th July, 1969, the Government of India, promulgated Banking
Companies (Acquisition and Transfer of Undertaking) Ordinance and acquired 14 commercial
banks. Later on in 1980, six more banks were nationalized. Thus, government effectively
brought about 91% of the total deposits, and 84% of the advances under pubic sector fold.

The period between 1969 and 1984, saw massive branch expansion by Public sector banks
covering rural and semi urban areas. However, this resulted in erosion of the assets of the
banking sector, increase in NPAs and lower profitability. Thus begin the consolidation phase
from 1985, which witnessed the stress on better customer services, improved house keeping of
the branches etc. This phase is marked by strict regulations by RBI in terms of the branch
expansion, interest rates etc.

Since 1991, the Indian banking industry has witnessed the reforms phase, and then started the de-
regulation of interest rates, use technology etc.
PHASES OF BANKING

Indian banking system, over the years has gone through various phases after establishment of Reserve
Bank of India in 1935 during the British rule, to function as Central Bank of the country. Earlier to creation
of RBI, the central bank functions were being looked after by the Imperial Bank of India. With the 5-year
plan having acquired an important place after the independence, the Govt. felt that the private banks may
not extend the kind of cooperation in providing credit support, the economy may need. In 1954 the All
India Rural Credit Survey Committee submitted its report recommending creation of a strong, integrated,
State-sponsored, State-partnered commercial banking institution with an effective machinery of branches
spread all over the country. The recommendations of this committee led to establishment of first Public
Sector Bank in the name of State Bank of India on July 01, 1955 by acquiring the substantial part of share
capital by RBI, of the then Imperial Bank of India. Similarly during 1956-59, as a result of re-organisation
of princely States, the associate banks came into fold of public sector banking.

Another evaluation of the banking in India was undertaken during 1966 as the private banks were still not
extending the required support in the form of credit disbursal, more particularly to the unorganised sector.
Each leading industrial house in the country at that time was closely associated with the promotion and
control of one or more banking companies. The bulk of the deposits collected, were being deployed in
organised sectors of industry and trade, while the farmers, small entrepreneurs, transporters ,
professionals and self-employed had to depend on money lenders who used to exploit them by charging
higher interest rates. In February 1966, a Scheme of Social Control was set-up whose main function was
to periodically assess the demand for bank credit from various sectors of the economy to determine the
priorities for grant of loans and advances so as to ensure optimum and efficient utilisation of resources.
The scheme however, did not provide any remedy. Though a no. of branches were opened in rural area
but the lending activities of the private banks were not oriented towards meeting the credit requirements
of the priority/weaker sectors.

On July 19, 1969, the Govt. promulgated Banking Companies (Acquisition and Transfer of Undertakings)
Ordinance 1969 to acquire 14 bigger commercial bank with paid up capital of Rs.28.50 cr, deposits of
Rs.2629 cr, loans of Rs.1813 cr and with 4134 branches accounting for 80% of advances. Subsequently
in 1980, 6 more banks were nationalised which brought 91% of the deposits and 84% of the advances in
Public Sector Banking. During December 1969, RBI introduced the Lead Bank Scheme on the
recommendations of FK Nariman Committee.

Meanwhile, during 1962 Deposit Insurance Corporation was established to provide insurance cover to the
depositors.

In the post-nationalisation period, there was substantial increase in the no. of branches opened in
rural/semi-urban centres bringing down the population per bank branch to 12000 appx. During 1976,
RRBs were established (on the recommendations of M. Narasimham Committee report) under the
sponsorship and support of public sector banks as the 3rd component of multi-agency credit system for
agriculture and rural development. The Service Area Approach was introduced during 1989.

While the 1970s and 1980s saw the high growth rate of branch banking net-work, the consolidation phase
started in late 80s and more particularly during early 90s, with the submission of report by the
Narasimham Committee on Reforms in Financial Services Sector during 1991.

In these five decades since independence, banking in India has evolved through four distinct phases:

Foundation phase can be considered to cover 1950s and 1960s till the nationalisation of banks in 1969.
The focus during this period was to lay the foundation for a sound banking system in the country. As a
result the phase witnessed the development of neces sary legislative framework for facilitating re-
organisation and consolidation of the banking system, for meeting the requirement of Indian economy. A
major development was transformation of Imperial Bank of India into State Bank of India in 1955 and
nationalisation of 14 major private banks during 1969.

Expansion phase had begun in mid-60s but gained momentum after nationalisation of banks and
continued till 1984. A determined effort was made to make banking facilities available to the masses.
Branch network of the banks was widened at a very fast pace covering the rural and semi-urban
population, which had no access to banking hitherto. Most importantly, credit flows were guided towards
the priority sectors. However this weakened the lines of supervision and affected the quality of assets of
banks and pressurized their profitability and brought competitive efficiency of the system at a low ebb.

Consolidation phase: The phase started in 1985 when a series of policy initiatives were taken by RBI
which saw marked slowdown in the branch expansion. Attention was paid to improving house-keeping,
customer service, credit management, staff productivity and profitability of banks. Measures were also
taken to reduce the structural constraints that obstructed the growth of money market.

Reforms phase The macro-economic crisis faced by the country in 1991 paved the way for extensive
financial sector reforms which brought deregulation of interest rates, more competition, technological
changes, prudential guidelines on asset classification and income recognition, capital adequacy,
autonomy packages etc.

History of Banking in India

Without a sound and effective banking system in India it cannot have a healthy
economy. The banking system of India should not only be hassle free but it should
be able to meet new challenges posed by the technology and any other external
and internal factors.

For the past three decades India's banking system has several outstanding
achievements to its credit. The most striking is its extensive reach. It is no longer
confined to only metropolitans or cosmopolitans in India. In fact, Indian banking
system has reached even to the remote corners of the country. This is one of the
main reasons of India's growth process.

The government's regular policy for Indian bank since 1969 has paid rich dividends
with the nationalisation of 14 major private banks of India.

Not long ago, an account holder had to wait for hours at the bank counters for
getting a draft or for withdrawing his own money. Today, he has a choice. Gone are
days when the most efficient bank transferred money from one branch to other in
two days. Now it is simple as instant messaging or dial a pizza. Money have become
the order of the day.

The first bank in India, though conservative, was established in 1786. From 1786 till
today, the journey of Indian Banking System can be segregated into three distinct
phases. They are as mentioned below:
• Early phase from 1786 to 1969 of Indian Banks
• Nationalisation of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
• New phase of Indian Banking System with the advent of Indian Financial &
Banking Sector Reforms after 1991.
To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II
and Phase III.

Phase I

The General Bank of India was set up in the year 1786. Next came Bank of
Hindustan and Bengal Bank. The East India Company established Bank of Bengal
(1809), Bank of Bombay (1840) and Bank of Madras (1843) as independent units
and called it Presidency Banks. These three banks were amalgamated in 1920 and
Imperial Bank of India was established which started as private shareholders banks,
mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians,
Punjab National Bank Ltd. was set up in 1894 with headquarters at Lahore. Between
1906 and 1913, Bank of India, Central Bank of India, Bank of Baroda, Canara Bank,
Indian Bank, and Bank of Mysore were set up. Reserve Bank of India came in 1935.

During the first phase the growth was very slow and banks also experienced
periodic failures between 1913 and 1948. There were approximately 1100 banks,
mostly small. To streamline the functioning and activities of commercial banks, the
Government of India came up with The Banking Companies Act, 1949 which was
later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No.
23 of 1965). Reserve Bank of India was vested with extensive powers for the
supervision of banking in india as the Central Banking Authority.

During those day’s public has lesser confidence in the banks. As an aftermath
deposit mobilisation was slow. Abreast of it the savings bank facility provided by the
Postal department was comparatively safer. Moreover, funds were largely given to
traders.

Phase II
Government took major steps in this Indian Banking Sector Reform after
independence. In 1955, it nationalised Imperial Bank of India with extensive banking
facilities on a large scale especially in rural and semi-urban areas. It formed State
Bank of india to act as the principal agent of RBI and to handle banking transactions
of the Union and State Governments all over the country.

Seven banks forming subsidiary of State Bank of India was nationalised in 1960 on
19th July, 1969, major process of nationalisation was carried out. It was the effort of
the then Prime Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in
the country was nationalised.

Second phase of nationalisation Indian Banking Sector Reform was carried out in
1980 with seven more banks. This step brought 80% of the banking segment in
India under Government ownership.

The following are the steps taken by the Government of India to Regulate Banking
Institutions in the Country:
• 1949 : Enactment of Banking Regulation Act.
• 1955 : Nationalisation of State Bank of India.
• 1959 : Nationalisation of SBI subsidiaries.
• 1961 : Insurance cover extended to deposits.
• 1969 : Nationalisation of 14 major banks.
• 1971 : Creation of credit guarantee corporation.
• 1975 : Creation of regional rural banks.
• 1980 : Nationalisation of seven banks with deposits over 200 core.
After the nationalisation of banks, the branches of the public sector bank India rose
to approximately 800% in deposits and advances took a huge jump by 11,000%.

Banking in the sunshine of Government ownership gave the public implicit faith and
immense confidence about the sustainability of these institutions.

Phase III

This phase has introduced many more products and facilities in the banking sector
in its reforms measure. In 1991, under the chairmanship of M Narasimham, a
committee was set up by his name which worked for the liberalisation of banking
practices.

The country is flooded with foreign banks and their ATM stations. Efforts are being
put to give a satisfactory service to customers. Phone banking and net banking is
introduced. The entire system became more convenient and swift. Time is given
more importance than money.
The financial system of India has shown a great deal of resilience. It is sheltered
from any crisis triggered by any external macroeconomics shock as other East Asian
Countries suffered. This is all due to a flexible exchange rate regime, the foreign
reserves are high, the capital account is not yet fully convertible, and banks and
their customers have limited foreign exchange exposure.

Nationalisation Of Banks In India

The nationalisation of banks in India took place in 1969 by Mrs. Indira Gandhi the
then prime minister. It nationalised 14 banks then. These banks were mostly owned
by businessmen and even managed by them.
• Central Bank of India
• Bank of Maharashtra
• Dena Bank
• Punjab National Bank
• Syndicate Bank
• Canara Bank
• Indian Bank
• Indian Overseas Bank
• Bank of Baroda
• Union Bank
• Allahabad Bank
• United Bank of India
• UCO Bank
• Bank of India
Befor the steps of nationalisation of Indian banks, only State Bank of India (SBI) was
nationalised. It took place in July 1955 under the SBI Act of 1955. Nationalisation of
Seven State Banks of India (formed subsidiary) took place on 19th July, 1960.

The State Bank of India is India's largest commercial bank and is ranked one of the
top five banks worldwide. It serves 90 million customers through a network of 9,000
branches and it offers -- either directly or through subsidiaries -- a wide range of
banking services.

The second phase of nationalisation of Indian banks took place in the year 1980.
Seven more banks were nationalised with deposits over 200 crores. Till this year,
approximately 80% of the banking segment in India were under Government
ownership.

After the nationalisation of banks in India, the branches of the public sector banks
rose to approximately 800% in deposits and advances took a huge jump by
11,000%.
• 1955 : Nationalisation of State Bank of India.
• 1959 : Nationalisation of SBI subsidiaries.
• 1969 : Nationalisation of 14 major banks.
• 1980 : Nationalisation of seven banks with deposits over 200 crores.

Scheduled Commercial Banks In India

The commercial banking structure in India consists of:

• Scheduled Commercial Banks in India
• Unscheduled Banks in India
Scheduled Banks in India constitute those banks which have been included in the
Second Schedule of Reserve Bank of India(RBI) Act, 1934. RBI in turn includes only
those banks in this schedule which satisfy the criteria laid down vide section 42 (6)
(a) of the Act.

As on 30th June, 1999, there were 300 scheduled banks in India having a total
network of 64,918 branches.The scheduled commercial banks in India comprise of
State bank of India and its associates ( , nationalised banks (19), foreign banks
(45), private sector banks (32), co-operative banks and regional rural banks.

"Scheduled banks in India" means the State Bank of India constituted under the
State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State
Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank
constituted under section 3 of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 (5 of 1970), or under section 3 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980), or any other bank
being a bank included in the Second Schedule to the Reserve Bank of India Act,
1934 (2 of 1934), but does not include a co-operative bank".

"Non-scheduled bank in India" means a banking company as defined in clause (c) of

section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduled
bank".

The following are the Scheduled Banks in India (Public Sector):

• State Bank of India
• State Bank of Bikaner and Jaipur
• State Bank of Hyderabad
• State Bank of Indore
• State Bank of Mysore
• State Bank of Patiala
• State Bank of Saurashtra
• State Bank of Travancore
• Andhra Bank
• Allahabad Bank
• Bank of Baroda
• Bank of India
• Bank of Maharashtra
• Canara Bank
• Central Bank of India
• Corporation Bank
• Dena Bank
• Indian Overseas Bank
• Indian Bank
• Oriental Bank of Commerce
• Punjab National Bank
• Punjab and Sind Bank
• Syndicate Bank
• Union Bank of India
• United Bank of India
• UCO Bank
• Vijaya Bank
The following are the Scheduled Banks in India (Private Sector):
• Vysya Bank Ltd
• Axis Bank Ltd
• Indusind Bank Ltd
• ICICI Banking Corporation Bank Ltd
• Global Trust Bank Ltd
• HDFC Bank Ltd
• Centurion Bank Ltd
• Bank of Punjab Ltd
• IDBI Bank Ltd
The following are the Scheduled Foreign Banks in India:
• American Express Bank Ltd.
• ANZ Gridlays Bank Plc.
• Bank of America NT & SA
• Bank of Tokyo Ltd.
• Banquc Nationale de Paris
• Barclays Bank Plc
• Citi Bank N.C.
• Deutsche Bank A.G.
• Hongkong and Shanghai Banking Corporation
• Standard Chartered Bank.
• The Chase Manhattan Bank Ltd.
• Dresdner Bank AG.

BANK NATIONALISATION & PUBLIC SECTOR BANKING

Organised banking in India is more than two centuries old. Till 1935 all the banks were in private sector
and were set up by individuals and/or industrial houses which collected deposits from individuals and
used them for their own purposes. In the absence of any regulatory framework, these private owners of
banks were at liberty to use the funds in any manner, they deemed appropriate and resultantly, the bank
failures were frequent.

Move towards State ownership of banks started with the nationalisation of RBI and passing of Banking
Companies Act 1949. On the recommendations of All India Rural Credit Survey Committee, SBI Act was
enacted in 1955 and Imperial Bank of India was transferred to SBI. Similarly, the conversion of 8 State-
owned banks (State Bank of Bikaner and State Bank of Jaipur were two separate banks earlier and
merged) into subsidiaries (now associates) of SBI during 1959 took place. During 1968 the scheme of
‘social control’ was introduced, which was closely followed by nationalisation of 14 major banks in 1969
and another six in 1980.

Keeping in view the objectives of nationalisation, PSBs undertook expansion of reach and services.
Resultantly the number of branches increased 7 fold (from 8321 to more than 60000 out of which 58% in
rural areas) and no. of people served per branch office came down from 65000 in 1969 to 10000. Much of
this expansion has taken place in rural and semi-urban areas. The expansion is significant in terms of
geographical distribution. States neglected by private banks before 1969 have a vast network of public
sector banks. The PSBs including RRBs, acount for 93% of bank offices and 87% of banking system
deposits.

Vision of Banks in India

The banking scenario in India has already gained all the momentum, with the domestic and
international banks gathering pace. The focus of all banks in India has shifted their approach to
'cost', determined by revenue minus profit. This means that all the resources should be used
efficiently to better the productivity and ensure a win-win situation. To survive in the long run, it
is essential to focus on cost saving. Previously, banks focused on the 'revenue' model which is
equal to cost plus profit. Post the banking reforms, banks shifted their approach to the 'profit'
model, which meant that banks aimed at higher profit maximization.

Focus of banks in India

The banking industry is slated for growth in future with a more qualitative rather than
quantitative approach. The total assets of all scheduled commercial banks by end-March 2010 is
projected to touch Rs 40,90,000 crore. This is going to comprise around 65% of GDP at current
market prices as compared to 67% in 2002-03. The bank's assets are estimated to grow at an
annual composite rate of growth of 13.4% during the rest of the decade as against 16.7%
between 1994-95 and 2002-03.
Barring the asset side, on the liability perspective, there will be huge additions to the capital base
and reserves. People will rely more on borrowed funds, pace of deposit growth slowing down
side by side. However, advances and investments would not see a healthy growth rate.

Consolidation of Banks in India

Would the banking industry in India get opened up for more international competition? India
would see a large number of global banks controlling huge stakes of the banking entities in the
country. The overseas banking units would bring along with it capital, technology, and
management skills. This would lead to higher competition in the banking frontier and ensure
greater efficiency. The FDI norms in the banking sector would give more leverage to the Indian
banks.

Thus, a consolidation phase in the banking industry in India is expected in the near future with
mergers and acquisitions gathering more pace. One might also see mergers between public sector
banks or public sector banks and private banks. Credit cards, insurance are the next best strategic
places where alliances can be formed.

Future challenges of Banks in India

The Indian banks are hopeful of becoming a global brand as they are the major source of
financial sector revenue and profit growth. The financial services penetration in India continues
to be healthy, thus the banking industry is also not far behind. As a result of this, the profit for
the Indian banking industry will surely surge ahead. The profit pool of the Indian banking
industry is probable to augment from US$ 4.8 billion in 2005 to US$ 20 billion in 2010 and
further to US$ 40 billion by 2015. This growth and expansion pace would be driven by the chunk
of middle class population. The increase in the number of private banks, the domestic credit
market of India is estimated to grow from US$ 0.4 trillion in 2004 to US$ 23 trillion by 2050.
Third largest banking hub of the globe by 2040 - is that vision too far away?

Can Banks in India Meet the Global Challenges?

In recent years, there has been a considerable widening and deepening of the Indian financial system,
coupled with the increasing globalisation of financial services. India is fast approaching an era of financial
conglomerisation and ‘bundling’ in the provision of financial services. These developments are
opportunities for the market participants but nevertheless pose serious challenges to regulation and
supervision of the banking system.
Since independence India has experimented a number of reforms to put the Indian Banking
Sector on fast track so as to meet the objectives which ranged from social cause to making them
ready to meet the global challenges.

The first phase of reforms were started in 1969 with the nationalization of banks clearly with a
view to meet the objectives. On the front end the objectives were the social objectives and at the
bank end it was the vote bank. This led to unprecedented growth of banking in India specially in
rural and semi urban areas. However, a lot of maladies cropped in and the financial health of
the banks started deteriorating. The inner strength of the banks were weak and it was felt that it
is danger to India's financial stability.

The second phase of reforms started in early nineties with the liberalization of the sector. Under
these reforms the highly regulated Indian banking sector has been slowly deregulated. It took
almost over a decade to show the results.

The following areas have seen the impact of these reforms :-

• To give more teeth to the Banking Sector for recovering bad debts, "The Recovery of
Debts due to Banks and Financial Institutions Act, 1993" (DRT Act)- Under DRT act
Debt Recovery Tribunal was set up for recovery of loans of banks and financial
institution .These tribunals are functioning efficiently which can be seen from the fact
that average recovery period is one year as against 5 to 7 year of civil court.

• A good indicator to measure the health of the banking industry in a country, is to

measure the level of NPAs of the banks in that country. Indian banks seem to be better
placed than their Asian neighbors in this regard. The net NPA ratio of Indian scheduled
commercial bank has been considerably reduced Some banks have even managed to
reduce their net NPAs to less than one percent SARFAESI (Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest) Act, 2002 has
helped in reducing the NPA, as act has empowered banks with regard to recovery of
defaulted loan and is a deterrent to willful defaulters.

• RBI has issued guidelines a number of guidelines for banks to ensure that steps are take
to measure, monitor and mitigate various types of risks, viz credit risk, market risk and
operational risk

• Banks have been asked to correct mismatches between assets and liabilities under ALM
(asset-liability management) guidelines
 • The international norms of classifying the assets as NPA has been introduced and the old
concept of "past due" in the identification of NPAs has given way to "90 days norm".

• The disclosure norms for the Banks have been made more stringent so as to bring out
transparency in the system e.g. Indian banks are now required to disclose in their
balance sheets information such as ownership pattern, NPA ratio, Capital adequacy ratio,
Return on assets, Business per employee, Profit per employee, movement of NPA,
movement in the depreciation of non-performing assets, depreciation in investments,
movement in provision towards non-performing non-SLR investments, issuer
composition of non-SLR investments, maturity profiles of assets and liabilities, segment
reporting, exposures to derivatives and Mark to market of these instruments.

• Public Sector Banks have been given managerial autonomy, giving them a level playing
ground with private sector banks in the country. The Public sector banks can now
acquire any company like a private sector, NBFC or other business to increase their
balance sheet size. They are also allowed to exit from non profitable areas. For such
moves, these banks do l not have to take specific clearances from the government.
Public sector banks are also permitted to pursue new lines of businesses as a part of
overall business strategy.

Financial sector reforms adopted in the 1990s have enhanced the strength of banks and financial
institutions in India. A striking feature of these institutions has been their improved resilience to the
domestic and the external environment. The reform process has changed the relationship between the
RBI and commercial banks from one of micro regulation to that of macro management. Aided by the
robust macroeconomic environment, banks’ bottom lines have improved significantly over the last two
years. The aggregate capital ratios of scheduled commercial banks at 12.83 per cent as at end March
2005 have been well above the stipulated level of 9 per cent.

The above indicates that Banks in India have witnessed major reforms in last 15 years or so and
Banking sector is on a way to become global. However the following issues are still of great
relevance if Indian Banks eye to make them global :-

(a) Implementation of Basel II norms

(b) Reduction in NPAs

(c) Consolidation of Banks

(d) Risk Management systems to be put in place

(e) Use of Technology at a much larger scale

LATEST TRENDS IN BANKING SECTOR IN INDIA

(A) Implementation of Basel II :

• Credit Risk : Rating of the loan portfolio

• Market Risk
• Operational risk

(B) Technology : The adoption of technology is an important issue for the banks in India. The
implementation of IT can help in reducing the transaction cost for the Banks and transaction time
for the customers. Some of the IT related issues which are of great relevance and are likely to
change the banking forever in India are :

• Inter-connectivity of branches - Core Banking Solutions

• RTGS
• NDS - OM.
• The implementation of Basel II requirements requires the banks to have highly advanced
IT infrastructure, which includes hardware, new software tools and applications,
dataware houses and Business Intelligence etc. to address the three compliance pillars of
the

However, the cost of introducing the technology is a great concern for banks in India.

(C ) Consolidation in Banking Sector

(D) Retail Banking : The main focus area of the bankers in India had always been the corporate
sector. The retail loans to individuals like personal loan, vehicle loans, housing loan were
discouraged. A middle class person hardly ever ventured to take a loan from Bank for his
personal needs. Bank was looked as a lender to the business houses. However, the latest trend
in banking sector in India is the focus on retail loans. We have in recent months have witnessed
the unprecedented competition among the banks to have a large pie in housing loan segment.

(E) Corporate Governance

 TOP CHALLENGES FOR BANKS IN INDIA / SOLUTIONS FOR FUTURE BANK PROBLEMS

1. Background / Current Scenario of Indian Banking Industry :

1.1 Thrust of Banking Sector Reforms :

The banking system in India has undergone significant transformation following financial sector reforms
since the early 1990s. The thrust of the banking sector reforms was on

• increasing operational efficiency,

• strengthening the prudential and supervisory norms,

• removing external constraints,

• creating competitive conditions; and

• developing the technological and institutional infrastructure.

1.2 Impact of Reforms on Indian Banking Industry :

The impact of the reform measures is reflected in banking sector in the shape of

• an improvement in profitability,

• an improvement in financial health,

• soundness and overall efficiency

 • ability to maintain or increase their capital adequacy ratio, despite the sharp increase in their
risk-weighted assets.

Moreover, with the entry of new private sector banks and increased presence of foreign banks,

• Indian banking sector has become more competitive.

• Public sector banks have also been raising capital from the market and are subject to market
discipline.

• Efficiency, productivity and soundness of the banking sector improved significantly in the post-
reform phase.

• Banks have increasingly diversified into non-traditional activities, as a result of which several
financial conglomerates have emerged.

All the above has posed several regulatory and supervisory challenges. Thus, while deregulation has
opened up new avenues for banks to augment incomes, it has also entailed greater risks. The banking
sector has witnessed the emergence of new banks, new instruments, new windows, new opportunities
and, along with all these, there have been new challenges

2. Recent Economic Developments

· The Indian economy continued to record robust growth in 2007-08, although marginally lower
than the last year. The overall growth momentum, which moderated particularly during the
second half of the year, was on account of industry and services, offset partially by recovery in
agriculture. On account of increased kharif foodgrain production, the overall foodgrain production
during 2007-08 was placed at an all-time high of 230.7 million tonnes.

· During 2008-09 so far (up to August 13, 2008), monsoon conditions have been favourable,
barring the deficient/scanty rainfall in some regions. The index of industrial production (IIP)
recorded year-on-year expansion of 5.2 per cent during April-June 2008 as compared with 10.3
per cent during April-June 2007. The First Quarter Review of the Annual Statement on Monetary
Policy for 2008-09 placed the real GDP growth at around 8.0 per cent for 2008-09.

· According to the First Quarter Review of Monetary Policy, the policy endeavour would be to bring
down inflation to around 7 per cent by end-March 2009.

· Indian financial markets remained largely orderly during 2008-09 so far. The Reserve Bank
managed liquidity with a judicious mix of the available tools. In the foreign exchange market, the
Indian rupee generally depreciated against major currencies during 2008-09 so far as against the
appreciation during 2007-08. During 2008-09 (April to July 2008), yields remained range bound
in the first two months but hardened significantly during June–July 2008 due to hardening of
inflation and soaring international oil prices. The Indian equity markets recovered somewhat
during April-May 2008, but declined thereafter in tandem with the trends in major international
equity markets.

· The key deficit indicators of the Central and State Governments are budgeted to decline
significantly during 2008-09. However, information on Central Government finances for April-June
2008 indicates some stress on Centre’s fiscal position, particularly in the revenue account.
 · India’s balance of payments position remained comfortable during 2007-08, notwithstanding a
sharp increase in merchandise trade deficit. However, the current account deficit was contained
at 1.5 per cent of GDP during the year. Significantly larger net capital inflows over the current
account deficit resulted in an accretion of US $ 110.5 billion to the foreign exchange reserves
during 2007-08 (US $ 47.6 billion during 2006-07). Trade deficit during April-June 2008-09 was
higher by US $ 8.9 billion over April-June 2007-08.

3. Evolution of Banking in India

Banking in India has a long history and it has evolved over the years passing through various phases. A
brief evaluation of Indian Banking Industry can be encapsulated as follows:

• Pre Independence Phase : (1930s and 1940s) : The period leading up to Independence was a
difficult period for Indian banks. A large number of small banks sprang up with low capital base.
This period saw the two World Wars and the Great Depression of the 1930s. Many banks failed
during the period. Apart from global factors, several other factors were also at play. Partly to
address the problem of bank failure, the Reserve Bank of India was set up in 1935.

• After independence (1947-1967) , the entire banking was in the private sector. The banking
scenario in the early independence phase raised three main concerns: (i) bank failures had raised
concern regarding the soundness and stability of the banking sector; (ii) there was large
concentration of resources in a few business families; and (iii) the share of agriculture in total
bank credit was miniscule. Although the issue of bank failure was addressed, two of three major
issues at the time of independence continued to raise concern even after 20 years of
independence.

• Nationalization of Banks (1967-1991) : Accordingly, with a view to aligning the banking system
to the needs of planning and economic policy, the policy of social control over the banking sector
was adopted in 1967, which marked the beginning of the next phase. Fourteen major banks were
nationalised in 1969 and six in 1980. With this, the major segment of the banking sector came
under the control of the Government. Some other social controls were also implemented such as
priority sector lending targets. Massive expansion of branch network that followed improved the
banking access considerably, especially in rural areas. This helped in mobilising the deposits and
stepping up the overall savings rate of the economy. The share of credit to agriculture, which
constituted a small portion for a long time, improved significantly by the end of this phase in 1991-
92. However, the objective to provide credit at concessional rate led to the administered structure
of interest rates and other micro controls. Large fiscal deficit by the Government necessitated pre-
emption of resources by way of CRR and SLR. These factors and the increased focus on priority
sector targets led to decline in profitability of the banking sector, high NPAs and weakening of the
capital base. With a view to overcoming several weaknesses that had crept into the system over
the years and with a view to creating a strong, competitive and vibrant banking system, financial
sector reform were initiated in the early 1990s, which marked the beginning of the current phase.

• Current Phase / Banking Reforms Phase (1991-Till now): Various reform measures resulted
in an improvement in profitability, financial health, soundness and overall efficiency of the banking
sector. With the entry of new private sector banks and increased presence of foreign banks,
competition in the Indian banking sector also intensified. Another major achievement of this
phase was the sharp increase in credit to agriculture from 2003-04 onwards; credit to agriculture
 had decelerated in the 1990s. Regional rural banks were also strengthened by way of
restructuring to improve the rural credit delivery system. In this phase, financial inclusion emerged
as a major policy objective and a significant progress was made in a short span of two years. The
problem of dual control in respect of urban co-operative banks, which had impeded the effective
regulation by the Reserve Bank for a long time, was overcome by a mechanism of Task Force on
Urban Co-operative Banks (TAFCUB). So far 19 State Governments have signed MOU with the
Reserve Bank constituting the TAFCUBs. The use of technology has improved significantly in the
current phase

4. FUTURE CHALLENGES :

The following are SEVEN major challenges that are likely to be faced by Indian Banking
Industry in coming few years:-

• Managing Resource Mobilisation

• Managing Capital and Risk
• Lending and Investment Operations of Banks
• Financial Inclusion
• Competition and Consolidation
• Efficiency, Productivity and Soundness of the Banking Sector in India
• Regulatory and Supervisory Challenges in Banking

Let us now discuss these in some detail:

4.1 Managing Resource Mobilization :

4.1.1 Growth of Deposits Till now: The deposit growth of SCBs in the post-nationalisation period could
be analysed broadly in four phases. In the first phase (1969-84) beginning immediately after
nationalisation of banks in July 1969, deposit growth accelerated sharply as the rapid branch expansion.
enabled banks to tap savings from the rural areas. In the second phase (1985-95), deposit growth
decelerated as banks faced increased competition from alternative savings instruments, especially capital
market instruments (shares/debentures/units of mutual funds) and non-banking financial companies. This
was the phase of disintermediation as savings instead of being deployed in bank deposits, were
increasingly deployed in alternative financial instruments. Deposit growth decelerated further during the
third phase (1995-2004) in the wake of competition from post office deposits and other small saving
instruments, which carried significantly higher tax-adjusted returns than bank deposits. Despite
deceleration, bank deposits, however, maintained their share in the savings of the household sector.
However, there was a significant change in both the ownership pattern and maturity pattern during this
phase. In the most recent phase (2004-08), deposit growth accelerated significantly in response to
vigorous resource mobilisation efforts by banks to meet the increased demand for credit. As a result, the
share of bank deposits in the financial savings of the household sector increased sharply.

4.1.2 Future challenges for resource mobilization : Banks have a major role to play in meeting the
resource requirements of India’s fast growing economy. Although bank deposits have all along been the
mainstay of the saving process in the Indian economy and banks have played an increasingly important
role in stepping up the financial savings rate, physical savings, nevertheless, have tended to grow in
tandem with the financial savings. A major challenge, thus, is to convert unproductive physical savings
into financial savings. Also, in view of the shrinking share of household sector deposits in total deposits,
banks need to explore ways of broadening the depositor base, especially in rural and semi-urban areas
by offering customised products and features suitable to individual risk-return requirements. Furthermore,
the changing demographics and employment patterns have also thrown opportunities for banks to
reorient their role as financial intermediaries beyond the traditional confines of passive deposit
mobilisation by providing new financial products demanded by the relatively younger age working
population.

Thus, we can sum up saying that despite India having a reasonably high and growing savings
rate, there is a need to increase financial savings. “The substitution of unproductive physical savings
in favour of financial savings can generate large resources for investment. There is an enormous
untapped saving potential in rural and semi-urban areas. For this purpose banks are in a better
position to develop innovative and cost effective products due to their “outreach as also special
features of deposits, viz, safety and liquidity.”

4.2 Managing Capital and Risk / Implementation of Basel II norms :

4.2.1 Why there is need for Managing Capital and Risk: The importance of maintaining bank capital in
line with the risks involved in the banking business has assumed greater significance in view of the need
for maintaining the safety and soundness of the financial system. The Basel I framework was adopted in
over 100 countries. However, over the years, several deficiencies of Basel I surfaced partly due to its
inherent features and partly due to rapid financial innovations. The major limitation of Basel I was its 'one-
size-fits-all' approach. The inadequacies of Basel I also became evident following the recent financial
turmoil as it failed to capture off-balance sheet exposures. The Basel II framework, finalised in July 2006,
attempts to align regulatory capital more closely with the inherent risks in banking by using enhanced risk
measurement techniques and a more disciplined approach to risk management. In addition, Basel II has
in place a variety of safeguards, which also have the benefit of reinforcing supervisors' objective of
strengthening risk management and market discipline.

4.2.2 Challenges in Implementation of Basel II / Managing Capital and Risk : In keeping with the
international best practices, India also decided to implement Basel II. Foreign banks operating in India
and Indian banks having operational presence outside India have already adopted the standardised
approach (SA) for credit risk and the basic indicator approach (BIA) for operational risk for computing their
capital requirements with effect from March 31, 2008. All other commercial banks (excluding local area
banks and regional rural banks) are expected to adopt Basel II not later than March 31, 2009. The parallel
runs for these banks are in progress. A significant improvement in risk management practices, asset-
liability management and corporate governance in Indian banks under regulatory pressure to adopt Basel
II framework has been observed.

As banks would have to maintain capital for operational risk, overall capital requirements are expected to
go up, even if there is an expected decline in the capital required on account of credit risk. Since most of
the banks in India are at present operating at capital adequacy ratios higher than the prescribed level,
meeting the Basel II requirements is not an issue in the immediate future. In the medium to long-term,
however, banks would need to raise capital resources to keep pace with the expansion of their business.
An assessment made in the Report suggests that the total capital requirements in the five years 2007-08
to 2011-12 are projected to go up by about Rs.5,70,000 crore assuming that banks maintain CRAR at 12
per cent, while the total capital requirements by public sector banks are projected to go up by about
Rs.3,70,000 crore. As regards the various options available to banks, more than 85 per cent of capital
requirements in the past were met by banks through internally generated resources. Apart from internal
resources, banks also have headroom available to raise Tier 1 capital under innovation perpetual debt
instruments (IPDI) and perpetual non-cumulative preference shares (PNCPS). In addition, some public
sector banks have some headroom available to raise capital from the market and dilute the Government
shareholding to 51 per cent.

While the Basel II framework, by making the capital requirements risk sensitive, would enhance the
stability of the financial system, its implementation also raises several issues/challenges. India follows a
three track approach with commercial banks, co-operative banks and regional rural banks having been
placed at different levels of capital adequacy norms. The varying degree of stringency in capital regulation
for different categories of banks raises the possibility of regulatory arbitrage. Non-Basel entities [RRBs
and rural co-operative banks such as state co-operative banks (StCBs) and district central co-operative
banks (DCCBs)], therefore, need to be subjected to Basel norms. Subsequently, based on the experience
of implementing Basel II framework in respect of commercial banks, a view could be taken on the
application of Basel II norms for other banks. The role of credit agencies is crucial under the standardised
approach for measuring credit risk. Banks would have to continuously and constantly upgrade their skills,
technology and risk management practices in line with market developments. Apart from the adequate
skills developed by the banks and by the Reserve Bank, the increased cost of adopting advanced
approaches along with other incumbent risks and uncertainties require adequate safeguards to be put in
place before these approaches are adopted. These, among others, could include prescribing the leverage
ratio so that the capital held does not fall significantly. The problems relating to pro-cyclical lending
behaviour, which is inherent in Basel II framework, could be countered by banks by managing regulatory
capital position in such a way that they remain adequately capitalised during economic downswings so
that they are not required to raise capital. Supervisors could also prescribe additional capital under Pillar 2
during a phase of business cycle expansion. The implementation of Basel II norms is likely to create
tensions on home-host co-ordination issues and it would be a challenge to mitigate such tensions.

5. Lending and Investment Operations of Banks

5.1.1 Growth of Credit Till Now: Credit extended by scheduled commercial banks from the early 1990s
witnessed three distinct phases. Bank credit growth was erratic in the first phase (from 1990-91 to 1995-
96). In the second phase (from 1996-97 to 2001-02), credit growth decelerated sharply and remained
range bound due to the industrial slowdown, high level of NPAs and introduction of prudential norms,
which made banks risk averse. The third phase (from 2002-03 to 2006-07) was generally marked by high
credit growth attributable to several factors, including pick-up in economic growth, sharp improvement in
asset quality, moderation in inflation and inflation expectations, decline in real interest rates, increase in
the income levels of households and increased competition with the entry of new private sector banks.

Credit growth by scheduled commercial banks to agriculture accelerated sharply from 2003-04. As a
result, the share of credit to the agricultural sector in total credit by scheduled commercial banks and
credit intensity of the agricultural sector improved significantly. However, some disquieting features were
also observed. First, the share of long-term loans in total credit to agriculture declined almost consistently
between 1991 and 2006 – the share in 2006 was less than half of that in 1991. Second, the share of
marginal farmers in direct finance to farmers in terms of amount disbursed and in total number of credit
accounts held by them showed little improvement.

Although the share of credit to industry in total bank credit declined in the current decade, the credit
intensity of industry increased sharply. A cross country survey suggests that the reliance of industry on
the banking sector in India was far greater than that in many other countries. Credit growth to the SME
sector, which slowed down significantly between 1996-97 and 2003-04, picked up sharply from 2004-05.
However, the share of the SME sector in the total non-food bank credit declined almost consistently from
15.1 per cent in 1990-91 to 6.5 per cent in 2006-07. This suggests that it is the large corporates that have
increased their dependence on the banking sector. The share of retail credit comprising housing loans,
credit to individuals, credit cards receivables and lending for consumer durables, in total bank credit
increased sharply from 6.4 per cent in 1990 to 25.4 per cent in 2007. On the whole, agriculture, large
corporates and retail sector benefited from credit expansion of recent years, while credit growth to the
SME sector remained tepid until recently.

Banks’ investment portfolio (other than that mandated by the minimum statutory requirement) was
adjusted mainly in response to the requirement of the loan portfolio.

5.1.2. Challenges for Increasing Credit: Notwithstanding some pick-up in credit growth to the
agriculture and SME sectors in recent years, there is need for more concerted efforts to increase the flow
of credit to these sectors given their significance to the economy. Creating enabling conditions, i.e.,
providing irrigation facilities, rural roads and other infrastructure in rural areas, is necessary to augment
the credit absorptive capacity. Devising products to suit the specific needs of the farmers is critical. There
is also a need for comprehensive public policy on risk management in agriculture. Computerisation of
land records can go a long way in smoothening the flow of credit to agriculture. Similarly the credit
assessment capabilities of banks need improvement to ensure flow of credit to SMEs. There is need to
increase the use of cluster based lending and credit scoring, which has proved quite effective in many
countries as also in India. In view of the increased exposure of banks to infrastructure and retail credit
segments, banks need to guard against exposures to attendant risks. The corporate sector needs to
gradually reduce its dependence on the banking sector and move towards tapping the capital market so
as to enable the banking sector to meet the growing requirements of agriculture, SMEs and other small
and tiny enterprises, which are unable to tap funds from other sources.

6. Financial Inclusion :

6.1 Financial Inclusion in the Past : Following a multi-pronged approach, several policy initiatives have
been undertaken to promote financial inclusion in India from time to time. The available information
suggests that financial inclusion improved considerably from the late 1960s to the early 1990s as
reflected in expansion of formal financial services. This trend continued in the 1990s. According to the
59th round of All India Debt and Investment Survey of the NSSO, the share of number of households
accessing credit from non-institutional sources increased sharply in 2002 in comparison with 1991 (the
reference year of last survey). This increase was mainly due to increased indebtedness of households for
consumption and similar other purposes for which finance could not be availed of easily from formal
sources. As a result, the share of household indebtedness to non-institutional sources in their total
indebtedness increased between 1991 and 2002 even as institutional credit to households expanded
broadly at the same rate as during 1981-91. There has been significant improvement in various indicators
of financial inclusion based on basic statistical return (BSR) data since the early 2000s. The number of
credit accounts with all organised financial institutions (commercial banks, regional rural banks, urban co-
operative banks, PACS, MFIs and SHGs)1 per 100 adults improved from 18 in 2002 to 25 in 2007. Apart
from credit penetration, significant improvement is also observed in deposit penetration. The number of
saving accounts in all formal institutions increased to 54 per 100 persons (82 per 100 adults) in 2007 from
51 per 100 persons (80 for adults) in 1993. Around 22 per cent people in the country, who are below the
poverty line, have little or no capacity to save. After excluding the people below poverty line, there are a
little over 100 saving accounts per 100 adults. The data also suggest a significant strengthening of the
micro-finance movement. Various data sets/sources suggest different extent of financial inclusion due to
methodological/definitional differences. There is, therefore, need to exercise utmost caution while drawing
any firm conclusion about the extent of financial inclusion/exclusion in India based on any single source.

6.2 Challenges for Financial Inclusion: While there has been a significant improvement in financial
inclusion in recent years, moving ahead several challenges remain to be addressed. A proper
assessment of the problem of financial exclusion is necessary. There is, therefore, a need to conduct
specific survey for gathering information relating to financial inclusion/exclusion. There is need to reduce
the transaction cost for which technology can be very helpful. RRBs and co-operative banks, are
expected to play a greater role in financial inclusion in future. There would be need to design appropriate
products tailor made to suit the requirements of the people with low income supported by financial literacy
and credit counselling. There is also a need to improve the absorptive capacity of financial services by
providing the basic infrastructure. Investment in human development such as health, water sanitation, and
education, in particular, would be very helpful.

7. Competition and Consolidation :

7.1 Competition and Consolidation in Recent Years : There has been a significant increase in the
number of bank amalgamations in India in the post-reform period. While amalgamations of banks in the
pre-1999 period were primarily triggered by the weak financials of the bank being merged, in the post-
1999 period, mergers occurred between healthy banks, driven by the business strategy and commercial
considerations. Significantly, despite increase in the number of bank mergers and acquisitions, the Indian
banking system has become less concentrated during the post-reform period. In fact, the degree of
concentration in the Indian banking system, based on the concentration ratio and Hirschman-Herfindhal
Index, was one of the lowest among the select countries studied for the year 2006. The level of
competition declined somewhat in the initial years of reforms, but improved significantly thereafter. Based
on the empirical evidence, the Indian banking industry could be characterised as a monopolistic
competitive structure, as is the case with most other advanced countries and EMEs. The empirical
analysis also suggests that mergers and amalgamation had a positive impact on efficiency both in terms
of increase in return on assets and reduction in cost, when the transferees were public sector banks. A
number of critical issues have emerged in the process of bank consolidation in India, viz., the nature and
extent of further consolidation; continued government ownership of public sector banks; further opening of
the banking sector to foreign banks; and combining of banking and commerce. The consolidation process
in the banking sector could accelerate in future in view of several developments such as the planned
review of the roadmap of foreign banks and implementation of Basel II. In the medium to long-term, the
ownership pattern of public sector banks may also change. While some consolidation of the banking
sector perhaps may be necessary, it would be appropriate to have in place a policy to ensure that the
competition is not undermined any time in the future.

7.2 Challenges of Competition and Consolidation: The ownership of public sector banks is not an
issue from the efficiency viewpoint as public sector banks in India now are as efficient as new private and
foreign banks, as revealed by the various measures. However, the operating environment for banks has
been changing rapidly and banks in the changed operating environment need flexibility to respond to the
evolving situation. Another issue that needs to be considered is the funding of capital requirements of
public sector banks given the present floor of minimum 51 per cent on Government equity in public sector
banks. In the medium term, this can become an issue hampering the growth of public sector banks if
Government is not able to provide adequate capital for their expansion.

The roadmap of foreign banks is due for review in 2009. This would involve several issues. The increased
presence of foreign banks, by intensifying competition, may accelerate the consolidation process that is
underway. However, at the same time, this may also raise the risk of concentration if
mergers/amalgamations involve large banks. The experience of some other countries also suggests that
the emergence of large banks due to consolidation has resulted in reduced lending to small enterprises
significantly. All these issues would need to be carefully weighed at the time of review. The policy relating
to ownership of banks by commercial interests may have to take full account of international practices,
given the issues relating to potential conflict of interests, increased potential of contagion effects and
increased concentration.

8. Efficiency, Productivity and Soundness of the Banking Sector in India:

8.1 Past Trends : The efficiency and productivity of scheduled commercial banks (SCBs) in India was
analysed empirically, using both the accounting and economic measures. The accounting measures
(ratios, etc. based on balance sheet data) reveal that there has been an all-round improvement in the
productivity/ efficiency of the SCBs in the post-reform period. The performance of banks, especially
nationalised banks, worsened in the initial years of reforms as they took time to adjust to the new
environment. However, a distinct improvement was discernable, especially beginning 2001-02. The
efficiency/productivity parameters have now moved closer to the global levels. The most significant
improvement has occurred in the performance of public sector banks and has converged with those of the
foreign banks and new private sector banks. Intermediation cost as also the net interest margin declined
across the bank groups. Despite this, however, profitability of the banking sector improved. Business per
employee and per branch also increased significantly across the bank groups. The improvement of
various accounting measures, however, varied across the bank groups. In terms of cost ratios (operating
cost to income) foreign banks, and with regard to labour productivity, foreign and new private banks were
ahead of their peer groups. In terms of net interest margins and intermediation cost, new private sector
banks and public sector banks, respectively, were more efficient than the other bank groups. The cost of
deposits of foreign banks was the lowest in the industry. However, this was not passed on to the
borrowers, leading to higher net interest spread. The empirical exercise suggested that the operating cost
was the main factor affecting the net interest margin. Non-interest income and the asset quality were the
other determinants of net interest margin.

Efficiency and productivity measured by using non-parametric Data Envelopment Analysis (DEA) method
corroborated the findings of the accounting measures or financial ratios. Efficiency improved across all
bank groups and most of these efficiency gains emanated a few years after the reforms, i.e., from 1997-
98 onwards. The empirical analysis suggests that, there is no relationship between ownership and
efficiency as most efficient banks relate to all the three segments, i.e., public, private and foreign. In fact,
the 28 least efficient banks belonged to the private and foreign bank segments. On the other hand, there
exists a positive and significant relationship between size and efficiency as also between diversification
and efficiency. This implied that large and diversified banks were more efficient. Various factors
contributed to improved efficiency and productivity. These included technological advances, reduction in
statutory pre-emptions, reduction in non-performing assets, shortening of maturity profile of deposits and
lengthening of asset profile. The soundness of the Indian banking sector also improved both at the
aggregate level and across bank groups as was reflected in the CRAR.

8.2 Challenges: Notwithstanding significant improvement, there are several areas which need to be
addressed. The intermediation cost in India, driven largely by the high operating costs, is still high
by global standards. As the competition intensifies, net interest margins of banks are likely to
come under pressure. Banks, therefore, need to focus on non-interest sources of income to
sustain their profitability. Although overall efficiency and productivity of public sector banks
improved, one area of concern is the low business per employee, which is almost one half of that
of new private sector banks. Public sector banks, therefore, have to strive further to improve labour
productivity and bring it on par with the new private sector banks. Similarly, there is a need for increased
absorption of enhanced technological capability (innovation) by several banks to further augment
productivity of the banking sector through changes in processes and improvement in human resource
skills.

9. Regulatory and Supervisory Challenges in Banking

As the financial landscape in the last few years has changed significantly, there has been rethinking on
several aspects of regulatory and supervisory practices/ framework/structure among the regulators and
supervisors all over the world. In some countries such as UK, supervision has been hived off from the
central bank to avoid perceived conflict of interest with monetary policy. In response to blurring of
distinctions among providers of financial services and emergence of financial conglomerates, a single
regulator approach has been adopted in some countries. Australia has adopted objective-based
regulation. Increased emphasis is being placed on market discipline to economise on scarce supervisory
resources. Greater attention is also being paid to disclosures, to allow markets and counterparties to
better control excessive risk-taking by acting as disciplinary agents. The fast evolving financial sector and
the ever expanding rule books of the regulatory bodies have made some countries such as UK to adopt
principles-based supervision.

The recent events in global financial markets in the aftermath of US subprime crisis have evoked
rethinking on several regulatory and supervisory aspects of the banking industry, viz., how to cope with
liquidity stresses under unusual circumstances; whether ‘pro-cyclicality’ of capital requirements is one of
the factors with inherent tendency that escalate the impact of booms and busts. Regulation of complex
products and monitoring of derivatives is becoming an important issue. Further, a question has been
raised whether institutions should be allowed to become so big and so complex that their problems can
have system-wide repercussions. As a fallout of these developments, the role of central bank as a lender
of last resort has come into focus and the need for central banks to be in close touch with both financial
markets, and banks and other financial institutions has received enhanced attention.

The Reserve Bank, like other bank supervisors, has been proactively responding to the various changes
in the financial system by bringing about necessary changes in the regulatory and supervisory framework.
There has been a shift in the regulatory focus from micro regulation to macro management based on
prudential elements, with a view to strengthening the banking sector and providing them with greater
operational flexibility. Mechanisms have also been put in place to meet challenges arising out of
globalisation and liberalisation, financial innovations and technological advancements and a growing
financial conglomeration. A major challenge in the years ahead would be to ensure that financial
conglomerates are regulated adequately. The existing monitoring mechanism of financial conglomerates
has some limitations, although an attempt is being made to take a group-wide perspective through inter-
regulatory discussions and co-operation. The growing use of e-finance products poses certain risks for
banks, which would require appropriate safeguards.

10. OVERALL ASSESSMENT :

The Report has attempted an in-depth analysis of various aspects of the banking sector in India against
the backdrop of the evolution of the Indian banking sector beginning the 18th century with a focus on the
post-independence period. The analysis suggests that the Indian banking sector has witnessed several
structural changes from time to time. India now has a well-developed banking infrastructure, conducive
regulatory environment and sound supervisory system. Banks have become efficient and sound and
compare well with banks around the world. Banks in India have benefitted from the robust growth in the
last few years, which enabled them to produce strong financial performance. Banks responded to the
increased competition by diversifying and expanding through inorganic (acquisitions) and organic growth
of existing businesses. While some of the changes were triggered by endogenous factors, some others
were on account of exogenous or part of global developments. While banks have been able to cope with
the changed environment, the fast evolving financial landscape would continue to pose several
challenges in future.

The end result of the rapidly changing financial landscape would be increased competition, both within the
banking industry and with non-banks putting pressure on margins which may impinge on profitability of
banks. Banks, therefore, need to restructure on the cost side. High operating cost and diversification of
activities would be some of the aspects, which banks need to focus on in the years ahead to remain
competitive and profitable. The increase in the technological intensity is crucial in order to reduce the
operating cost and achieve higher productivity. Though Indian banks have done exceedingly well in terms
of containment of non-performing loans (NPLs), maintaining asset quality would continue to pose a
constant challenge for banks.
The banking system’s focus should continue to be on strengthening the safety and soundness of the
banking sector so that benefits of increased competition and greater efficiency can be fully realised. It is
the banks themselves, rather than the regulators or supervisors that are mainly responsible for the
performance as well as their financial health. In view of growing complexity, risk measurement and risk
management at the institutional level and governance practices in banks need to be on the top of the
agenda. The major challenge would be to exploit the opportunities that would emerge, while managing
the risks.

An important lesson emerging from the recent financial market developments is that the focus
should not be on how the turmoil should be managed, but on what policies could be put in place
to strengthen the financial system on a longer-term basis regardless of specific sources of
disturbances. These issues point towards the challenges that lie ahead to preserve the safety and
soundness of the financial system.

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CORPORATE GOVERNANCE
Corporate Governance is concerned with the systems and processes for ensuring proper
accountability, probity and openness in the conduct of an organization’s business. Thus, it is the
process under which the organizations try to hold the balance between economic and social goals
and between individual and communal goals. In a nutshell, we can say that the corporate
governance framework strives to the efficient use of resources and equally to require
accountability for the stewardship of those resources. The basic aim of Corporate Governance
is to align as nearly as possible the interests of individuals, corporations and society.

Corporate Governance has three important features, and these are :-

(a) Transparency in operations and decision-making.

(b) Accountability for the decisions taken

(c ) Accountability for the stakeholders

For example, it the duty of the Board members to ensure that in the case of shareholders, the
investments and the return on investment is safeguarded. This means that the managements of
the company has to ensure that the decisions taken by them actually create wealth and do not
destroy wealth. In case the net earnings are less than the cost of capital it is considered as net
destruction of wealth and can not be considered as good governance.
 Indian Banks - Some Sound Practices for Corporate Governance

According to the Organization for Economic Co-operation & Development (OECD), some of
the sound corporate governance practices for Banks in India include :-

(a) The Board of a bank should be broad-based with induction of non-executive directors of
sufficient caliber and number for their independent views to carry the desired weight in the
Board’s decisions.

(b) The Board is responsible to establish certain strategic objectives and a set of corporate
values for the senior management, employees and the Board members themselves.

(c ) The Board should set and enforce clear systems & procedures, lines of responsibility and
accountability throughout the bank.

(d) The Board should ensure that senior managers exercise supervisory role with respect to
line managers in specific business and activities with great sense of propriety.

(e) The Board should recognize the importance of the audit process, communicate this
importance throughout the bank and ensure effective utilization of the work by internal &
external auditors.

Recent Steps Taken by Banks in India for Corporate Governance

(a) Induction of non executive members on the Boards

(b) Constitution of various Committees like Management Committee, Audit Committee,

Investor’s Grievances Committee, ALM Committee etc.

(c) Gradual implementation of prudential norms as prescribed by RBI,

(d) Introduction of Citizens Charter in Banks

(e) Implementation of “Know Your Customer” concept,

The primary responsibility for good governance lies with the Board of Directors and the senior
management of the Bank