DEVELOPMENT AND REFORMS IN INDIAN BANKING GROWTH OF BANKING SYSTEM IN INDIA : In order to understand present make up of banking sector

in India and its past progress, it will be fitness of things to look at its development in a somewhat longer historical perspective. The past four decades and particularly the last two decades witnessed cataclysmic change in the face of commercial banking all over the world. Indian banking system has also followed the same trend. 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) EVOLUTION PHASE: (PRIOR TO 1950) Enactment of the RBI Act 1935 gave birth to scheduled banks in India, and some of these banks had already been established around 1981. The prominent among the scheduled banks is the Allahabad Bank, which was set up in 1865 with European management. The first bank which was establishedwith Indian ownership and management was the Oudh Commercial Bank, Iformed in 1881, followed by the Ajodhya Bank in 1884, the Punjab National Bank in 1894 and Nedungadi Bank in 1899. Thus, there were five Banks inexistence in the 19th century. During the period 1901-1914, twelve morebanks were established, prominent among which were the Bank of Baroda(1906), the Canara Bank (1906), the Indian Bank (1907), the Bank of India(1908) and the Central Bank of India (1911). Thus, the five big banks of today had come into being prior to the commencement of the First World War. In 1913, and also l in 1929, the IndianBank faced serious crises. Several banks succumbed to these crises. Publicconfidence in banks received a jolt. There was a heavy rush on banks. An important point to be noted here is that no

commercial bank was established during the First World War, while as many as twenty scheduled banks came into existenceafter independence -- two in the public sector and one in the private sector. The United Bank of India was formed in 1950 by the merger of four existingcommercial banks.Certain non-scheduled banks were included in the second schedule ofthe Reserve Bank in view of these facts, the number of scheduled banks roseto 81. Out of 81 Indian scheduled banks, as many as 23 were either liquidatedor merged into or amalgamated with other scheduled banks in 1968, leaving 58 Indian schedule banks.It may be emphasized at this stage that banking system in India cameto be recognized in the beginning of 20 century as powerful instrument toinfluence the pace and pattern of economic development of the county. In1921 need was felt to have a State Bank endowed with all support andresources of the Government with a view to helping industries and bankingfacilities to grow in all parts of the country. It is towards the accomplishment ofthis objective that the three Presidency Banks were amalgamated to form the Imperial Bank of India. The role of the Imperial Bank was envisaged as toextend banking facilities, and to render the money resources of India moreaccessible to the trade and industry of this country, thereby promotingfinancial system which is an indisputable condition of the social and economicadvancement of India.Until 1935 when RBI came into existence to play the role of CentralBank of the country and regulatory authority for the banks. Imperial Bank ofIndia played the role of a quasicentral bank. It was by making it the solerepository of all its funds and by changing the volume of its deposits with theBank as and when desired by it, the Government tried to influence the base of deposits and hence credit creation by Imperial Bank and by rest of the banking system.Thus, the role of commercial banks in India remained confined toproviding vehicle for the communitys savings and attending to the creditneeds of only certain selected and limited segments of the economy. Banksoperations were influenced primarily by commercial principle and not bydevelopmental factor.Regulation was still only being introduced and unhealthy practices inthe banks were then more rules than exceptions. Failure of banks wascommon as governance in privately owned joint stock banks left much to bedesired.

FOUNDATION PHASE: 1948-1968 In those initial days, the need of the hour was to reorganize and to consolidate the prevailing banking network keeping in view the requirementsof the economy. The first step taken to that end was the enactment of theBanking Companies Act, 1949 followed by rapid industrial finance. Roleplayed by banks was instrumental behind industrialization with the impetusgiven to both heavy and Small Scale Industries. Subsequently after theadoption of social control, banks started taking steps in extending credit toagriculture and small borrowers. Finally, on July l969, 14 banks werenationalised with a view to extending credit to all segments of the economyand also to mitigate regional imbalances. Thus, the period of regulated growthfrom 1950 till bank nationalization witnessed a number of far-reachingchanges in the banking system.The banking scenario prevalent in the country during the period 1948-1968 presented a strong focus on class banking on security rather than onpurpose. The emphasis of the banking system during this period was onlaying the foundation for a sound banking system in the country. BankingRegulating Act was passed in 1949 to conduct and control operations of thecommercial banks in India. Another major step taken during this period wasthe transformation of Imperial Bank of India into State Bank of India and aredefinition of its role in the Indian economy, strengthening of the co-operative credit structure and setting up of institutional framework for providing longtermfinance to agriculture and industry. Banking sector, which during thepreindependence India was catering to the needs of the government, richindividuals and traders, opened its door wider and set out for the first time tobring the entire productive sector of the economy large as well as small, in its fold. During this period number of commercial banks declined remarkably. There were 566 banks as on December, 1951; of this, number scheduledbanks was 92 and the remaining 474 were non-scheduled banks. Thisnumber went down considerably to the level of 281 at the close of the year1968. The sharp decline in the number of banks was due to heavy fall in thenumber of non-scheduled banks which touched an all time low level of 210. The banking scenario prevalent in the country up-tothe year 1968

depicted a strong stress on class banking based on security rather than on'purpose. Before 1968, only RBI and Associate Banks of SBI were mainlycontrolled by Government. Some associates were fully owned subsidiaries ofSBI and in the rest, there was a very small shareholding by individuals andthe rest by RBI.

EXPANSION PHASE (1968-1984) The motto of bank nationalization was to make banking services reach the masses that can be attributed as "first- banking revolution". Commercialbanks acted as vital instruments for this purpose by way of rapid branchexpansion, deposits mobilization and credit creation. Penetrating into ruralareas and agenda for geographical expansion in the form of branchexpansion continued. The second dose of nationalization of 6 morecommercial 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 phase witnessed socialization of banking in 1968. Commercialbanks were viewed as agents of change and social control on banks.However, inadequacy of social control soon became apparent because allbanks except the SBI and its seven associate banks were in the private sectorand could not be influenced to serve social interests. Therefore, banks werenationalized (14 banks in 1969 and 6 banks in 1980) in order to control theheights of the economy in conformity with national policy and objectives. This period saw the birth and the growth of what is now termed as directed lendingby banks. It also saw commercial banking spreading to far and wide areas inthe country with great pace during which a number of poverty alleviation andemployment generating schemes were sought to be implemented throughcommercial banks. Thus, this period was characterized by the death of private banking and the dominance of social banking over commercial banking. It washardly realized that banks 'were organizations with social

responsibilities butnot social organizations. This period also witnessed the birth of RegionalRural Bank (RRBS) in 1975 and NABARAD in 1982 which had priority sectoras their focus of activity.Although number of commercial banks declined from 281 in 1968 to268 in 1984, number of scheduled banks shot up from 71 to 264 during thecorresponding period, number of non-scheduled banks having registeredperceptible decline from 210 to 4 during the period under reference. The risein the number of scheduled banks was, as stated above, due to theemergence of RRBS. The fifteen years following the banks nationalization in 1969 were dominated by the Banks expansion at a path breaking pace. As many as50,000 bank branches were set up; three-fourths of these branches wereopened in rural and semi-urban areas. Thus, during this period a distincttransformation of far reaching significance occurred in the Indianbanking system as it assumed a broad mass base and emerged as an importantinstrument of socio-economic changes. Thus, with growth came inefficiency and loss of control over widely spread offices. Moreover, retail lending to morerisk-prone areas at concessional interest rates had raised costs, affected thequality of assets of banks and put their profitability under strain. Thecompetitive efficiency of the banks was at a low ebb. Customer servicebecame least available commodity. Performance of a bank/banker began tobe measured merely in terms of growth of deposits, advances and other suchtargets and quality became a casualty. Theimpact of this phenomenal growth was to bring down the population perbranch from 60,000 in 1969 to about 14,000. The banking system thusassumed a broad mass-base and emerged as an important instrument ofsocial-economic changes. However, this success was neither unqualifiednor without costs. While the rapid branch expansion, wider geographicalcoverage has been achieved, lines of supervision and control had beenstretched beyond the optimum level and had weakened. Moreover, retaillending to more risk-prone areas at concessional interest rates had raisedcosts, affected the quality of assets of banks and put their profitability understrain.

CONSOLIDATION PHASE; (1985-1990) A realization of the above weaknesses thrust the banking sector into the phase of consolidation. This phase began in 1985 when a series of policy initiatives were taken with the objectives of consolidating the gains of branch expansion undertaken by the banks, and of relaxing albeit marginally, the verytight regulation under which the system was operating. Although number ofschedule banks increased from 264 in 1984 to 276 in 1990, branch expansionof the banks slowed down. Hardly 7000 branches were set up during this period. For the first time, serious attention was paid to improving housekeeping, customer services, credit management, staff productivity andprofitability of the banks and concrete steps were taken during this period torationalize the rates of bank deposits and lending. Measures were initiated toreduce the structural constraints which were then inhibiting the developmentof money market. 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 bythe RBI; prices of service were fixed uniformly by the Indian Banking Association (IBA); composition of assets was also somewhat fixed in as muchas 63.5% of bank funds were mopped up by CRR and SLR and the remainedwas to directed towards priority sector leading and small loaning; salarystructure was negotiated by the IBA and validated by the Government. Thus,there was no autonomy in vital decisions Government. Thus, there was noautonomy in vital decisions. Commercial approach in operations and drivetowards efficiency was almost nonexistent. The result was that during thisperiod, the banks ended up consolidating their losses rather than the gains. A very interesting development that had taken place during 1960s was the liquidation of many smaller banks by amalgamation with bigger and stronger banks. During the two decades 1949 to 1969 the banking sectorwitnessed the process of Consolidation for the first time. The number ofbanking companies came down drastically from 620 in 1949 to 89 in 1969. Deposit Mobilization and Credit Expansion While acting as financial intermediaries between the savers and

investors, commercial banks render a yeomen service to the development of an economy. Deposit expansion, which is one of the parameters indicating thedevelopment of banking, contributed to the growth of the economy.Nationalization of major banks in 1969 accompanied by massive branchexpansion gave fillip to deposit mobilization. The total deposits which stood atRs. 908 crore in 1951 increased to Rs. 4646 crore by 1969-an increase of a little more than 5 times. In the subsequent eight years till 1987, the deposits increased by Rs. 1,02,699 crore They stood at Rs. 2,01,199 crore in 1991.Correspondingly, bank credit had also increased from Rs. 547 crore in 1951to Rs. 3599 crore in 1969 and to Rs. 1,21,865 crore in 1991. DECLINE IN PRODUCTIVITY AND PROFITABILITY Despite this commendable progress serious problems have emerged reflected in a decline in productivity and efficiency and erosion of the profitability of the banking sector. The squeeze on profitability has emanatedboth from the factors operating on the side of income and on the side ofexpenditure. 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, pre-empting well 64over half of the total resources mobilized by banks. ii. Directed credit programme of deploying 40 per cent of bank credit to the priority sectors at low interest rates. iii. Low capital base. iv. Low technology. v. Phenomenal branch expansion. vi. Political interference in loan disbursal and poverty eradication programmes. The above factors led to the depression in the interest income available to banks on the one hand and the deterioration in the quality of loan portfolio both of the priority sector and traditional sectors resulting in accumulation of non-performing assets on the other. This has been responsible for erosion of earnings and profitability of banks. Commenting on the squeeze on the profitability of banks, 'The Narasimham Committee on Financial System' observed, "Perhaps the single most important cause for the further increase in expenditure has

been the impact of the phenomenal expansion of branch banking. Growing diversification of functions, particularly with respect to extending thecoverage of bank credit to agriculture and small industries, where the unit cost of administering the loan tend to be high in proportionate terms, have also contributed to a faster growth of expenditure.Many of rural branches, unfortunately, have not been able to generateadequate business to justify their existence, most of them operating below the break-even point. An inverse correlation between the extent of the commercial banks presence in rural areas and the volume of business generated by these outlets is clearly visible.This has decisive impact on theoverall profits of the banks. The public sector banks, although have a largenumber of rural branches, only a small proportion of their business isgenerated by these branches. It is estimated that 41 per cent of PSBs branches handle only 10 per cent of total advances and the contribution ofrural branches to deposit mobilization is only 14 per cent. It is a laborintensiveprocess to handle a large number of small deposit accounts andthis has resulted in low average business per employee in rural branches.These branches have to service 39 per cent of small borrowing accounts amajor number of which are less revenue generating.The story is not different in the case of private sector banks. 22 percent of their rural branches mobilize only 6 per cent of their deposits. Theydisburse hardly 4 per cent of the total credit and deploy 11 per cent of thestaff to manage these branches. The rural branches of the private sectorbanks appear as a small appendage maintained because of its inevitabilityunder the existing banking regulations than for its utility, As a result of theabove factors gross profits ie surplus before provision been declining for the banking system over the past decades and in the year1989-90, such profit were no more than 1.10 per cent of working funds. During 1992-93 they posted huge losses to the tune of Rs. 3648 crore. In case of private sector banks too the net profits have declinedfrom Rs. 77 crore in 1991-92 to Rs. 60 crore. In 1992-93. The Foreign bankstoo have sustained losses in 1992-93. These losses in 1992-93 may beattributed mainly to the securities scam engineered by Harshad Mehta andprovisions made for non-performing assets. Further, it may be noted that the

average Return on Assets in the second half of 1980s was about 0.15 percent, an extraordinarily low figure when compared to the international standards Reflecting low capitalization of Indian banks, Return on Equity covered around 9.5 per cent and capital and reserves averaged about 1.05per cent of assets in sharp contrast to 4 to 6 per cent in other Asian countries. The capital base defined as the ratio of paid-up capital and reserves to deposits of PSBs at a slightly over 2.85 per cent in 1990-91 compared very poorly with gIobal standards. Thus by 1991, the county erected an unprofitable, inefficient and financially unsound banking sector. The operational efficiency of banking system had been unsatisfactory in terms of low profitability, growing incidence of NPAs and relatively low capitalbase. Consequently, the.financial health of banks deteriorated. Further, thecustomer service was poor, their work technology was outdated and theywere unable to meet the challenges of a competitive environment. These developments have necessitated devising a reform agenda for the banking sector. REFORMATORY PHASE (1991 ONWARDS) The main objective of the financial sector reforms in India initiated in the early 1990s was to create an efficient, competitive and stable financial sector that could then contribute in greater measure to stimulate growth. Concomitantly, the monetary policy framework made a phased shift from direct instruments of monetary management to an increasing reliance on indirect instruments. However, as appropriate monetary transmission cannot take place without efficient price discovery of interest rates and exchange rates in the overall functioning of financial markets, the corresponding development of the money market, Government securities market and the foreign exchange market became necessary. Reforms in the various segments, therefore, had to be coordinated. FINANCIAL AND BANKING SECTOR REFORMS : The last two decades witnessed the maturity of India's financial markets. Since 1991, every governments of India took major steps in reforming thefinancial sector of the country. The important achievements in the followingfields, is discussed under separate heads:

-banking finance companies capital market

The details of the above segments have been explained separately as under. FINANCIAL MARKETS In the last decade, Private Sector Institutions played an important role. They grew rapidly in commercial banking and asset management business.With the openings in the insurance sector for these institutions, they startedmaking debt in the market.Competition among financial intermediaries gradually helped theinterest rates to decline. Deregulation added to it. The real interest rate wasmaintained. The borrowers did not pay high price while depositors hadincentives to save. It was something between the nominal rate of interest andthe expected rate of inflation. REGULATORS The Finance Ministry continuously formulated major policies in the field of financial sector of the country. The Government accepted the important role of regulators. The Reserve Bank of India (RBI) has become more independent. Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development Authority (IRDA) became important institutions. Opinions are also there that there should be a superregulator for the financial services sector instead of multiplicity of regulators. 68 THE BANKING SYSTEM Almost 80% of the businesses are still controlled by Public Sector

Banks (PSBs). PSBs are still dominating the commercial banking system.Shares of the leading PSBs are already listed on the stock exchanges.The RBI has given licenses to new private sector banks as part of theliberalization process. The RBI has also been granting licenses to industrial houses. Many banks are successfully running in the retail and consumer segments but are yet to deliver services to industrial finance, retail trade,small business and agricultural finance. The PSBs will play an important role in the industry due to its number of branches and foreign banks facing the constraint of limited number of branches. Hence, in order to achieve an efficient banking system, the onus ison the Government to encourage the PSBs to be run on professional lines. DEVELOPMENTOF FINANCIAL INSTITUTIONS capital market for debt and equity funds. sanctioned by term-lending institutions. nts of financial services such as commercial banking, asset management and insurance through separate ventures. The move to universal banking has started. NON-BANKING FINANCE COMPANIES In the case of new NBFCs seeking registration with the RBI, the requirement of minimum net owned funds, has been raised to Rs.2 crores.Until recently, the money market in India was narrow and circumscribed bytight regulations over interest rates and participants. The secondary marketwas underdeveloped and lacked liquidity. Several measures have beeninitiated and include new money market instruments, strengthening of existinginstruments and setting up of the Discount and Finance House of India(DFHI). The RBI conducts its sales of dated securities and treasury bills through itsopen market operations (OMO) window. Primary dealers bid for these securities and also trade in them. The DFHI is the principal agency for developing a secondary market for money market instruments and Government of India treasury bills. The RBI has introduced a liquidity

adjustment facility (LAF) in which liquidity is injected through reverse repoauctions and liquidity is sucked out through repo auctions. On account of the substantial issue of government debt, the gilt- edged market occupies an important position in the financial set- up. The SecuritiesTrading Corporation of India (STCI), which started operations in June 1994has a mandate to develop the secondary market in government securities.Long-term debt market: The development of a long-term debt market iscrucial to the financing of infrastructure. After bringing some order to theequity market, the SEBI has now decided to concentrate on the developmentof the debt market. Stamp duty is being withdrawn at the time ofdematerialization of debt instruments in order to encourage paperless trading. THE CAPITAL MARKET The number of shareholders in India is estimated at 25 million. However, only an estimated two lakh persons actively trade in stocks. There has been adramatic improvement in the country's stock market trading infrastructureduring the last few years. Expectations are that India will be an attractiveemerging market with tremendous potential. Unfortunately, during recenttimes the stock markets have been constrained by some unsavourydevelopments, which has led to retail investors deserting the stock markets. MUTUAL FUNDS The mutual funds industry is now regulated under the SEBI (Mutual Funds) Regulations, 1996 and amendments thereto. With the issuance ofSEBI guidelines, the industry had a framework for the establishment of manymore players, both Indian and foreign players. The Unit Trust of India remains easily the biggest mutual fund controlling a corpus of nearly Rs.70,000 crores, but its share is going down. The biggest shock to the mutual fund industry during recent times was the insecurity generated in the minds of investors regarding the US 64 scheme. With the growth in the securities markets and tax advantages granted for investment inmutual fund units, mutual funds started becoming popular. The foreign owned AMCs are the ones which are now setting the pace for the industry. They are introducing new products, setting new standards of customer service, improving disclosure standards and

experimenting with new types of distribution.The insurance industry is the latest to be thrown open to competition fromthe private sector including foreign players. Foreign companies can only enterjoint ventures with Indian companies, with participation restricted to 26 per cent of equity. It is too early to conclude whether the erstwhile public sectormonopolies will successfully be able to face up to the competition posed bythe new players, but it can be expected that the customer will gain fromimproved service. The new players will need to bring in innovative products as well as freshideas on marketing and distribution, in order to improve the low per capitainsurance coverage. Good regulation will, of course, be essential. OVERALL APPROACH TO REFORMS The last ten years have seen major improvements in the working of various financial market participants. The government and the regulatory authorities have followed a step-by-step approach, not a big bang one. The entry of foreign players has assisted in the introduction of internationalpractices and systems. Technology developments have improved customer service. Some gaps however remain (for example: lack of an inter-bankinterest rate benchmark, an active corporate debt market and a developedderivatives market). On the whole, the cumulative effect of the developmentssince 1991 has been quite encouraging. An indication of the strength of thereformed Indian financial system can be seen from the way India was not affected by the Southeast Asian crisis. However, financial liberalization alone will not ensure stable economic growth. Some tough decisions still need to be taken. Without fiscal control,financial stability cannot be ensured. The fate of the Fiscal Responsibility Bill remains unknown and high fiscal deficits continue. In the case of financialinstitutions, the political and legal structures have to ensure that borrowersrepay on time the loans they have taken. The phenomenon of richindustrialists and bankrupt companies continues. Further, frauds cannot betotally prevented, even with the best of regulation. However, punishment hasto follow crime, which is often not the case in India. DEREGULATION OF BANKING SYSTEM Prudential norms were introduced for income recognition, asset

classification, provisioning for delinquent loans and for capital adequacy. In order to reach the stipulated capital adequacy norms, substantial capital wereprovided by the Government to PSBs.Government preemption of banks' resources through statutory liquidityratio (SLR) and cash reserve ratio (CRR) brought down in steps. Interest rates on the deposits and lending sides almost entirely were deregulated. New private sector banks are allowed to promote and encourage competition. PSBs were encouraged to approach the public for raising resources. Recovery of debts due to banks and the Financial Institutions Act,1993 was passed, and special recovery tribunals set up to facilitate quicker recovery of loan arrears. Bank lending norms liberalized and a loan system to ensure better controlover credit introduced. Banks asked to set up asset liability management(ALM) systems. RBI guidelines issued for risk management systems in banksencompassing credit, market and operational risks. A credit information bureau arebeing established to identify bad risks. Derivative products such as forward rate agreements (FRAs) and interest rateswaps (IRSs) introduced. CAPITAL MARKET DEVELOPMENTS The Capital Issues (Control) Act, 1947, repealed, office of the Controller of Capital Issues were abolished and the initial share pricing were decontrolled.SEBI, the capital market regulator was established in 1992. Foreign institutional investors (FIIs) were allowed to invest in Indian capitalmarkets after registration with the SEBI. Indian companies were permitted toaccess international capital markets through euro issues. The National Stock Exchange (NSE), with nationwide stock trading and electronic display, clearing and settlement facilities was established. Severallocal stock exchanges changed over from floor based trading to screen basedtrading. PRIVATE MUTUAL FUNDS PERMITTED The Depositories Act had given a legal framework for the establishment ofdepositories to record ownership deals in book entry form. Dematerialisationof stocks encouraged paperless trading. Companies were required to discloseall material facts and specific risk factors associated with their projects while making public issues. To reduce the cost of issue, underwriting by the issuer were made

optional, subject to conditions. The practice of making preferential allotment ofshares at prices unrelated to the prevailing market prices stopped and freshguidelines were issued by SEBI.SEBI reconstituted governing boards of the stock exchanges, introducedcapital adequacy norms for brokers, and made rules for making client orbroker relationship more transparent which included separation of client and broker accounts. BUY BACK OF SHARES ALLOWED The SEBI started insisting on greater corporate disclosures. Steps were taken to improve corporate governance based on the report of a committee.SEBI issued detailed employee stock option scheme and employee stockpurchase scheme for listed companies. Standard denomination for equity shares of Rs. 10 and Rs. 100 were abolished. Companies given the freedom to issue dematerialized shares in any denomination. Derivatives trading start with index options and futures. A system of rollingsettlements introduced. SEBI empowered to register and regulate venturecapital funds.The SEBI (Credit Rating Agencies) Regulations, 1999 issued for regulatingnew credit rating agencies as well as introducing a code of conduct for allcredit rating agencies operating in India. CONSOLIDATION IMPERATIVE Another aspect of the financial sector reforms in India is the consolidation of existing institutions which is especially applicable to the commercial banks. In India the banks are in huge quantity. First, there is noneed for 27 PSBs with branches all over India. A number of them can bemerged. The merger of Punjab National Bank and New Bank of India was adifficult one, but the situation is different now. No one expected so manyemployees to take voluntary retirement from PSBs, which at one time weremuch sought after jobs. Private sector banks will be self consolidated whileco-operative and rural banks will be encouraged for consolidation, andanyway play only a niche role. In the case of insurance, the Life Insurance Corporation of India is a behemoth, while the four public sector general insurance companies will probably move towards consolidation with a bit of nudging. The UTI is yet

again a big institution, even though facing difficult times, and most other publicsector players are already exiting the mutual fund business. There are anumber of small mutual fund players in the private sector, but the businessbeing comparatively new for the private players, it will take some time.We finally come to convergence in the financial sector, the newbuzzword internationally. Hi-tech and the need to meet increasing consumer needs is encouraging convergence, even though it has not always been asuccess till date. In India organizations such as IDBI, ICICI, HDFC and SBIare already trying to offer various services to the customer under oneumbrella. This phenomenon is expected to grow rapidly in the coming years. Where mergers may not be possible, alliances between organizations may beeffective. Various forms of bank assurance are being introduced, with the RBIhaving already come out with detailed guidelines for entry of banks intoinsurance. The LIC has bought into Corporation Bank in order to spread itsinsurance distribution network. Both banks and insurance companies havestarted entering the asset management business, as there is a great deal of synergy among these businesses. The pensions market is expected to openup fresh opportunities for insurance companies and mutual funds.It is not possible to play the role of the Oracle of Delphi when a vastnation like India is involved. However, a few trends are evident, and thecoming decade should be as interesting as the last one. Indian banking system has been subject to widespread structural reforms initiated since June 1991. This phase can be regarded as "secondbanking revolution". Reform measures such as introduction of new accountingand prudential norms, liberalization measures etc., are heading towards atruly competitive and well structured banking system resilient from aninternational perspective.Continued financial profligacy of the Government coupled with closemonitoring and control rendered the financial systems completely dependentand inefficient so much so that by the year 1991, the situation was ripe fordrastic reforms. It was, however, precipitated by the unprecedented economiccrisis which engulfed the economy in 1991. For the first time in its history,India faced the problem of defaulting on its international commitments. The access to external commercial credit markets was completely denied; International credit ratings had been downgraded and the international

financial communitys confidence in Indias ability to manage its economy hadbeen severally eroded. The economy suffered from serious inflationarypressures, emerging scarcities of essential commodities and breakdown offiscial discipline. The Government took swift action to restore international confidence in the economy and redress the imbalances. Various macro-economic structuralreformatory measures were undertaken in the field of foreign trade, taxsystem, industrial policy and financial and other sectors. The objective was toimprove the underlying strength of the economy, attempt to ensure againstfuture crises and further the fundamental developmental; objectives of growth with equity and self reliance. NARASIMHAM COMMITTEE I (FIRST GENERATION REFORMS) To restore the financial health of commercial banks and to make their functioning efficient and profitable, the Government of India appointed a committee called 'The Committee on Financed System' under the chairmanship of Sri M. Narasimham, ex-Governor of Reserve Bank of India which made recommendations in November 1991. The Committee laid downa blue print of financial sector reforms, recognized that a vibrant andcompetitive financial system was central to the wide ranging structuralreforms. In order to ensure that the financial system operates on the basis ofoperational flexibility and functional autonomy, with a view to enhanceefficiency, productivity and profitability, the Committee recommended a seriesof measures aimed at changes according greater flexibility to bank operations,especially in Pointing out statutory stipulations, directed credit program,improving asset quality, institution of prudential norm, greater disclosures,better housekeeping, in terms of accounting practices. In the words of BimalJalan, ex-Governor of RBI, "the central bank is a set of prudential norm thatare aimed at imparting strength to the financial institutions, and inducinggreater accountability and market discipline. The norms include not onlycapital adequacy, asset classifications and provisioning but also accountingstandards, exposure and disclosure norms and guidelines for investment, risk management and asset liability management." These recommendations are alandmark in the evolution of banking system from a highly regulated to moremarket-oriented system. The reforms introduced since 1992-93 breathed a fresh air in the

banking sector. Deregulation and liberalization encouraged banks to go in forinnovative measures, develop business and earn profits. These reforms, theNarasimham Committee-I felt, will improve the solvency, health and efficiencyof institutions. The measures were aimed at (i) ensuring a degree of operational flexibility, (ii) internal 'autonomy for public sector banks in their decision-making process, and (iii) greater degree of professionalism in banking operations The Reserve Bank of India grouped the first phase of reform measures into three main areas: Enabling measures, Strengthening measures and Institutional measures. In other way, they can also be classified into five different groups (a) Liberalization measures, (b) Prudential norms, (c) Competition directed measures, (d) Supportive measures, and (e) Other measures. (A) LIBERALIZATION MEASURES Statutory Liquidity Ratio (SLR) /Cash Reserve Ratio (CRR): The SLR and CRR measures were originally designed to give the RBI two additionalmeasures of credit control, besides protecting the interests of depositors.Under the SLR, commercial banks are required to maintain with the RBIminimum 25 per cent of their total net demand and time liabilities in the formof cash, gold and unencumbered eligible securities (under the BankingRegulation Act, 1949). The RBI is capital adequacy which have all beenimplemented. (B) PRUDENTIAL NORMS In April 1992, the RBI issued detailed guidelines on a phased introduction ofprudential norms to ensure safety and soundness of banks and impart greatertransparency and accounting operations. The main objective of prudentialnorms is the strengthening financial stability of banks.Inadequacy of capital is a serious cause for concern. Hence, as per Basle Committee norms, the RBI introduced capital: adequacy norms. It wasprescribed that banks should achieve a minimum of 4 per cent capitaladequacy ratio in relation to risk weighted assets by March 1993, of which

Tier I capital should not be less than 2 per cent. The BIS standard of 8 percent should be achieved over a period of three years, that is, by March 1996,For banks with international presence, it is necessary to reach the figure evenearlier. Before arriving at the capital adequacy ratio of each bank, it isnecessary that assets of banks should be evaluated on the basis of theirrealizable value. Those banks whose operations are profitable and which enjoy reputation in the markets are all over to approach capital market for enhancement of capital. In respect of others, the Government should meet the shortfall by direct subscription to capital by providing loan. As per the recommendations of the Narasimham Committee banks cannot recognize income (interest income on advances) on assets whereincome is not received within two quarters after it is past due. The committee recommended international norm of 90 days in phased mannerby 2002. The assets are now classified on the basis ,of their performance into 4 categories: (a) standard, (b) sub-standard, (c) doubtful, and (d) loss assets. Adequate provision is required to be made for bad and doubtful debts (substandard assets). Detailed instructions for provisioning have been laid down. In addition, a credit exposure norm of 15 per cent to a single party and40 per cent to a group has been prescribed. Banks have been advised tomake their balance sheets transparent with maximum 'disclosure' on thefinancial health of institutions. The Committee recommended provisioning norms for nonperforming assets. On outstanding substandard assets 10 percent general provision should be made (1992). On loss assets the permission shall be 100 percent.On secured portion of doubtful assets, the provision should be 20 to 50 percent.:" (C) COMPETITION DIRECTED MEASURES Since 1969 none bank had allowed to be opened in India. That policy

changed in January 1 1993 when the RBI announced guidelines for openingof private sector banks public limited companies. The criteria for setting up of new banks in private sector were: (a) capital of Rs. 100 crore, (b) mostmodern technologic, and (c) head office at a nonmetropolitan centre, InJanuary' 2001, paid-up capital of these banks was increased to Rs. 200 crorewhich has to be raised to Rs. 300 crore within a period of 3 years after thecommencement of business, The promoters share in a bank shall not be lessthan 40 per cent. After the issue of guidelines in 1993, 9 new banks have been set up in the private sector. Foreign banks have also been permitted toset-up subsidiaries, joint ventures or branches, Their number have increasedfrom 24 in 1991 to 42 in 2000 and their branch network increased from 140 to185 over the same period. Banks have also been permitted to rationalize their existing branches, spinning off business at other centers, opening of specialized branches, convert the existing non-urban rural branches into satellite offices. Banks have also been permitted to close down branches other than in rural areas.Banks attaining capital adequacy norms and prudential accounting standardscan set-up new branches without the prior approval of RBI. Tworecommendation of the Narasimham Committee was to abolish the system ofbranch licensing and allow foreign banks free entry. (D) SUPPORTIVE MEASURES Revised format for balance sheet and profit and loss account reflecting andactual health of scheduled banks were introduced from the accounting year1991-92. There have also been changes in the institutional framework. TheRBI evolved a risk-based supervision methodology with international bestpractices. New Board of Financial Supervision was set-up in the RBI totighten up the supervision of banks. The system of external supervisionhas been revamped with the establishment in November 1994 of the Boardof Financial Supervision with the operational support of the Department ofBanking. supervision. In tune with international practices of supervision, athree-tier supervisory model comprising outside inspection, off-sitemonitoring and periodical external auditing based on CAMELS (CapitalAdequacy, Asset quality, Management, Earnings, Liquidity and Systemcontrols) had been put in place. Special Recovery Tribunals are set-up to

expedite loan recovery process.21 The recent Securitization and Reconstruction of Financial; Assets and Enforcement of Security Interests(SARFAAESI) Act, 2002 enables the regulation of securitization of andreconstruction of financial assets and enforcement of security interests bysecured creditors. The Act will enable banks to dispose of securities ofdefaulting borrowers to recover debt. (E) OTHER MEASURES The Banking Companies (Acquisition and Transfer of Undertaking) Act was amended with effect from July 1994 permitting public sector banks toraise capital up to 49 per cent from the public. There are number of otherrecommendations of the Narasimham Committee such as reduction in prioritysector landings, appointment of .special tribunals for speeding up the processof loan recoveries, and reorganization of the rural credit structure, all of whichneed detailed examination as these recommendations have far-reachingimplications both in terms of the structure of the financial system and also thefinancing required to implement them. The Committee proposed structural reorganization of the banking sector which involves a substantial reduction of public sector banks throughmergers and acquisitions. It proposed a pattern of a) 3 or 4 large banks of international character, b) 8 to 10 national banks engaged in "general or universal banking c) local banks whose operation be confined to a specific areas, and d) RRBs financing permanently agriculture I and allied activities. The Government had not taken any decision regarding this suggestion. RECOMMENDATIONS OF NARASIMHAM COMMITTEE I The main recommendations of the Committee were :1. Reduction of Statutory Liquidity Ratio (SLR) to 25 percent over a period of five years 2. Progressive reduction in Cash Reserve Ratio (CRR) 80 3. Phasing out of directed credit programmes and redefinition of the priority sector 4. Deregulation of interest rates so as to reflect emerging market conditions I

5. Stipulation of minimum capital adequacy ratio of percent to risk weighted assets by March 1993, 8 percent by March 1996, and 8 percent by those banks having international operations by March 1994. 6. Adoption of uniform accounting practices in regard to income recognition, asset classification and provisioning against bad and doubtful debts 7. Imparting transparency to bank balance sheets and making more disclosures 8. Setting up of special tribunals to speed up the process of recovery of loans 9. Setting up of Asset Reconstruction Funds (ARFs) to take over from banks a portion of their bad and doubtful advances at a discount 10. Restructuring of the banking system, so as to have 3 or 4 large banks, which could become international in character, 8 to 10 national banks and local banks confined to specific regions. Rural banks, including Regional Rural Banks (R.RBs), confined to rural areas. 11. Setting up one or more rural banking subsidiaries by Public Sector Banks 12. Permitting RRBs to engage in all types of banking business 13. Abolition of branch licensing 14. Liberalizing the policy with regard to allowing foreign banks to open offices in India. 15. Rationalisation of foreign operations of Indian banks 16. Giving freedom to individual banks to recruit officers 17. Inspection by supervisory authorities based essentially on the internal audit and inspection reports. 18. Ending duality of control over banking system by Banking Division and RBI 19. A separate authority for supervision of banks and financial institutions which would be a semi-autonomous body under RBI

20. Revised procedure for selection of Chief Executives and Directors of Boards of public sector banks 21. Obtaining resources from the market on competitive terms by DFIs 22. Speedy liberalization of capital market 23. Supervision of merchant banks, mutual funds, leasing companies etc., by a separate agency to be set up by RBI and enactment of a separate legislation providing appropriate legal framework for mutual funds and laying down prudential norms for these institutions, etc. Several recommendations have been accepted and are being implemented in a phased manner. Among these are the reductions SLR/CRR, adoption of prudential norms for asset classification and provisions, introduction of capital adequacy norms, and deregulation of most of the interest rates, allowing entry to new entrants in private sector banking sector, etc. IMPACT OF FIRST GENERATION REFORMS The visible impact of first generation reforms may be summarized as follows: (i) The banking system is well diversified with the establishment of new private banks and about 20 new foreign banks after 1993. The entry of modern, professional private sector banks and foreign banks has enhanced competition. With the deregulation of interest rates both for advances as well as deposits, competition between different bank groups and between banks in the same group has become intense. What is more important is that apart from growth of banks and commercial banking, various other financial intermediaries like mutual funds, equipment leasing and hire purchase companies, housing finance companies etc., which are sponsored by banks have cropped up. (ii) Finance regulation through statutory preemptions has been lowered while stepping up of the prudential regulations.

(iii) Steps have been taken to strengthen PSBs through increasing their autonomy, recapitalization, etc. Based on specified criteria nationalized banks were given: autonomy in the matters of creation, abolition, up- gradation of posts for their administrative officers up to the level of Deputy General Manager. Rs. 10,987.12 crore for capitalization funds were pumped into banks during 1993-95. This indicates the extent of capital erosion faced by the nationalized banks. (iv) A set of micro-prudential measures have been stipulated with regard to capital adequacy, asset classification, provisioning, accounting rules, valuation norms, etc. CRAR (Per cent to the risk weighted assets) of banks stood at 8 per cent. The percentage of Net NPAS to net advances of PSBs has declined from 14.4 per cent in 1993-94 to 8.5 per cent by 1997-98. The prudential norms have been significantly contributed towards improvement in pre-sanction appraisal and post-sanction appraisal and control, the impact of which is clearly seen in the decrease in fresh addition of performing accounts into the NPA category. As per RBI Report on Currency and Finance consequent upon prudential norms, the most visible structural change has been improvement in asset quality. (v) Measures have been taken to broaden the ownership base of PSBs by allowing them]o approach the capital market. The Government of India, in a major policy announcement, decided to reduce its stake in PSBs from 100 per cent to 51 per cent retaining, however, the policy parameters of PSBs. The Government proposes to reduce further its stake to 33 per cent. Moreover, there is a provision for foreign investments to the extent of 20 per cent. The net result of the dilution in ownership of PSBs is that these banks are becoming slowly joint sector banks. A number of PSBs like State Bank of India, Andhra Bank, Bank of Baroda, Canara Bank, Punjab National Bank have gone up for public issue since 1994. (vi) Mergers and acquisitions have been taking place in the banking sector. In the past, due to the existence of a large 83

number of small non-viable banks, the RBI encouraged larger of small banks with big banks. Now, market driven mergers between private banks have been taking place. (vii) As intense competition becomes a way of doing, banks have to pay attention to customer service. Product innovations and process engineering are the order of the day. Since interest income has fallen with lowering of interest rates on advances, banks have to look for enhancing fee-based income, to fill the gap in interest income. Banks have therefore been mooring towards providing value added services to customers. Under the impact of technological up-gradation and financial innovations, banks have now become super markets one stop shop of varied financial services. The set of measures, coupled with many others, did have a positive impact on the system. There has been considerable improvement in profitability of the banking system. There has been improvement in key financial indicators of all bank groups during the period 1992-98. For example,the net profits of the scheduled commercial banks as a percentage of the totalassets has been turned around from a negative figure of 1.0 per cent onaverage during 1992-93 and 1993-94 to a positive of 0.5 per cent during1994-95 to 1997-98. Simply, net profits as a percentage of working fundswhich was 0.39 per cent in 1991-92 and ()1.08 per cent in 1992-93 turnedpositive in 1994-95 and reached 0.81 per cent by 1997-98.In case of most of the public sector banks business per employee andprofit per employee have shown improvement in the recent period, For egg.,in 1991-92 the average profit per employee of PSBs ,vas Rs. 1.58 crore, itbecame positive in 1996-97 at Rs. 0.35 crore It further improved to Rs, 0.59crore by 1999-2000 and Rs. 1.63 crore in 2002-03. By 1997, almost all publicsector banks achieved the minimum capital adequacy norms of 8 per cent.The gross and net NPAs of banking system as a percentage ofadvances have dec1ined to 16 per cent and 8.2 per cent respectively byMarch 1998, In terms of percentage of total assets, gross and net nonperforming assets have declined to 7.0 per cent and 3.3 per cent respectivelyby March 1998. As the second report of Narasimham Committee has observed, "this improvement has arrested the deterioration in these parameters that had marked the functioning of the system earlier. There is still a considerable

distance to traverse. The process of strengthening the banking system has tobe viewed as a continuing process. NARASIMHAM COMMITTEE-II (1998)(SECOND GENERATION REFORMS) The recommendations of Narasimham Committee-I (1991) provided blueprint for first generation reforms of the financial sector. The period 1992-97 witnessed laying of the foundations for reforms of the banking system.26It also saw the implementation of prudential norms relating to capitaladequacy, asset classification, income recognition and provisioning,exposure norms, etc. The difficult task of ushering in some of the structuralchanges accomplished during this period provided the bedrock for futurereforms. In fact, India withstood the contagion of 1997 (South-East Asiacrisis) indicates the stability of the banking system Against such a backdrop,the Report of the Narasimham Committee-II in 1998 provided the road mapfor the second-generation reform process. Two points are worth noting atthis juncture. First, the financial sector reforms were undertaken in the earlyreform cycle, and secondly, the reforms in the financial sector were initiatedin well structured, sequenced and phased manner with cautious and propersequencing, mutually reinforcing measures; complementarily between reforms in the banking sector and changes in the fiscal, external and monetary policies, developing financial infrastructure; and developing financial markets. The Government appointed a second high-level Committee on Banking Sector Reforms under the chairmanship' of Mr. Narasimham to "review the progress of banking sector reforms to date andchart a programme of financial sector reforms necessary to strengthen theIndian Financial System and make it internationally competitive.TheCommittee in its report (April 1998) made wide-ranging recommendationscovering entire gamut of issues ranging from capital adequacy, assetquality, NPAs, prudential norms, asset-liability management, earnings andprofits, mergers and acquisitions, reduction in government shareholdings to33 per cent in public sector banks, the creation of gIobal-sized banks,recasting banks boards to revamping banking legislation. The second generation reforms could be conveniently looked at in terms of three broad inter-related issues: (i) measures that need to be taken to strengthen the

foundations of the banking system, (ii) related to this, streamlining procedures, upgrading" technology and human resource development, and (iii) structural changes in the system. These would cover aspects of banking policy, institutional, supervisory and legislative dimensions. The important recommendation of the Committee may be stated as under: A. MEASURES TO STRENGTHEN THE BANKING SYSTEM (i) Capital Adequacy The Committee set new an(t. Higher norms of capital adequacy. It recommended that the "minimum capital to risk assets ratio be increased to10 per cent from its present level of 8 per cent in a phased manner -9 per centto be achieved by the year 2000 and the ratio of 10 per cent by 2002. The RBIshould have authority to rise further in respect of individual banks if in its judgment the situation warrants such increase. (ii) Asset Quality NPAs and Directed Credit The Committee recommended that and asset be classified as doubtful if it is in the substandard category for 18 months in the first instance and eventually 12 months and loss of it has been identified but not written off.Advances guaranteed by the government should also be treated as NPAs.Banks should avoid the practice 9f 'ever greening' by making fresh advance tothe troubled parties with a view to settle interest dues and avoiding such loanstreating as NPAs. The Committee believes that the objective should be toreduce the average level of net NPAs for all banks to below 5 per cent by theyear 2000 and to .3 per cent by 2002. For banks with international presence,the minimum objective should be to reduce gross NPAs to 5 per cent and 3per cent by 2000 and 2002 respectively and net NPA and to 3 per cent and 0per cent by these dates. For banks with a high NPA portfolio, the Committeesuggested the setting up of an Asset Reconstruction Company to take overbad debts. (iii) Prudential Norms and Disclosure Requirements It recommended moving to international practice for income recognition and recommended 90 days norm in a phased manner by the year 2002. Infuture income recognition, asset classification and provisioning must applyeven to government guaranteed advances.

Banks should pay greater attention to asset liability' management to avoidmismatches. B. SYSTEMS AND METHODS IN BANKS The internal control systems which are internal inspection and audit, including concurrent audit submission of controls returns by banks and controlling offices to higher level offices, risk management system, etc. should be strengthened. There are recommendations for inducting an additional whole time director on the board of the banks, recruitment of skilled manpower, revising remuneration to persons at managerial level, etc. C. STRUCTURAL ISSUES (i) Mergers The Committee is of the view that the convergences of activities between bank and DFIs, the DFIs over a period of time convert themselvesinto banks. There will be only two forms of financial intermediarys banks andnon-bank financial companies. Mergers between banks and between banksand DFIs and NBFCs need to base on synergies and location and businessspecific complementarities of the concerned institutions. Merger of publicsector banks should emanate from the management of banks, thegovernment playing supportive role. Mergers should not be seen as bailingout weak banks. Mergers between strong banks would make for greatereconomic and commercial sense and would be a case where the whole is greater than the sum of parts and have a 'force multiplied effect', (ii) Weak Banks A weak bank should be one whose accumulated losses and net NPAs exceed its net worth or one whose operating profits less, its income on recapitalization bonds is negative for three consecutive years. A caseby-caseexamination of weak banks should be undertaken to identify those that arepotentially viable with a programme of financial and operational restructuring.Such banks should be nurtured into healthy units by eschewing high costfunds, confinement of expenditure recovery initiatives, etc. Mergers should beallowed only after they clean up their balance sheets. (iii) Narrow Banks Those banks, which have become weak because of high proportion of NPAs (20 per cent of the total assets in some cases), the Committee

recommended the concept of 'Narrow banking'. Narrow banking implies thatthe weak banks place their funds in the short-term risk-free assets. (iv) New Banks The Committee also recommended the policy of permitting new private banks. It is also of the view that foreign banks may be allowed to set-up subsidiaries or joint ventures in India. They should be treated on par with private banks and subject to the same conditions in the regard to branchesand directed credit as other banks. (v) Need for Stronger Banks The Committee made out a strong case for stronger banking system in the country, especially in the context of capital account convertibility, whichwould involve large inflows, and outflows of capital and consequentcomplications for exchange rate management and domestic stability. TheCommittee therefore recommended winding up of unhealthy banks andmerger of strong and weak banks. (vi) Banking Structure The Committee has argued for the creation of 2 or 3 banks of international standard and 8 or 10 banks at the national level. It also suggested the setting up of small local banks, which would be confined to alimited area to serve local trade, small industry and agriculture at the sametime these banks will have corresponding relationship with the large nationaland international banks. (vii) Local Area Banks In the 1996-97 budget, the Government of India announced the setting up of new Private Local Area Banks (LABs) with jurisdiction over three contiguous districts. This banker will help in mobilizing rural saving and inchanneling them into investment in local areas. The RBI has issued guidelinesfor setting up such banks in 1996 and gave its approval 'in principle' to thesting up of seven LABs in the private sector. Of these, RBI had issuedlicenses to 5 LABs, located in Andhra Pradesh, Karnataka, Rajasthan, Punjaband Gujarat. These LABs have commenced business. (viii) Public Ownership and Autonomy The Committee argued that the government ownership and management of banks does not enhance autonomy and flexibility in the working of public sector banks. In this connection, the Committee

recommended a review of functions of boards so that they remain responsibleto the shareholders. The management boards are to be reorganized and theyshall not be any government interference. (ix) Review of Banking Laws The Committee suggested the need to review and amend the provisions of RBI Act, SBI Act, Banking Regulation Act, and Banking Nationalization Act, etc. so as to bring them in line with the current needs of the industry. Other recommendations pertain to computerization process,permission to establish private sector banks, setting up of Board of FinancialRegulation and Supervision and increasing the powers of debt recoverytribunals. To summarize, the major recommendations were: 1. Capital adequacy requirements should take into account market risks also 2. In the next three years, entire portfolio of Govt. securities should be marked to market 3. Risk weight for a Govt. guaranteed account must be 100% 4. CAR to be raised to 10% from the present 8%; 9% by 2000 and 10% by 2002 5. An asset should be classified as doubtful if it is in the sub-standard category for 18 months instead of the present 24 months 6. Banks should avoid ever greening of their advances . 7. There should be no further re-capitalization by the Govt. 8. NPA level should be brought down to 5% by 2000 and 3% by 2002 9. 9. Banks having high NPA should transfer their doubtful and loss categories to Asset Reconstruction Company (ARC) which would issue Govt. bonds representing the realizable value of the assets. 10. We should move towards international practice of income recognition by introduction of the 90 day norm instead of the present 180 days. 11. A provision of 1% on standard assets is required. 12. Govt. guaranteed accounts must also be categorized as NPAs under the

usual norms 13. Banks should update their operational manuals which should form the basic document of internal control systems. 14. There is need to institute an independent loan review mechanism especially for large borrower accounts to identify potential NPAs. 90 15. Recruitment of skilled manpower directly from the market be given urgent consideration 16. To rationalize staff strengths, an appropriate VRS must be introduced. 17. A weak bank should be one whose accumulated losses and net NPAs exceed its net worth or one whose operating profits less its income on recap bonds is negative for 3 consecutive years. The Narsimham Committee seeks to consolidate the gains made in the Indian financial sectors while improving the quality of portfolio, providing greater operational flexibility, autonomy in the internal operations of the banksand FIs so to nurture in, a healthy competitive and vibrant financial sector. REVIEW OF BANKING SECTOR REFORMS: In line with the recommendations of the second Narasimham Committee, the Mid-Term Review of the Monetary and Credit Policy of October 1999 announced a gamut of measures to strengthen the bankingsystem. Important measures on strengthening the health of banks included: (i) assigning of risk weight of 2.5 per cent to cover market risk in respect of investments in securities outside the SLR by March 31, 2001 (over and abovethe existing 100 per cent risk weight) in addition to a similar prescription forGovernment and other approved securities by March 31, 2000, and (ii)

lowering of the exposure ceiling in respect of an individual borrower from 25per cent of the banks capital fund to 20 per cent, effective April 1, 2000. CAPITAL ADEQUACY AND RECAPITALISATION OF BANKS Out of the 27 public sector banks (PSBs), 26 PSBs achieved the minimum capital to risk assets ratio (CRAR) of 9 per cent by March 2000. Of this, 22 PSBs had CRAR exceeding 10 per cent. To enable the PSBs tooperate in a more competitive manner, the Government adopted a policy ofproviding autonomous status to these banks, subject to certain benchmarks.As at endMarch 1999, 17 PSBs became eligible for autonomous status. PRUDENCIAL ACCOUNTING NORMS FOR BANKS The Reserve Bank persevered with the ongoing process of strengthening prudential accounting norms with the objective of improving thefinancial soundness of banks and to bring them at par with internationalstandards. The Reserve Bank advised PSBs to set up Settlement AdvisoryCommittees (SACs) for timely and speedier settlement of NPAs in the smallscale sector, viz., small scale industries, small business including trading andpersonal segment and the agricultural sector. The guidelines on SACs wereaimed at reducing the stock of NPAs by encouraging the banks to go in forcompromise settlements in a transparent manner. Since the progress in the recovery of NPAs has not been encouraging, a review of the scheme wasundertaken and revised guidelines were issued to PSBs in July 2000 toprovide a simplified, non-discriminatory and non-discretionary mechanism forthe recovery of the stock of NPAs in all sectors. The guidelines will remainoperative till March 2001. Recognising that the high level of NPAs in the PSBscan endanger financial system stability, the Union Budget 2000-01 announcedthe setting up of seven more Debt Recovery Tribunals (DRTs) for speedyrecovery of bad loans. An amendment in the Recovery of Debts Due to Banksand Financial Institutions Act, 1993, was effected to expedite the recovery process. ASSET LIABILITY MANAGEMENT (ALM) SYSTEM The Reserve Bank advised banks in February 1999 to put in place an ALM system, effective April 1, 1999 and set up internal asset liability

management committees (ALCOs) at the top management level to oversee itsimplementation. Banks were expected to cover at least 60 per cent of theirliabilities and assets in the interim and 100 per cent of their business by April1, 2000. The Reserve Bank also released ALM system guidelines in January2000 for all-India term-lending and refinancing institutions, effective April l,2000. As per the guidelines, banks and such institutions were required toprepare statements on liquidity gaps and interest rate sensitivity at specifiedperiodic intervals. RISK MANAGEMENT GUIDELINES The Reserve Bank issued detailed guidelines for risk management systems in banks in October 1999, encompassing credit, market and operational risks. Banks would put in place loan policies, approved by theirboards of directors, covering the methodologies for measurement, monitoringand control of credit risk. The guidelines also require banks to evaluate theirportfolios on an on-going basis, rather than at a time close to the balancesheet date. As regards off-balance sheet exposures, the current and potentialcredit exposures may be measured on a daily basis. Banks were also askedto fix a definite time-frame for moving over to the Value-at-Risk (VaR) andduration approaches for the measurement of interest rate risk. The bankswere also advised to evolve detailed policy and operative framework foroperational risk management. These guidelines together with ALM guidelineswould serve as a benchmark for banks which are yet to establish anintegrated risk management system. DISCLOSURE NORMS As a move towards greater transparency, banks were directed to disclose the following additional information in the Notes to accounts in thebalance sheets from the accounting year ended March 31, 2000: (i) maturitypattern of loans and advances, investment securities, deposits andborrowings, (ii) foreign currency assets and liabilities, (iii) movements in NPAsand (iv) lending to sensitive sectors as defined by the Reserve Bank from timeto time. TECHNOLOGICAL DEVELOPMENTS IN BANKING India, banks as well as other financial entities have entered domain of information technology and computer networking. A satellite-based Wide AreaNetwork (WAN) would provide a reliable communication framework for thefinancial sector. The Indian Financial Network (INFINET) was

inaugurated inJune 1999. It is based on satellite communication using VSAT technology andwould enable faster connectivity within the financial sector. The INFINETwould serve as the communication backbone of the proposed IntegratedPayment and Settlement System (IPSS). The Reserve Bank constituted a National Payments Council (Lnairman: Shri S. P. Talwar) in 1999-2000 tofocus on the policy parameters for developing an IPSS with a real time grosssettlement (RTGS) system as the core. REVIVAL OF WEAK BANKS The Reserve Bank had set up a Working Group (Chairman: Shri S. Verma) to suggest measures for the revival of weak PSBs in February 1999. The Working Group, in its report submitted in October 1999, suggested thatan analysis of the performance based on a combination of seven parameters covering three major areas of (i) solvency (capital adequacy ratio and coverage ratio), (ii) earnings capacity (return on assets and net interest margin) and (iii) profitability (operating profit to average working funds, cost to income and staff cost to net interest income plus all other income) could serveas the framework for identifying the weakness of banks. PSBs were,accordingly, classified into three categories depending on whether none, all orsome of the seven parameters were met. The Group primarily focused onrestructuring of three banks, viz., Indian Bank, UCO Bank and United Bank ofIndia, identified as weak as they did not satisfy any (or most) of the sevenparameters. The Group also suggested a twostage restructuring process,whereby focus would be on restoring competitive efficiency in stage one, withthe options of privatization and/or merger assuming relevance only in stagetwo. Deposit Insurance Reforms.Reforming the deposit insurance system, as observed by the Narasimham Committee (1998), is a crucial component of the present phaseof financial sector reforms in India. The Reserve Bank constituted a WorkingGroup (Chairman: Shri Jagdish W. Kapoor) to examine the issue of depositinsurance which submitted its report in October 1999. Some of the majorrecommendations of the Group are : (i) fixing the capital of the DepositInsurance and Credit Guarantee Corporation

(DICGC) at Rs. 500 crore,contributed fully by the Reserve Bank, (ii) withdrawing the function of creditguarantee on loans from DICGC and (iii) risk-based pricing of the depositinsurance premium in lieu of the present, flat rate system. A new law, insupersession of the existing enactment, is required to be passed in order toimplement the recommendations. The task of preparing the new draft law has been taken up. The relevant proposals in this respect would be forwarded to the Government for consideration. Banking Reform in India 1 Introduction Measured by share of deposits, 83 percent of the banking business in India is in the hands ofstate or nationalized banks, which are banks that are owned by the government, in some, increasinglyless clear-cut way. Moreover, even the non-nationalized banks are subject to extensive regulations on who they can lend to, in addition to the more standard prudential regulations. Government control over banks has always had its fans, ranging from Lenin to Gerschenkron.While there are those who have emphasized the political importance of public control overbanking, most arguments for nationalizing banks are based on the premise that profit maximizing lenders do not necessarily deliver credit where the social returns are the highest. The Indiangovernment, when nationalizing all the larger Indian banks in 1969, argued that banking wasinspired by a larger social purpose and must subserve national priorities and objectives such as rapid growth in agriculture, small industry and exports.1 There is now a body of direct and indirect evidence showing that credit markets in developingcountries often fail to deliver credit where its social product might be the highest, and bothagriculture and small industry are often mentioned as sectors that do not get their fair share ofcredit. If nationalization succeeds in pushing credit into these sectors, as the Indian government claimed it would, it could indeed raise both equity and efficiency. The cross-country evidence on the impact of bank nationalization is not very encouraging.

For example, La Porta et. al. find in a cross-country setting that government ownership of banks is negatively correlated with both financial development and economic growth. Theyinterpret this as support for their view, which holds that the potential benefits of public ownershipof banks, and public control over banks more generally, are swamped by the costs thatcome from the agency problems it creates: cronyism, leading to the deliberate misallocation ofcapital, bureaucratic lethargy, leading to less deliberate, but perhaps equally costly errors in theallocation of capital, as well as inefficiency in the process of mobilizing savings and transformingthem into credit.Unfortunately the interpretation of this type of cross-country analysis is never easy, and never more so than the case of something like bank nationalization, which typically occurs as part of a package of other policies. For example, Bertrand et. al. study a 1985 banking deregulation in France, which gave banks much greater freedom to compete for clients.Theyfind that deregulated banks respond more to profitability when making lending decisions. After the reform, firms that suffer a negative shock are much more likely to undertake restructurinmeasures, and there is more entry and exit in bank-dependent industries.Micro studies of the effect of bank nationalization are rare: an important exception is Mianwho examines the privatization of a large public bank in Pakistan in 1991.5 He finds that theprivatized bank does a better job both at choosing profitable clients and monitoring existingclients, than the commercial banks that remained public.Our previous paper uses micro data from a nationalized bank to evaluate the effectiveness ofthe Indian banking system in delivering credit.6 The conclusion from that paper was that the Indian financial system is characterized by under-lending in the sense that there are many firms that could earn large profits if they were given access to credit at the current market prices. This paper builds on the previous work with the aim of using that evidence and evidencefrom other research by ourselves and others, to come to an assessment of the appropriate roleof the Indian government vis a vis the banking sector. We first provide a very brief history of banking in India.

there is substantial under-lending in India. To understand what role public ownership of banksmay play in underlending, we identify differences between public and private banks in the sectoral allocation of credit between public and private banks. In particular, we focus on the question ofwhether being nationalized has made these banks more responsive to what the Indian governmentwants them to do. We report results, based on work by Cole showing that on many of the declaredobjectives of social banking, the private banks were no less responsive than the comparablenationalized banks, with the exception of agricultural lending. Finally, the last sub-section compares the performance of public and private banks as financial intermediaries and concludesthat the public banks have been less aggressive than private banks both in lending, in attractingdeposits and in setting up branches, at least since 1990.In section 4, we dig deeper into the lending processes used by the nationalized banks, in an attempt to understand under-lending. We find that official lending policy is very rigid. Moreover,loan officers do not appear to use what little flexibility they have. We argue that the evidencesuggests that bankers in the public sector have a preference for what we may call passive lending. To understand why this is the case, we examine the incentives and constraints faced by publicloan officers. We focus on whether vigilance activity impedes lending, and whether public sectorbanks prefer to lend to the government, rather than private firms. The penultimate section compares the performance of public and private banking in twoother areas. First, we examine how nationalization of banks has affected the availability of bankbranches in rural areas, and find that, if anything, nationalization appears to have inhibited the growth of rural branches. Second, we try to say something about the sensitive issue of NPAsand bailouts. While the dataset we have now is sparse, it appears that the bailouts of thepublic banks have proved more expensive for the government, but once we control for differencesin size between the public and private banks, it is less clear-cut. We conclude in section 6 with a short discussion of the implications of these results for thefuture of banking reform. 2 Background

India has a long history of both public and private banking. Modern banking in India began inthe 18th century, with the founding of the English Agency House in Calcutta and Bombay. In the first half of the 19th century, three Presidency banks were founded. After the 1860 introductionof limited liability, private banks began to appear, and foreign banks entered the market. Thebeginning of the 20th century saw the introduction of joint stock banks. In 1935, the presidency banks were merged together to form the Imperial Bank of India, which was subsequently renamedthe State Bank of India. Also that year, Indias central bank, the Reserve Bank of India (RBI),began operation. Following independence, the RBI was given broad regulatory authority overcommercial banks in India. In 1959, the State Bank of India acquired the state-owned banks ofeight former princely states. Thus, by July 1969, approximately 31 percent of scheduled bankbranches throughout India were government controlled, as part of the State Bank of India. The post-war development strategy was in many ways a socialist one, and the Indian government felt that banks in private hands did not lend enough to those who needed it most. InJuly 1969, the government nationalized all banks whose nationwide deposits were greater thanRs. 500 million, resulting in the nationalization of 54 percent more of the branches in India,and bringing the total number of branches under government control to 84 percent. Prakesh Tandon, a former chairman of the Punjab National Bank (nationalized in 1969) describes the rationale for nationalization as follows: Many bank failures and crises over two centuries, and the damage they did underlaissez faire conditions; the needs of planned growth and equitable distribution ofcredit, which in privately owned banks was concentrated mainly on the controllingindustrial houses and influential borrowers; the needs of growing small scale industryand farming regarding finance, equipment and inputs; from all these there emerged an inexorable demand for banking legislation, some government control and a centralbanking authority, adding up, in the final analysis, to social control and nationalization. After nationalization, the breadth and scope of the Indian banking sector expanded at a rateperhaps unmatched by any other country. Indian

banking has been remarkably successful atachieving mass participation. Between the time of the 1969 nationalizations and the present, over 58,000 bank branches were opened in India; these new branches, as of March 2003, hadmobilized over 9 trillion Rupees in deposits, which represent the overwhelming majority ofdeposits in Indian banks.9. This rapid expansion is attributable to a policy which requiredbanks to open four branches in unbanked locations for every branch opened in banked locations. Between 1969 and 1980, the number of private branches grew more quickly than public banks,and on April 1, 1980, they accounted for approximately 17.5 percent of bank branches in India. In April of 1980, the government undertook a second round of nationalization, placing undergovernment control the six private banks whose nationwide deposits were above Rs. 2 billion,or a further 8 percent of bank branches, leaving approximately 10percent of bank branches inprivate hands. The share of private bank branches stayed fairly constant between 1980 to 2000.Nationalized banks remained corporate entities, retaining most of their staff, with the exception of the board of directors, who were replaced by appointees of the central government. The political appointments included representatives from the government, industry, agriculture,as well as the public. (Equity holders in the national bank were reimbursed at approximately par).Since 1980, has been no further nationalization, and indeed the trend appears to be reversingitself, as nationalized banks are issuing shares to the public, in what amounts to a step towardsprivatization. The considerable accomplishments of the Indian banking sector notwithstanding,advocates for privatization argue that privatization will lead to several substantial improvements. Recently, the Indian banking sector has witnessed the introduction of several new privatebanks, either newly founded, or created by previously extant financial institutions. The newprivate banks have grown quickly in the past few years, and one has grown to be the secondlargest bank in India. India has also seen the entry of over two dozen foreign banks since thecommencement of financial reforms. While we believe both of thesetypes of banks deserve study,our focus here is

on the older private sector, and nationalized banks, since they represent theoverwhelming majority of banking activity in India. The Indian banking sector has historically suffered from high intermediation costs, due inno small part to the staffing at public sector banks: as of March 2002, there were 1.17 crores ofdeposits per employee in nationalized banks, compared to 2.05 crores per employee in privatesector banks. As with other government-run enterprises, corruption is a problem for public sectorbanks: in 1999, there were 1,916 cases which attracted attention from the Central VigilanceCommission. While not all of these represent crimes, the investigations themselves may have aharmful effect, if bank officers fear that approving any risky loan will inevitably lead to scrutiny.Advocates for privatization also criticize public sector banking as unresponsive to credit needs. In the rest of the paper, we use recent evidence on banking in India to shed light on therelative costs and benefits of nationalized banks. Throughout this exercise, it is important to bearin mind that the Indian banking sector is going through something like a transformation. Thus, it is potentially a dangerous time to evaluate its performance using historical data. Nevertheless, data from the past is all we have, and we believe things are not changing so quickly that the lessons learned are not useful. 3 Quality of Intermediation 3.1 Is there under-lending? 3.1.1 Identifying under-lending A firm is getting too little credit if the marginal product of capital in the firm is higher than therate of interest the firm is paying on its marginal rupee of borrowing. Under-lending therefore isa characteristic of the entire financial system: the firm has not been able to raise enough capitalfrom the market as a whole. In other words, while we will focus on the clients of a public sectorbank, if these firms are getting too little credit from that bank, they should in theory have theoption of going elsewhere for more credit. If they do not or cannot exercise this option, the market cannot be doing what, in its idealized form, we would have expected it to do. However, we know that the Indian financial system does not function as the ideal credit

market might. Most small or medium firms have a relationship with one bank, which they havebuilt up over some timethey cannot expect to walk into another bank and get as much creditas they want. For that reason, their ability to finance investments they need to make does depend on the willingness of that one bank to finance them. In this sense the results we report below might very well reflect the specificities of the public sector banks, or even the one bankthat was kind enough to share its data with us, though given that it is seen as one of the bestpublic sector banks, it seems unlikely that we would find much better results in other banks in its category. On the other hand we do not have comparable data from any private bank andtherefore cannot tell whether under-lending is as much of a problem for private banks. We will,however, later report some results on the relative performance of public and private banks in terms of overall credit deliveryOur identification of credit constrained firms is based on the following simple observation: if a firm that is not credit constrained is offered some extra credit at a rate below what it ispaying on the market, then the best way to make use of the new loan must be to pay down thefirms current market borrowing, rather than to invest more. This is because, by the definition of not being credit constrained, any additional investment will drive the marginal product ofcapital below what the firm is paying on its market borrowing. It follows that a firm that isnot facing any credit constraint will expand its investment in response to additional subsidized credit becoming available, only if it has no more market borrowing. By contrast, a firm that iscredit constrained will always expand its investment to some extent.A corollary to this prediction is that for unconstrained firms, growth in revenue should be slower than the growth in subsidized credit. This is a direct consequence of the fact that firmsare substituting subsidized credit for market borrowing. Therefore, if we do not see a gap inthese growth rates, the firm must be credit constrained. Of course, revenue could increase slowerthan credit even for non-constrained firms, if the technology has declining marginal return tocapital. These predictions are more robust than the traditional way of measuring credit constraintsas the excess sensitivity of investment to cash flow.

The evidence for under-lending Data: The data we use were obtained from one of the better-performing Indian public sectorbanks. We use data from the loan folders maintained by the bank on profit, sales, credit linesand utilization, and interest rates. The loan folders also report all numbers that the banker was required to calculate (e.g. his projection of the banks future turnover, his calculation of thebanks credit needs, etc.) in order to determine the amount to be lent. We also record these, and will make use of them in the analysis described in the next section. We have data on 253firms (including 93 newly eligible firms). The data is available for the entire 1997 to 1999 periodfor 175 of these firms. Specification Through much of this section we will estimate an equation of the form yit yit1 = yBIGi + yPOSTt + yBIGi POSTt + yit, (1) with y taking the role of the various outcomes of interest (credit, revenue, profits, etc.) and thedummy POST representing the post January 1998 period. We are in effect comparing how theoutcomes change for the big firms after 1998, with how they change for the small firms. Sincey is always a growth rate, this is, in effect, a triple differencewe can allow small firms and bigfirms to have different rates of growth, and the rate of growth to differ from year to year, butwe assume that there would have been no differential changes in the rate of growth of small and large firms in 1998, absent the change in the priority sector regulation. Using, respectively, the log of the credit limit and the log of next years sales (or profit) inplace of y in equation 1, we obtain the first stage and the reduced form of a regression of sales on credit, using the interaction BIG POST as an instrument for credit. We will present the corresponding instrumental variable regressions. Results: The change in the regulation certainly had an impact on who got priority sector credit. The credit limit granted to firms below Rs. 6.5 million in plant and machinery (henceforth, small firms) grew by 11.1 percent during 1997, while that granted to firms between Rs.6.5 million and Rs. 30 million (henceforth, big firms), grew by 5.4 percent. In 1998, after the change

in rules, small firms had 7.6 percent growth while the big firms had 11.3 percent growth.

Bank Ownership and Sectoral Allocation of Credit As mentioned above, an important rationale for the Indian bank nationalizations was to direct credit towards sectors the government thought were underserved, including small scale industry, as well as agriculture and backward areas. Ownership was not the only means of directing credit: the Reserve Bank of India issued guidelines in 1974, indicating that both public and private sector banks must provide at least one-third of their aggregate advances to the priority sector by March 1979. In 1980, it was announced that this quota would be increased to 40 percent by March 1985. Sub-targets were also specified for lending to agriculture and weaker sectors within the priority sector. Since public and private banks faced the same regulation, in this section we focus on how ownership affected credit allocation. The comparison of nationalized and private banks is never easy: banks that fail are often merged with healthy nationalized banks, which makes the comparison of nationalized banks and non-nationalized banks close to meaningless. Bank Ownership and the Quality of Intermediation Limitations on Public Sector Banks Official Lending Policies While public sector banks in India are nominally independent entities, they are subject tointense regulation by the Reserve Bank of India (RBI). This includes rules about how much abank should lend to individual borrowersthe so-called maximum permissible bank finance.

Until 1997, the rule was based on the working capital gap, defined as the difference between thecurrent assets of the firm and its total current liabilities excluding bank finance (other currentliabilities). The presumption is that the current assets are illiquid in the very short run andtherefore the firm needs to finance them. Trade credit is one source of finance, and what thefirm cannot finance in this way constitutes the working capital gap.Firms were supposed to cover a part of this financing need, corresponding to no less than 25percent of the current assets, from equity. The maximum permissible bank finance under this method was thus: 0.75 CURRENT ASSETS OTHER CURRENT LIABILITIES (5) The sum of all loans from the banking system was supposed not to exceed this amount. This definition of the maximum permissible bank finance applied to loans above Rs. 20million. For loans below Rs.20 million, banks were supposed to calculate the limit based on the projected turnover of the firm. Projected turnover was to be determined by a loan officer inconsultation with the client. The firms financing need was estimated to be 25 percent of theprojected turnover and the bank was allowed to finance up to 80 percent of what the firm needs, i.e. up to 20 percent of the firms projected turnover. The rest, amounting to at least 5 percentof the projected turnover has again to be financed by long term resources available to the firm.In the middle of 1997, following the recommendation of the committee on financing of thesmall scale industries (the Nayak committee), the RBI decided to give each bank the flexibility Nayak committee recommended that the turnover rule be used to calculate the lending limit for all loans under Rs. 40 millions. Given the freedom to choose the rule, different banks went for slightly different strategies. The bank we studied adopted a policy which was, in effect, a mix between the now recommendedturnover-based rule and the older rule based on the firms asset position. First the limit onturnover basis was calculated as: min(0.20 Projected turnover, 0.25 Projected turnover available margin) (6)

The available margin here is the financing available to the firm from long term sources (suchas equity), and is calculated as Current Assets Current Liabilities from the current balance sheet. In other words the presumption is that the firm has somehow managed to finance thisgap in the current period and therefore should be able to do so in the future. Therefore the bank only needs to finance the remaining amount. Note that if the firm had previously managed toget the bank to follow the turnover based rule exactly, its available margin would be precisely 5percent of turnover and the two amounts in 6 would be equal. The rule did not stop here. For all loans below Rs 40 million (all the loans in our sampleare below 40 million), the loan officer was supposed to use both equation 6 and the older rulerepresented by 5. The largest permissible limit on the loan was the maximum of these twonumbers. Two comments about the nature of this rule are in order. First, this turnover based approachto working capital finance is relatively standard even in the USA. However the view in the USAis that working capital finance is essentially financing inventories and is therefore backed by thevalue of the inventories. In India, the inventories do not seem to provide adequate security, asevidenced by the high rates of default. In such cases it may be much more important to payattention to profitability, since profitable companies are less likely default. Second, in the USAthe role of finding promising firms and promoting them is carried out, to a significant extent, byventure capitalists. In India the venture capital industry is still nascent and it will be a whilebefore it can play the role that we expect of its US equivalent. Therefore banks may have to bemore pro-active in promoting promising firms. Following a rule that doesnot put any weighton profits may not be the way to favor the most promising firms: while the projected turnovercalculation does favor faster growing firms, the loan officer is not allowed to project a growth rate greater than 15 percent. This may be enough to meet the needs of a mature firm, but asmall firm that is growing fast clearly needs much more than 15 percent. It is important thatthe rules encourage the loan officers to lend more to companies on the basis of promise. TheFutureofBankingReform

When we take this evidence together, where does it leave us? There are obvious problems withthe Indian banking sector, ranging from underlending to unsecured lending, which we havediscussed at some length. There is now a greater awareness of these problems in the Indian government and a willingness to do something about them. One policy option that is being discussed is privatization. The evidence from Cole, discussedabove, suggests that privatization would lead to an infusion of dynamism in to the bankingsector: private banks have been growing faster than comparable public banks in terms of credit, deposits and number of branches, including rural branches, though it should be noted that inour empirical analysis, the comparison group of private banks were the relatively small old private banks.48 It is not clear that we can extrapolate from this to whatwe could expectwhen the State Bank of India, which is more than an order of magnitude greater in size than the largest old private sector banks. The new private banks are bigger and in some ways would have been a better group to compare with. However while this group is also growing very fast, they have been favored by regulators in some specific ways, which, combined with their relatively short track record, makes the comparison difficult. Privatization will also free the loan officers from the fear of the CVC and make them somewhat more willing to lend aggressively where the prospects are good, though, as will be discussed later, better regulation of public banks may also achieve similar goals. Historically, a crucial difference between public and private sector banks has been their willingness to lend to the priority sector. The recent broadening of the definition of priority sector has mechanically increased the share of credit from both public and private sector banks that qualify as priority sector. The share of priority sector lending from public sector banks was 42.5 percent in 2003, up from 36.6 percent in 1995. Private sector lending has shown a similar

increase from its 1995 level of 30 percent. In 2003 it may have surpassed for the first time ever public sector banks, with a share of net bank credit to the priority sector at 44.4 percent to the priority sector.49 Still, there are substantial differences between the public and private sector banks. Most notable is the consistent failure of private sector banks to meet the agricultural lending subtarget, though they also lend substantially less in rural areas. Our evidence suggests that privatization will make it harder for the government to get the private banks to comply with what it wants them to do. However it is not clear that this reflects the greater sensitivity of the public banks to this particular social goal. It could also be that credit to agriculture, being particularly politically salient, is the one place where the nationalized banks are subject to political pressures to make imprudent loans. Finally, one potential disadvantage of privatization comes from the risk of bank failure. In the past there have been cases where the owner of the private bank stripped its assets, and declared that it cannot honor its deposit liabilities. The government is, understandably, reluctant to let banks fail, since one of the achievements of the last forty years has been to persuade people that their money is safe in the banks. Therefore, it has tended to take over the failed bank, with the resultant pressure on the fiscal deficit. Of course, this is in part a result of poor regulationthe regulator should be able to spot a private bank that is stripping its assets. Better enforced prudential regulations would considerably strengthen the case for privatization.

On the other hand, public banks have also been failingthe problem seems to be part corruption and part inertia/laziness on the part of the lenders. As we saw above, the cost of bailing out the public banks may well be larger (appropriately scaled) than the total losses incurred from every bank failure since 1969. 49All numbers are from various issues of Report on Trends and Progress of banking in India. 39 Once again the fact that the new private banks pose a problem: So far none of them have defaulted, but they are also new, and as a result, have not yet had to deal with the slow decline of once successful companies, which is one of the main sources of the accumulation of bad debt on the books of the public banks. On balance, we feel the evidence argues, albeit quite tentatively, for privatizing the nationalized banks, combined with tighter prudential regulations. On the other hand we see no obvious case for abandoning the social aspect of banking. Indeed there is a natural complementarity between reinforcing the priority sector regulations (for example, by insisting that private banks lend more to agriculture) and privatization, since with a privatized banking sector it is less likely that the directed loans will get redirected based on political expediency. However there is no reason to expect miracles from the privatized banks. For a variety of reasons including financial stability, the natural tendency of banks, public or private, the world over, is towards consolidation and the formation of fewer, bigger banks. As banks become larger, they almost inevitably become more bureaucratic, because most lending decisions in big banks,

by the very fact of the bank being big, must be taken by people who have no direct financial stake in the loan. Being bureaucratic means limiting the amount of discretion the loan officers can exercise and using rules, rather human judgment wherever possible, much as is currently done in Indian nationalized banks. Berger et al. have argued in the context of the US that this leads bigger banks to shy away from lending to the smaller firms.50 Our presumption is that this process of consolidation and an increased focus on lending to corporate and other larger firms is what will happen in India, with or without privatization, though in the short run, the entry of a number of newly privatized banks should increase competition for clients, which ought to help the smaller firms. In the end the key to banking reform may lie in the internal bureaucratic reform of banks, both private and public. In part this is already happening as many of the newer private banks (like HDFC, ICICI) try to reach beyond their traditional clients in the housing, consumer financeand blue-chip sectors. This will require a set of smaller step reforms, designed to affect the incentives of banker in private and public banks. A first step would be to make lending rulesmore responsive to current profits and projections of future profits. This may be a way to both target better andguard against potential NPAs, largely because poor profitability seems to be a good predictor offuture default. It is clear however that choosing the right way to include profits in the lendingdecision will not be easy. On one side there is the danger that unprofitable companies default.On the other side, there is the danger of pushing a company into default by cutting its access tocredit exactly when it needs it the most, i.e. right after a shock to demand or costs has pushedit into the red. Perhaps one way to balance these objectives would be to create three categoriesof firms: (1) Profitable to highly profitable firms. Within this category lending should respondto profitability, with more profitable firms getting a higher limit,

even if they look similar on theother measures. (2) Marginally profitable to loss-making firms that used to be highly profitablein the recent past but have been hit by a temporary shock (e.g. an increase in the price of cottonbecause of crop failures, etc.). For these firms the existing rules for lending might work well.(3) Marginally profitable to loss-making firms that have been that way for a long time or havejust been hit by a permanent shock (e.g., the removal of tariffs protecting firms producing in anindustry in which the Chinese have a huge cost advantage). For these firms, there should be anattempt to discontinue lending, based on some clearly worked out exit strategy (it is importantthat the borrowers be offered enough of the pie that they feel that theywill be better off byexiting without defaulting on the loans).Of course it is not always going to be easy to distinguish permanent shocks from the temporary.In particular, what should we make of the firm that claims that it has put in placestrategies that help it survive the shock of Chinese competition, but that they will only work ina couple of years? The best rule may be to use the information in profitsand costs over several years, and the experience of the industry as a whole.One constraint on moving to a rule of this type is that it puts more weight on the judgmentof the loan officer. The loan officer would now have to also judge whether the profitability of acompany (or the lack of it) is permanent or temporary. This increased discretion will obviouslyincrease both the scope for corruption and the risk of being falsely accused of corruption. As wesaw above, the data is consistent with the view that the loan officers worry about the possibilityof being falsely accused of corruption and that this pushes them in the direction of avoidingtaking any decisions if they can help it. It is clear that it would be difficultto achieve better 41targeting of loans without reforming the incentives of the loanofficers.There are probably a number of steps that can go some distance towards this goal, evenwithin public banks. First, to avoid a climate of fear, there should be a clear separation betweeninvestigation of loans and investigations of loan officers. The loan should be investigated first(could the original sanction amount have made sense at the time it was given, were there obviouswarning signs, etc.) and a prima facie case that the failure of the loan could have been predicted,must be made before the authorization to start investigating the officer is given. Ideally, untilthat point the loan officer should not

know that there is an investigation. The authorization toinvestigate a loan officer should also be based on the most objective available measures of thelife-time performance of the loan officer across all the loans where hemade decisions and weight should be given both to successes and failures. A loan officer with a good track record shouldbe allowed a number of mistakes (and even suspicious looking mistakes) before he is open to investigation. Banks should also create a division, staffed by bankers with high reputations, which isallowed to make a certain amount of high risk loans. Officers posted to this division shouldbe explicitly protected from investigation for loans made while in this division. This may notbe enough, and some extra effort to reach out more effectively to the smaller and less wellestablishedfirms will probably be needed, not just on equity grounds, but also because thesefirms may have the highest returns on capital. A possible step in this direction would be toencourage established reputable firms in the corporate sector as well as multinationals to setup small specialized companies whose only job is to lend to smaller firms in a particular sector(and possibly in particular location). In other words these would be the equivalents of the manyfinance companies that do extensive lending all over India, but with links to a much biggercorporate entity and therefore creditworthiness. The banks would then lend to these entities atsome rate that would be somewhat below the cost of capital (instead of doing priority sectorlending) and these finance companies would then make loans to the firms in their domain,at a rate that is at most x per cent higher than their borrowing rates. By being small andconnected to a particular industry, these finance companies would have the ability to acquiredetailed knowledge of the firms in the industry and the incentive to make loans that wouldappear adventurous to outsiders. Finally we feel that giving banks a stronger incentive to lend by cutting the interest rate ongovernment borrowing will also help. The evidence reported above is only suggestive but it doessuggest that where lending is difficult, making lending to the government less lucrative can havea strong effect on the willingness of bankers to make loans to the private sector. Thus it is theless obviously creditworthy firms that suffer most from the high rates of government borrowing.

CONCLUSION The banking sector reforms, which were implemented as a part of overall economic reforms, witnessed the most effective and impressive changes, resulting in significant improvements within a short span. The distinctive features of the reform process may be stated thus: (i) The process of reforms has all along been pre-designed with a longterm vision. The two Committees on financial sector reforms (Narasimham Committee-I and II) have outlined a clear long-term vision for the banking segment particularly in terms of ownership of PSBs, level of competition, etc. (ii) Reform measures have been all pervasive in terms of coverage of almost all problem areas. In fact, it can be said that, it is difficult to find an area of concern in the banking sector on which there has not been a Committee or a group. (iii) Most of the reform measures before finalization or implementation were passed through a process of extensive consultation and discussion with the concerned parties. (iv) Most of the reform measures have targeted and achieved international best practices and standards in a systematic and phased manner. . (v) All the reform measures and changes have been systematically recorded and are found in the annual reports as well as in the annual publications of RBI on "Trend and Progress of Banking in India". The banking system, which was over-regulated and over administered, was freed from all restrictions and entered into an era of 95competition since 1992. The entry of modern private banks and foreignbanks enhanced competition. Deregulation of interest rates had alsointensified competition. Prudential norms relating to income recognition,asset classification, provisioning and capital adequacy have led to theimprovement of financial health of banks. Consequent upon prudentialnorms the most visible structural change has been improvement in thequality of assets. Further, there has been considerable improvement in theprofitability of banking system. The net profits of SCBs, which were negativein 1992-93, become positive in

1994-95 and stood at Rs. 17,077.07 Croreby March 2003. The profitability of the Indian Banking System wasreasonably in line with International experience. It may be pointed out that the banking sector reform is certainly not a one-time affair. It has evolutionary elements and follows a progression of being and becoming. Form this point, Indian experience of restructuring banking sector has been reasonably a successful one. There was no majorbanking crisis and the reform measures were implemented successfully since 1992. Some expressed the fear that the reforms will sound a blow tosocial banking. The Government did not accept the Narasimham Committee-I recommendation that advances to priority sector should be brought down from 40 per cent to 10 per cent. The Banks continued to bedirected to lend a minimum of 18 per cent of total banks credit toagriculturesector. References Banerjee, Abhijit, 2003. Contracting Constraints, Credit Markets, and Economic Development. in M. Dewatripoint, L. Hansen and S. Turnovsky, eds. Advances in Economics and Econometrics: Theory and Applications, Eight World Congress of the Econometric Society, Volume III. Cambridge University Press.