UNIT 20 FINANCIAL SECTOR REFORMS

Objectives
The objectives of this unit are to help you:

understand the nature and use of money;

understand the role played by finance in an economy;

examine the Indian financial system; and

analyse the significance and need for financial reforms

Structure
20.1

Introduction

20.2

Basic Functions of Money

20.3

Indian Financial System

20.4

Financial Sector Reforms

20.5

Summary

20.6

Key Words

20.7

Self Assessment Questions

20.8

Further Readings

20.1 INTRODUCTION
Indias financial system has vast geographical and functional reach, capacity to
mobilize savings, institutional diversity, and large trained manpower. However,
over time, the system has developed weaknesses due to state ownership of
banks and insurance companies, its rapid expansion, externally induced
constraints on bank profitability, an over-regulated interest rate regime, and
internal organizational deficiencies.
Profitability in the banking sector has been very low and some banks have
become financially weak. The reform of the banking sector has only addressed
these problems partially. It has however sought to develop the money market as
well as a secondary market in long-term government debt. Very high statutory
liquidity requirements through which banks are compelled to invest in
government securities have been reduced. Indian banks must maintain 25% of
their demand and time deposits in government securities. Government paper
now carries market-clearing rates. There is only one ceiling rate on term
deposits prescribed by the RBI. Interest rates on money market instruments
have been freed. With government securities now carrying market rates, the
basic requirement for developing a secondary market in such paper has been
met. Institutions and fora have been created to help develop trade in money
and long-term debt markets. To improve the working of banks, a strong
prudential regime regarding capital adequacy, income recognition, loan-loss
provisions and transparency of accounts has been established. Profitable banks
have been permitted to access the capital market to augment their capital.
Commercial banks are increasingly entering new businesses such as merchant
banking, underwriting, mutual funds and leasing, usually through subsidiaries.
Efforts are on for expediting computerization of bank operations. To enhance
competition, many new private sector banks, including some more foreign banks,
have been allowed entry into the market. RBIs supervision over commercial
banks and other financial institutions including non-bank financial companies has
been strengthened. One of the critical areas where banking sector reforms
have not progressed relates to government control over public sector banks.

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Economic Reforms Since

1991

Public sector ownership imposes several constraints including limitations in

methods of recruitment and promotion and restrictions on the salaries they can
pay. Public sector banks are also burdened by standards of public
accountability, which may be inconsistent with the degree of flexibility needed
for commercial decision-making. The Committee on Banking Sector Reforms
has recommended that the governments equity holding should be reduced to 33
percent. However, no action on this recommendation has been taken so far.
Over the last two decades, the capital market has grown phenomenally in
terms of capital raised, listed companies, trading volumes, market capitalization,
and investor base. The number and diversity of market intermediaries merchant banks, underwriters, custodians, share registrars and transfer agents,
mutual fund, rating agencies etc. - have grown rapidly. There are 23 stock
exchanges. The Over-the Counter Exchange of India (OTCEI) and the
National Exchange have screen based trading and are developing a nationwide
reach. The capital market has been liberalized. Corporates are now free to
issue capital and price their issues. FIIs (about 280 in number) have been
permitted to invest in the Indian market and about 80 of them are quite active.
Many Indian companies are accessing foreign markets for raising equity and
debt finance. The regulation of the primary and stock markets as well as of
stock exchanges and market intermediaries has been strengthened through the
establishment of the Securities and Exchange Board of India (SEBI). SEBI is
trying to control insider trading, regulate large acquisition of shares, and improve
the trading practices in stock exchanges. It has been able to revamp the
governing boards of stock exchanges, which were predominantly the domain of
the broker community.
Though the primary market has grown dramatically, the stock market
infrastructure, practices and procedures are relatively inadequate and slow.
Many market intermediaries also lack sufficient capacity to handle growing
business and paper work. Share transfers take considerable time. A major
challenge is to expand the market infrastructures, upgrade technology, and
establish institutions and practices for reducing paper work and delays. Apart
from the National Exchange and OTCEI, the Bombay Stock Exchange too has
screen based trading. Measures are also underway to improve clearing and
settlement procedures and to establish a national depository system with a view
to moving towards scrip less trading in due course. This would require several
changes in existing laws. Though it will take considerable time to achieve a
desirable level of reform of the financial sector, some progress has been made.
Based on the recommendations of the Committee on Reform of the Insurance
Sector, the government has opened up the insurance industry to domestic and
foreign companies with a view to introduce competition in insurance industry,
which, for some decades, had been a government monopoly.
The fundamental function of any monetary and financial system, no matter how
simple or complex, is to promote efficiency in the process of exchange or trade
in real goods and services, and thus to contribute to economic welfare. This
statement suggests several related questions. In what ways is the exchange of
real goods and services beneficial? How do money and finance promote
efficiency in trade? What is meant by efficiency in this context?
Let us take the last question first. There are two types of efficiency:
(a) transactions or operational efficiency, and (b) allocational efficiency.

50

Transactions, or operational efficiency, refers to economizing on the use of

scarce real resources in carrying out the exchange process. The exchange
process is not costless in real terms. It requires the time and energy of
traders themselves, the services of brokers and others, materials and supplies,
and the land and equipment to perform the required functions of gathering and

analyzing information concerning trade opportunities, consummating trade

transactions and setting trade accounts. Obviously, scarce resources used to
effect transactions are not available to satisfy other wants. Also, high costs
reflecting inefficiencies in transactions usually lead to a sacrifice of some
allocational efficiency. Allocational efficiency is the degree to which potential
gains from trade are exploited. Complete allocational efficiency would mean
that all opportunities for potential gains from trade are exploited; and no
opportunities remain unexploited so that at least one party feels better off
without making the other feel worse off. In economics, you would recall
(refer to unit 3), this is known as pareto efficiency.

Financial Sector
Reforms

However two important questions still remain : What are the sources of
benefits from trade? In what specific ways do money and finance facilitate
transactions and operational efficiency? In this unit we take up these questions.
Further, we shall briefly examine the Indian financial system, and finally, analyse
the significance and need for financial reforms.

20.2 BASIC FUNCTIONS OF MONEY

Not even love has made so many fools of men as the pondering
over the nature of money.
W.E. Gladstone, (1844)

It was the classical economists who first attempted to provide an explanation

for the holding of cash balances by people, even though such cash balance
yielded no return as contrasted with other forms of assets. The classical
economists claimed that money was demanded by people for their transaction
needs. This is because no economic unit firm or household- enjoyed a perfect
synchronization between the seasonal pattern of flow of receipts and the flow
of expenditures. It is these discrepancies which give rise to balances that
accumulate temporarily and are used up later when the expenditures catch up.
That is, these discrepancies give rise to the need for balances to meet seasonal
excesses of expenditures over receipts. These balances are hence transaction
balances. This is precisely what the Quantity Theory of Money (QTM) implies
QTM : MV = PT
Where:
M

- quantity of money in circulation

- Velocity of money (number of times a unit of currency

exchanges hands)

- average price level of all transactions

- physical volume of transactions

The idea of QTM is that no rational person holds money idle, for it produces
nothing and thereby yields no utility.
It was in 1936-37 that John Maynard Keynes proposed the idea for the first
time that money apart from acting as a unit of account, was also a store of
wealth. This meant that there was an asset demand for money as well.
Keynes attacked the classical theory as a great abstraction from reality.
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Economic Reforms Since

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He proposed two principal purposes for holding money:

a)

As a unit of account, money facilitates exchange. In this respect it is a

matter of convenience. This give rise to the transactions demand for
money.

b)

As a store of wealth, money is held as a speculative balance. In Kenynes

own words, this balance is held partly on reasonable and partly on
instinctive grounds. Our desire to hold money as a store of wealth is a
barometer of the degree of distrust of our own calculations and
conventions concerning the future.

Thus Md = Mt (Y) + MSP (r)

Transactions demand for money, Mt, depends on the level of income, Y. Speculative
demand for money, MSP, depends on the prevailing rate of interest, r.
The relationship between the rate of interest and speculative demand for money
however need not be similar at all levels of interest rate. Below a critical
minimum rate of interest, r c, all investors would prefer to hold cash (since in
this range, the premium is too low to induce the investor to part such a
perfectly liquid asset). This range is called the liquidity trap. However at
higher rates, the high premium on assets would tempt the investor to part with
cash. And as the rate of interest rises the incentive to lend would also
increase. This is known as the famous Theory of Liquidity Preference, which
is presented graphically in Figure 20.1.
The four broad functions of money may be described briefly as follows:
I. Primary Functions
Money as a Unit of Value: The monetary unit serves as the unit in terms of
which the value of all goods and services is measured and expressed (i.e. as
rupee, or dollar, or mark, or pound sterling, or yen etc). The value of goods
and services can be expressed as a price which implies the number of
monetary units for which it will exchange. The real value of the monetary unit
is subject to fluctuation.

52

Figure 20.1 Theory of Liquidity Preferences

Money as a Medium of Exchange: Money is generally referred to as the

generalized purchasing power or as a bearer of options (since there is freedom
of choice in the use of money). This function of money is served by anything
which is generally accepted by people in exchange for goods and services. In
earlier days copper or gold coins served as money. In modern days, however,
paper currency, and cheques against commercial banks, current and savings
deposits function as the major forms of money. In the well developed financial
system credit cards have become a very important form of payment.

Financial Sector
Reforms

II. Derivative Functions

Money as a Standard of Deferred Payments: Modern economic systems
require the existence of a large volume of contracts where payment of
principal and interest on debt as future payments are in terms of monetary
units.
Money as a Store of Value: The holding of money is, in effect, the holding
of generalized purchasing power. The holder of money is aware of its universal
acceptance any time. Also, the value of money remains constant in itself over
time. Money is thereby an ideal store of value with which contingencies as well
as speculative motives may be satisfied.
Kinds of Money
1.

Ordinary money M may be narrowly defined as the sum of currency, C,

and demand deposits, DD of banks held by the public.
M = C + DD
Since other deposits of the RBI included in the measure of M are a small
proportion, they can be reasonably neglected.

2.

High-powered money H i.e., high-powered money may be defined as

money (small coins and one rupee notes) produced by RBI and the
Government of India and is held by the public and banks. H is called the
reserve money by the RBI.
H is therefore the sum of
a) currency held by the public, C
b) cash reserves of banks, R
c) other deposits of the RBI, OD

However, since OD is a small proportion, it may be left out for simplicity of

anlysis.
H = C + R
The student should note here that this empirical definition of H is from the
point of view of its users or holders and not its producers (RBI and the
government).
Let us sum up. In this section we have learned that money performs various
functions in the economy. Its basic function is to improve the efficiency of the
transaction in the process of production, consumption, saving and investment.
Money can function as a unit of value, medium of exchange, store of value or
means of deferred payment.
Ultimately, money is a liability of the monetary system. The control of money is
therefore a direct responsibility of the central bank of the economy. In India it
is the Reserve Bank of India (RBI). However, in a modern economy the

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Economic Reforms Since

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central bank can directly control only a part of money known as high-powered
money (H). There is however a stable relationship between H and money
supply in the economy.

20.3 INDIAN FINANCIAL SYSTEM

The structure of the Indian financial system may be summarised in the
following schematic representation (Figure 20.2). Broadly the Indian financial
system may be divided into organized and unorganized segments. The
organized market consists of commercial banks, development banks, cooperative banks, post-office savings bank operations, stock markets etc.
Unorganised financial market operations consist of hundis, money-lending, chit
funds etc. They operate mainly in the rural areas. However in the urban areas
also unorganized money market activities are quite significant. There is no
precise estimate of the size of the unorganized money market. It is generally
expected that the relative size of the unorganized money market transactions
would decline over time.
RESERVE BANK OF INDIA

Organised Sector

Non-Banking
Institutions

LIC

GIC

Banking
Institutions

UTI

Private
Finance
Companies

Unorganised Sector

Money
Lenders

Development
Banks

Cooperative
Banks

Indigenous
Bankers

Commercial
Banks

Figure 20.2 : Structure of Indian Financial System

As depicted in figure 20.2 the Indian financial system consists of an impressive

network of banks and financial institutions and a wide range of financial
instruments. The primary role of the RBI is to maintain a monetary equilibrium
and balance in the economy by formulating various policies from time to time
and controlling the financial instruments of the economy. The balance sheet
identity for the RBI is as follows:
Monetary liabilities (ML) + Non-Monetary liabilities (NML)
= Financial assets (FA) + other assets
If net Non-monetary liabilities (NNML) =
ML = FANML

NML other assets, then

The monetary liabilities of the RBI are also called Reserve Money. In some
text books on monetary economics it has also been referred to as high
powered money.

54

The monetary liabilities of RBI consist of currency in circulation (CUR) and

commercial banks deposits with the RBI (RES, also known as bank reserves).
As against these the financial assets of the RBI consist of RBI credit to the
government (RBCG), RBI credit to the commercial banks borrowings from the

RBI (RBCB), RBI credit to the development banks, such as National Bank for
Rural Development (NABARD), National Housing Bank etc., and net foreign
exchange assets of the RBI.

Financial Sector
Reforms

The variations in the reserve money therefore depend essentially on the RBIs
financial assets and liabilities, which in turn are influenced by the governments
fiscal policy and various other rules and regulations.
1. Net RBI Credit to the Government
As banker to the government, RBI provides credit to both the central
government and the state governments. This it does by investing in government
securities (including treasury bills of the central government) and through shortterm advances to state governments. Until recently the central government
was empowered to borrow any amount from RBI through treasury bills and
rupee securities. In recent years the government has made some restrictions
on the amount of borrowing from RBI. In the case of state governments,
however RBI had put restrictions on borrowing even earlier.
2. RBI Credit to Commercial Banks
RBI provides credit to commercial banks through loans and advances against
government securities, use of bills or promissory notes as collateral and through
purchase or discounting of internal commercial bills as well as treasury bills.
However the RBI does not regard its purchase or rediscounting of bills for
banks as a part of its credit to banks. Instead it classifies it as RBC to
whatever sector, commercial or government, which issued these bills in the first
instance.
3. RBI Credit to Development Banks
A large number of development banks had been established in the country
through the initiative and help of RBI for the provision of long and medium
term finance to industry and agriculture. RBI provides them credit by investing
in their securities and through loans. Prominent development banks created
through RBI are: Industrial Development Bank of India (IDBI), Industrial
Financial Corporation of India(IFCI) and National Bank for Agriculture and
Rural Development (NABARD).
4. Net Foreign Assets of RBI
These assets constitute foreign currency reserves of RBI and therefore
represent RBC to the foreign sector (because of the financial liabilities of the
foreign governments). Most of these assets held abroad are in the form of
foreign securities and cash balances. The RBI comes to acquire them as the
custodian of the countrys foreign exchange reserves. As the controller of all
foreign exchange transactions, whether on private or government account, it
regularly buys and sells foreign exchange against Indian currency.
5. Net Non-Monetary Liabilities of the RBI
The net RBC to the above four sectors viz, Government, commercial banks,
development banks and foreign sector, is financed by RBI partly by creating its
monetary liabilities and partly by its net non-monetary liabilities (NNML).
FA or net RBC = ML + NNML
NNML basically consists of the owned funds of RBI (capital and reserves and
accumulated contributions to the National Funds) and compulsory deposits of
the public. The larger these non-monetary resources of RBI, the lesser its
dependence upon the creation of new H (high-powered money) to finance its
credit to various sectors. Hence this factor enters with a negative sign in the
equation.

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Economic Reforms Since

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The current magnitude of different components of reserve money is shown in

Table 20.1.
Is H an Autonomous Policy Determined Variable?
In the Indian case, the monetary authority (RBI) is not autonomous of the
government. RBI is obliged to lend whatever amount the Central Government
chooses to borrow from it; even state governments can go on drawing
unauthorized overdrafts. Thus, for all practical purposes, RBI has no control
over the deficit financing of the government. The government shares the
monetary authority directly with RBI. H is not a fully policy-determined
variable, because it is the decision of both the authorities as well as the public
and the banks which lead to the generation or destruction of H. Banks and
development banks can change H within narrow limits by varying their
borrowing from RBI. The net purchases or sales of foreign exchange by the
public also change H. But despite all this, it would not be wrong to say that
because of the vast powers of monetary control enjoyed by RBI and the
government, net variations in the stock of adjusted H (or disposable H) are
directly within the close control of authorities so that the adjusted H can be
claimed to be a policycontrolled variable, though not a direct policy or control
instrument.
Table 20.1: Sources of Changes in Reserve Money
(Rs. in crores)
Indicator
Reserve Money
Broad Money
Currency with the Public
Aggregate Deposits
Net Bank Credit to Government
Bank credit to Commercial Sector
Net Foreign Exchange Assets of the
Banking Sector

2002-03

2001-02

25,196

26,608

2,14,249

1,70,536

32,932

34,251

1,81,759

1,37,716

76,214

71,763

1,29,803

62,763

82,991

51,650

Source: RBI, Report on Currency and Finance, 2001-02.

Reserve Requirements
By the technique of varying the reserve requirements the central bank at its
initiative can change the amount of cash reserves of banks and affect their
credit creating capacity. It may be applied on the aggregate outstanding
deposits or the increments after a base date or even on certain specific
categories of deposits depending mainly on the origin of deposit expansion.
Direct regulation of the liquidity of the banking system is made by the Reserve
Bank by two complementary methods: depositing in cash with Reserve Bank
of an amount equal to the percentage of deposits with each bank as prescribed
from time to time (known as cash reserve ratio or CRR), and maintenance by
the bank of a proportion of its deposit liabilities in the form of specified liquid
assets (known as the statutory liquidity ratio or SLR). As a result of the
application of reserve ratios, the free liquidity at the disposal of banks at any
time for lending would be the difference between the total deposits and the
total of the sums equivalent to the cash reserve ratio and the statutory liquidity
ratios.
Cash Reserve Ratio (CRR)

56

The RBI has been pursuing its medium-term objective of reducing the CRR to
its statutory minimum level of 3.0 percent by gradually reducing the CRR from
11.0 percent in August 1998 to 7.5% in May 2001. In October, 2001 mid-term

review the CRR of scheduled commercial banks excluding RRBs and Local
Area banks was reduced by 200 basis points to 5.5 percent of their net
demand and time liabilities (NDTL). All exemptions were withdrawn, except
inter-bank liabilities, for the computation of NDTL (for requirement of CRR)
with effect from the fortnight beginning Nov 3, 2001. In the Annual policy the
CRR was furher reduced to 5% of NDTL. The CRR would continue to be
used in both directions of liquidity management in addition to other instruments.

Financial Sector
Reforms

Liquidity Adjustment Facility (LAF)

In recent years, the thrust of monetary management has shifted towards
development of indirect instruments of monetary policy to enable the Reserve
Bank of India to transmit liquidity and interest rate signals in a flexible manner.
The LAF operated through daily repo and reverse auctions, is assigned the
objective of meeting day to day liquidity mismatches in the system but not the
funding requirements, restricting volatility in short-term money market rates and
steering these rates consistent with monetary policy objectives.
Statutory Liquidity Ratio (SLR)
The effective SLR of the scheduled commercial banks is estimated to have
fallen to 25.0 per cent of their total net demand and time liabilities (NDTL) at
end March 2002. Bank Rate has fallen to 6 percent with effect from April
2003. All these measures have generated sufficient liquidity in the system.
Bench mark rate for the Prime Lending Rates was also worked out by the
Indian Banks Association consequent on which the PLRs of various banks have
come to signal a new approach to lending rate policy of the various players in
the lending system.
Development Banks
As the name suggests, development banks are development oriented.
Development banks are specialized financial institutions which perform the twin
functions of providing medium and long term finance to private entrepreneurs
and of performing various promotional roles conducive to economic
development. They are different from commercial banks in three ways:
i)

They do not seek or accept deposits from the public

ii)

They specialize in providing medium and long-term finance (commercial

banks specialize in providing short-term finance).

iii) Their functions are confined to providing long-term finance.

The distinguishing role of development banks is the promotion of economic
development by way of providing investment and enterprise in their chosen
spheres (manufacturing, agriculture, etc). The factors which led to the growth
of development banks are the inability of the normal institutional structure to
keep pace with the requirements of funds and entrepreneurship of the growing
industrial sector.
Figure 20.3 gives a detailed structure of development banks in India. As clearly
depicted, the four main categories of development banking in India are:
a)

Industrial development banks

b)

EXIM (exportimport) bank

c)

Agricultural development banks (NABARD)

d)

Housing Development banks

Except land development banks (LDB) the rest are a post-independence

phenomenon. With a variegated structures, the development banking institutions
as a group have played a significant part in the economic development of India
via the investment market and have emerged as the backbone of the financial
system.

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Economic Reforms Since

1991

Development banks provide financial assistance to industry in the following

forms:
i)

term loans and advances

ii)

subscription to shares and debentures

iii) underwriting of new issues

iv) guarantees for term loans and deferred payments
The first two forms place funds directly in the hands of companies as
subscription to shares and debentures. The last two forms facilitate the raising
of funds from other sources.
Aggregative Role of Development Financing Institutions
Development Financing Institutions consist of Development Banks like the
IDBI, SIDBI, NABARD and the State Finance Corporations. Three of the
development financing institutions has exited from the market after the RBI
announced its policy of harmonization of the development and banking
functions. They are: ICICI with a reverse merger with its off-spring ICICI
Bank Ltd., impending merger of IFCI with the Punjab National Bank, and the
winding up of the IRBI due to its unsustainable nature. The IDBI is also
slated for conversion to a Bank and the Parliament already gave its approval.
The process is yet to commence.
The role played by development banks is of two broad types.
1. Quantitative Role
This is the part played by development banks as a constituent of the industrial
financing system in India and refers to the magnitude of funds provided by
them jointly to industrial enterprises. The magnitude of industrial financing by
these development banks has been considerable.
A. These banks have emerged as the single most important source of
institutional finance to industry and have come to occupy a pre-eminent
position in the institutional structure of the financial system. The annual
average of sanctioned assistance by all the development banks during the
three year period 1978-79 to 1980-81 touched an all time high of Rs.1808
crores. At present, as much as one-third of the gross fixed capital
formation in private industry is being contributed by development banks.
DEVELOPMENT BANKS

Housing
Development
Bank
(HDFC)

Industrial
Development
Bank

All-India

For Small-scale
Industries
(SIDBI)

State Level
(SFCs, SIDC/SIIC)

For Large Scale

Industries
(IDBI)

Exim
Bank

Agricultural
Development
Banks
(NABARD)

Local level

Primary Land Development

Banks and Branches of SLDBs

Figure 20.3 : Development Banks

58

State Land
Development
Banks (SLDBs)

B. In India, their operations have the effect of improving the allocative

efficiency of the financial system. The development banks perform the
function of being a substitute for the capital market. When industrial
enterprises are unable to raise funds from the normal channels,
development banks fill the gap as well as restore or resuscitate the capital
market.

Financial Sector
Reforms

C. As integral part of their lending operations, they thoroughly appraise

projects as regards the priority aspect, financial viability and economic
soundness and so on. The rigorous and exacting scrutiny by development
banks tones up the quality of industrial projects and enables a more
efficient use of available project resources.
D. Appraisal by the development banks is impersonal and objective. This
results in financial assistance to diverse enterprises for a wide variety of
purposes which would not otherwise have been possible. Included in this
category are; new enterprises, small or mediumsized firms, enterprises in
backward regions, and non-traditional industries.
2. Qualitative Role
Development banking in India has an overwhelmingly qualitative dimension too
in terms of the recent orientation towards promotional or innovative functions in
their operations. With the evolution of a meaningful strategy of industrial
development, a more positive role has been assigned to, and it being played by,
development banks in India since 1969-70. The essential elements of these are:
(i) development of backward regions, (ii) encouragement to a new class of
small entrepreneurs and enterprises, and (iii) rehabilitation of sick mills.
Commercial Banks
Commercial banks are the single most important source of institutional credit in
India. Figure 20.4 shows a detailed structure of commercial banks in India.
There are two essential functions which make a financial institution a bank
(i) Acceptance of cheque-able deposits from the public, and (ii) lending.
Acceptance of chequeable deposits is the most distinctive function or its
unique function. Chequeable deposits have the following features;

These are deposits of money and non-financial assets

Deposits are accepted from public at large

Deposits are repayable on demand and withdrawable by cheque

The second essential function related to the use of deposits (Lending includes
direct lending to borrowers and indirect lending through investment in open
market securities). Table 20.2 gives some selected indicators about scheduled
commercial banks.
Table 20.2: Branches of Public Sector Banks and other Commercial Banks
Bank Group
A. State Bank of India & Associates
B. Nationalised Banks
C. Regional Rural Banks
Total of Public Sector Banks (A+B+C)
D. Other Indian Scheduled Commercial Banks
E. Foreign Banks
All Scheduled Banks
F. Non-scheduled Banks
All Commercial Banks

Branches
(as on 30 th June 2001)
13416
32663
14452
60531
5206
194
65931
0
65931

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Source: Economic Survey 2001-02.

Economic Reforms Since

1991

1. Indian Banks
The bulk of the banking business in India is done by the commercial banks
owned and operated from India. Some Indian banks also operate in a few
foreign countries. The Indian banks constitute both public and private sector
banks.
Public Sector Banks
They constitute the dominant part of commercial banking in India. The public
sector banks constitute both nationalized commercial banks and regional rural
banks (RRBs). The public sector banks may also have some private by-owned
shares.
i) Nationalised Banks : Nationalisation began in 1955, when the Imperial
Bank of India was converted into SBI. In addition, this bank has seven other
state banks as its subsidiaries. By April 1980, 28 banks were nationalized in the
public sector. Together they control more than 90 per cent of bank deposits.
ii) Regional Rural Banks : Regional Rural Banks are the newest form of
banks that have been set up in the country on the sponsorship of individual
nationalized commercial banks. These were set up with the express objective of
developing the rural economy by providing credit and other facilities for
agriculture and other productive activities of all kinds in rural areas. The paid
up capital of a rural bank is Rs.25 lakhs, 50 per cent of which is contributed
by the central government, 15 per cent by the state government, and the
remaining 35 per cent by the sponsoring commercial public sector bank.
iii) Local Area Banks (LABs) : As a follow up of the Narasimham
Committee Report I, LABs were to be set up under Private or NGO
initiative. The policy had a proverbial Hamletian to be or not to be
oscillation for more than seven years. It granted three licenses one in
Karnataka, and two in Andhra Pradesh in 2000. But their functional data is not
available under separate head. It has become part of rural financial data.

2. Foreign Banks
These are banks which have been incorporated and have their head offices
outside India. They occupy a place of importance in the Indian banking
industry, especially in financing foreign trade and in the field of merchant
banking.

COMMERCIAL BANKS

Indian Banks

Private Sector
Banks

Foreign Banks

Public Sector
Banks

Nationalised Banks
(including SBI and
its 7 Associated Banks)

Regional Rural Banks &

Local Area Banks (LABs)

Figure 20.4: Commercial Banks

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Financial Sector
Reforms

3. Co-operative Banks
Co-operative banks are so called because they have been organized under the
provisions of the co-operative societies law of the states. Under the law, cooperative societies may be organized for credit or for non-credit purposes. The
co-operative banking system is much smaller than commercial banking. The
major beneficiary of co-operative banking is the agriculture sector in particular
and the rural sector in general. Despite several organizational weakness, village
level primary cooperative credit societies are best suited to the socio-economic
conditions of Indian villages.
Table 20.3: Deposits of Public Sector Banks and other Commercial Banks
(As at end March)
(Rs. in crore)
Bank Group

2002

2003

Public Sector Banks

Nationalised Banks
State Bank Group
Private Sector Banks

968623.57
617550.78
351072.79
169432.92

1079393.81
688361.12
391032.69
207173.57

Source: Report on Trend and Progress of Banking In India 2002-03.

The co-operative credit structure is represented in Figure 20.5. The arrows

denote flow of funds; the downward flow of funds is larger than the upward
flow. The State Cooperative Banks (SCBs) and Central Cooperative Banks
(CCBs) are also called the higher or central financing agencies (for the primary
societies). At the apex are the SCBs. Primary Agricultural Credit Societies
(PACS) lend to their individual borrowing members. An SCB does not lend
directly to primary societies in areas where a CCB exists and the CCB lends
only to primary societies and not to their members or other individuals (except
in a few cases). This is in the interest of functional specialization,
manageability and cost-effectiveness which is the rationale of the threetier
structure. The basic need for higher financing agencies arises because the
PACS are not able to raise enough resources or funds by way of deposits from
the public. In fact about 60 per cent of their working capital comes as loans
from the CCBs who in turn borrow about from higher financing agencies.

CO-OPERATIVE BANKS
Agricultural
Long-term Credit
(Land Development Banks)

Non-Agricultural
Short and Medium term Credit
State Co-operative Banks (SCB- State Level)

Central Co-operative Banks (CCB- District Level)

Primary Agricultural Credit Societies (PACS- Village Level)

Figure 20.5 : Co-operative Banks

Contrary to popular belief, the government is actually the net debtor to the cooperative banking system because :
i)

A large part of the governments financial assistance (about 50 per cent) in

the form of its contribution to the share capital of societies is advanced by
NABARD.

61

Economic Reforms Since

1991

ii)

The cooperative banking system (including LDBs) provides funds to the

government by way of investment in its securities. For SCBs and CCBs
such investment is required by RBI under its SLR requirement. Hence,
there is a net withdrawal of funds by the government from the cooperative banking system.

Investment Institutions
We now refer to Figure 20.2, which depicts four categories of non-banking
financial institutions or investment institutions in India, viz.
a)

UTI (Unit Trust of India)

b)

LIC (Life Insurance Corporation of India)

c)

GIC (General Insurance Corporation of India)

d)

Private Finance Companies.

The Reserve Bank of India (Amendment) Ordinance, 1997 confers wideranging powers on RBI for controlling the functioning of non-banking financial
companies. The ordinance has defined an NBFC as a financial institution,
which is a company, or a non-banking institution, and which has, as its principal
business, the receiving of deposits under any scheme or arrangement or in any
other manner, or lending in any manner. As per the ordinance, no NBFC can
commence or carry on business (a) without obtaining from RBI a certificate of
registration; and b) having net owned funds of Rs.50 lakhs or such other
amount, not exceeding Rs.200 lakhs, as RBI may specify. As the UTI has
now become a part of SEBI mutual fund discipline, its loan sanction and
disbursement functions are being eliminated, as per SEBI guidelines relating to
mutual funds.
Activity 1
Briefly explain the role played by the following institutions.
a) IDBI

.......................................................................................................
.......................................................................................................

b) PACSs .......................................................................................................
.......................................................................................................
d)

SCBs .......................................................................................................
.......................................................................................................

e)

RRBs .......................................................................................................
.......................................................................................................

f)

LIC

.......................................................................................................
.......................................................................................................

g) UTI

.......................................................................................................
.......................................................................................................

20.4 FINANCIAL SECTOR REFORMS

62

By now you are well aware that the economic reforms launched by the
Government more than a decade ago were designed to accelerate overall
growth and help India realize its full productive potential. The experience of
successful developing countries indicates that rapid growth requires a sustained
effort at mobilizing savings and resources and deploying them in ways, which
encourage efficient production. Financial sector reform thus constitutes an
important component of the programme of stablisation and structural reform.

At the outset the Government had recognised that financial sector reform was
an integral part of the new economic policy. A high level committee headed
by Mr. M.N. Narasimham was appointed to consider all relevant aspects of the
structure, organisation, functions and procedures of the financial system.
Following the committees report in November 1991, the Government embarked
on a farreaching processes of reform covering both the banking system and
the capital market. The need for a thorough going reform of the financial
system was further underscored by the now famous securities scam (or
irregularities of the banks) news of which broke out in April 1992.

Financial Sector
Reforms

A large part of the agenda for reform of the financial system relates to the
problems facing the public sector commercial banks, which have dominated
banking in India since nationalization in July 1969. The goal of nationalization
was to extend the reach of banking and financial services to all parts of the
country and to all sections of society. It also aimed at widening the net of
resources mobilization.
While there are significant achievements, they have been accompanied by
serious shortcomings as well. For instance, the quality of customer service has
not kept pace with modern standards and changing expectations. The time
taken for processing and completing banking transactions is too long. The
banks have also not kept pace with the revolutionary changes in computer and
communication technologies. This affected the speed, accuracy and of
efficiency of services and the basic integrity of banking processes such as
internal controls and inter-branch reconciliation of accounts. It also militated
against prompt decisionmaking and against improved productivity and
profitability. All these were greatly reflected in the poor financial condition of
the banks and the adverse impact it had on the economy.
The Narasimham Committee recognised the fact that the quantitative success
of the public sector banks in India was achieved at the expenses of
deterioration in qualitative factors such as profitability, efficiency and the most
important the quality of the loan portfolio which now needed to take the centre
stage. The elements of the recovery programme reiterated by the committee
are as follows:

Reduce presumption of lending capacity through staged reductions in SLR and

CRR, while moving the yield on government debt to marketrelated levels.

Stress availability rather than subsidy in provision of credit to the priority

sector, and restrict cross-subsidy only to the smaller borrowers. The goal
should be to establish incentives that induce adequate flows of credit to
priority uses, especially agriculture, without compromising on prudential and
commercial consideration.

Move to objective, internationally recognised accounting standards, with

suitable transitional provisions to give banks time to adjust. These accounting
norms will clarify and strengthen the incentives for bank managements to
exercise greater care in credit assessment and recover.

Make additional capital available from the government and the capital
markets to strengthen banks financial position and provide a basis for future
growth. Provision of capital by the government will be conditional on
monitorable improvements in the management and recovery performance of
each bank. Access to the markets will impose the additional discipline of
prospectus registration or assessment by credit rating agencies and
accountability to non-governmental shareholders.
63

Economic Reforms Since

1991

Improve prospects for recovery by setting up special recovery tribunals in

major metropolitan areas.

Set up a credit information database for exchange of information on the

credit history of large borrowers subject to confidentiality.

Upgrade the caliber of appointees to board level posts, stressing longevity

and security of tenure.

Enhance managerial accountability and stress performancerelated

promotion.

Encourage technological modernization in banks through computerization and

greater labour flexibility.

Encourage greater competition for public sector banks through the

controlled entry of modern, professional private sector banks including
foreign banks.

Create a new board for financial supervision to devote exclusive attention to

issues of compliance and supervision and review the Banking Regulation
Act.

Ensure viable mechanisms for supply of credit to the rural sector, smallscale industry and weaker sections.

The steadfast pursuit of this agenda promised to transform Indian banking and
the public sector banks in particular (By June 1996 the following targets had to
be attained).
a)

all public sector banks achieving 8 percent capital to riskassets ratio

b)

half the public sector banks (weighted by deposits) should be quoted on the
stock market with appropriate representation of shareholders on bank
boards.

c)

significant entry of new private sector banks

d)

SLR and CRR appreciably reduced

e)

interest rates deregulated

f)

at least 500 branches of public sector banks would be fully computerized.

Capital Market Reforms

The Securities Exchange Board of India (SEBI) has been issuing guidelines
from time to time for establishing a fair and transparent capital market. Some
of the major measures announced by SEBI are briefly enumerated below:

64

In October 1993, regulations for underwriters of capital issues and capital

adequacy norms for the stock brokers in the stock exchanges were
announced.

As per modified guidelines, bonus issues can be made out of free reserves
built out of the genuine profits or share premium collected and the interest
of holders of fully or partly convertible debentures will have to be taken into
account while issuing bonus shares.

The stock exchanges have been directed to broadbase their governing

boards and change the composition of their arbitration, default and
disciplinary committees.

SEBI notified regulations for bankers to issues in July 1994. The

regulations make registration of bankers to issues with SEBI compulsory.
It stipulates the general obligations and responsibilities of the bankers to
issues and contains a code of conduct. Under the regulations, inspection of
bankers to an issue will be done by the Reserve Bank on request from
SEBI.

RBI has liberalized the investment norms evolved for NRIs by allowing
companies to accept capital contributions and issue shares or debentures to
NRIs or overseas corporate bodies without prior permission.

The government has allowed foreign institutional investors (FIIs) such as

pension funds, mutual funds, investment trusts, asset or portfolio
management companies etc. to invest in the Indian Capital market provided
they register with SEBI.

SEBI has made it compulsory for credit rating of debentures and bonds of
more than 18 months maturity.

The maximum debt-equity ratio of banks is 2:1 and the minimum debt
service coverage ratio required is 1:2.

Financial Sector
Reforms

Reductions in Statutory Liquidity Ratio (SLR) and

Cash Reserve Ratio (CRR)
According to the Narasimham Committee, one of the problems facing our
banking system was that the levels of SLR and CRR had been
progressively increased over the past several years. In the case of SLR this
happened because of the desire to mobilize even larger resources through
so-called market borrowing (at below-market rates) in support of the central
and state budgets. In the case of the CRR this happened because of the
need to counter the expansionary impact on money supply of large budget
deficits. Together the SLR and CRR stipulations preempted a large part of
bank resources into low income earning assets thus reducing bank
profitability and pressurising banks to charge high interest on their
commercial advances. The high SLR and CRR were in effect a tax on
financial savings in the banking system and served to encourage flows in
the market where this tax did not apply. The Government therefore decided
to (and has) reduced SLR in stages over a three year period from 38.5 per
cent to 25 per cent and that of CRR over a forty-year period to a level of
10 per cent.
Reforms in Development Banking Sector
The Narasimham Committee recognized that the development financial
institutions operation in India was marked by the total absence of competition
in the matter of provision of loans and medium-term finances. The system
had evolved into a segmentation of business between DFIs and the banks, the
latter concentrating on working capital finance and the former on investment
finance. Borrowers as a consequence had no choice in selecting an
institution to finance their projects. The committee suggested delinking of
these institutions from the state governments for better efficiency. The
operations of the DFIs in respect of loan sanctions should be the sole
responsibility of the institutions themselves based on a professional appraisal
of projects. The Government also embarked on a process of disinvestments
in some of the bigger institutions like IDBI etc.

65

Economic Reforms Since

1991

Activity 2
Discuss with some people having relevant knowledge/expertise and find out if
the proposed reforms have actually been worked out successfully in the
following sectors. Give examples.
a) Commercial Banks
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
b) Development Financing Institutions
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
c)

Capital Market
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

d)

CRR and SLR

.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

20.5 SUMMARY
Let us summarise the main points of the unit.

66

The fundamental function of any monetary and financial system is to

promote efficiency in the processes of exchange

The four broad functions of money are to act as

-

a unit of account

a medium of exchange

a standard of deferred payments

a store of wealth

The Reserve Bank of India is the apex institution of the Indian financial
system. It regulates and controls, by means of laws, financial instruments,
etc., the working of a vast network of financial institutions under it, directly
or indirectly.

The monetary liabilities of the RBI are called the Reserve Bank Money
(RBM).

RBM

Financial Sector
Reforms

(1) net RBC to the government

+ (2) RBC to development banks
+ (3) RBC to banks
+ (4) net foreign assets of RBI
+ (5) net non-monetary liabilities of RBI.

Highpowered money, H, is the money produced by RBI and the

Government of India (small coins and one rupee notes) and is held by the
public and banks. It is also called reserve money.

H is not a fully policy-determined variable. However, adjusted H can be

claimed to be a policycontrolled variable.

Development banks are specialized financial institutions, which perform the

twin functions of providing medium and long-term finance to private
entrepreneurs and of performing various promotional roles conducive to
economic development.

Commercial banks are the single largest source of institutional credit in

India.

Public sector banks constitute the dominant part of commercial banking in

India.

Cooperative banks are so called because they have been organized under
the provisions of the cooperative societies laws of the states. Despite
several weaknesses, village level PACs are best suited to the socioeconomic conditions of Indian villages.

The direct regulations of the banking system is done by the Reserve Bank
by two complementary methods:
a) depositing in cash with the Reserve Bank of an amount equal to the
percentage of deposits with each bank as prescribed from time to time
known as CRR. (Cash Reserve Ratio).
b) maintenance by the bank of a proportion of its deposit liabilities in the
form of specified liquid assets known as SLR (Statutory Liquidity
Ratio).

A high-level committee headed by Mr. M.N. Narasimhan was appointed to

consider all relevant aspects of the structuring, organisation, functioning and
procedures of the Indian financial system. The Committee placed its report
before Parliament in December, 1991.

The Committees main recommendations were:

a) Reductions in SLR and CRR.
b) Norms for income recognition, provisioning and capital adequacy.
c) Provision of balance-sheet and profit and loss accounts formats for banks.
d) Branch licensing.
e) Permission to set up new private sector banks.

67

Economic Reforms Since

1991

Along with banking system reforms, the committee also thought it

necessary for capital market reforms to be undertaken. The main features
of these reforms (as provided for in SEBI guidelines) are:
a) no promoters contribution
b) underwriting not mandatory
c) maximum debt-equity ratio 2:1 minimum debt service coverage ratio 1:2
d) credit rating compulsory for debentures and bonds of more than 18
months maturity
e) The committee also felt the need for reforms in the operations of
DFIs.

20.6 KEY WORDS

Reserve Money: A component of money supply directly controlled by RBI.
High Power Money: Money produced by RBI and the Government of India
in the form of small coins and one rupee notes which is held by the public and
banks. High power money is also called the reserve money of RBI.
Cash Reserve Ratio (CRR): The ratio of cash required to be maintained
from time to time with the RBI by the banks against their total net demand
and time liabilities (deposits).
Statutory Liquidity Ratio (SLR): The proportion of deposit liabilities to be
maintained by a bank in the form of specified liquid assets.
Investment Institutions: All institutions making investments for commercial or
industrial purposes. This includes commercial banks, development banks (or
institutions) cooperative banks and non-banking institutions including LIC, GIC,
UTI, and private finance companies.
Development Banks: Specified finance institutions performing the twin
functions of providing medium and long term finance and performing various
promotional roles for economic development of the country.
Commercial Banks: Banks accepting deposits from the public and lending
money for short term requirements of industrial and commercial enterprises.
Cooperative Banks: Banks registered under the provisions of Cooperative
Societies Act and providing credit mainly for agricultural purposes.
Public Sector Banks: Commercial banks owned and managed by the
Government (after nationalization), banks not falling in this category are called
private sector banks.
Monetary Policy: Policy of the Government concerned primarily with the
maintenance of stability in domestic prices and exchange rate stability. The
subsidiary objectives may be social justice, growth etc.

68

20.7 SELF ASSESSMENT QUESTIONS

1)

What are the functions of money. Explain briefly.

2)

What are the components of Reserve Bank Money. Explain each briefly.

3)

Briefly describe the present Indian financial system.

4)

Critically examine the recommendations of the Narasimhan Committee.

Financial Sector
Reforms

20.8 FURTHER READINGS

Economic Survey 1992-93, 1996-97 and 2003-04.
Report on Currency and Finance 1996-97 and 2002-03, RBI.
Gupta, S.B. 1995, Monetary Planning, S. Chand, Delhi.
Reserve Bank of India, Annual Report, 1993-94 and 2002-03.
Narasimham Committee Report 1991, GOI.

69

Economic Reforms Since

1991

Annexure-I

PROGRESS OF FINANCIAL SECTOR REFORMS

(till March 2000)

70

01.Banking Market

Banking industry in India in 1990 consisted of just

70 players, 27 of these were in the public sector,
24 in private and 21 are the foreign banks. Ten
years later, banking industry is vastly expanded
with the number of foreign banks nearly doubling
and ten more new banks in the private sector.
Banking industry today is intensively competitive.

02.Banking Products

At the time of reforms, most of the products

offered by banks are plain vanilla. Massive
expansion of products and services took place in
the last few years driven by rapid advances in
technology that has dramatic impact on the delivery
systems and ability to service a greater number of
products.

03.Regulation

Regulation is much more refined now. While

banks are given greater operational freedom, the
quality of regulation has heightened with stringent
norms prescribed in respect of capital adequacy,
classification of assets, provisioning, valuation of
investments etc. Regulation is evolved broadly on
the emerging international developments which
while promotes deregulation and liberation at the
same time prescribes stringent rules governing
business operations and market developments.

04.Supervision

Increase in the quality of on-site and offsite

surveillance and supervision. A new Board for
Supervision came into being which undertakes
comprehensive banking supervision on the lines of
international better practices.

05.Ownership

While public sector continues to account for a

major part of the banking, greater inroads are
made by the private sector in the form of new
banks allowed in the private sector, entry of a
large number of foreign banks, partial divestment
of the government equity in the public sector
banks, allowing the public sector banks, allowing
the public sector to dilute government equity upto
33 percent, allowing foreign direct investment in
banking etc.

Contd.

Financial Sector
Reforms

Contd.
06.Prudential Norms

International better practices covering a wide range

of banking operations and practices prescribed in
the post reforms and are being introduced gradually
in a number of areas.

07.Disclosure
Standards

The balance sheet of banks today is vastly

different from what was in the beginning of
reforms. Every year additional disclosures are
being made in the bank balance sheets providing
greater amount of information to market players
and participants.

08.Governance

A code of governance in banking is yet to be

evolved but the implementation of prudential norms
and adoption of banking standards particularly in
respect of transparency and disclosure has
significant impact on the quality of governance in
Indian banking.

09.Market Share

There are sizeable shifts in the market share of

domestic banking institutions; but there is no
perceptible increase in the share of foreign banks.
For instance in the total assets, the share of the
public sector banks has declined from 90 percent in
1990-91 to 80 percent in 1999-00, whereas that of
the private sector shot up from 3.62 percent to
12.56 percent during this period. The share of
foreign banks in assets which was 6.05 percent in
1990-91 increased to 8.08 percent in 1992-93 but
later softened to 7.30 percent in 1990-00.

10.Capital

The equity of banks made a massive jump from

Rs.3071 crores in 1990-91 to Rs.18448 crores in
1999-00. All the bank segments such as the public
sector, private sector and foreign banks showed
impressive rise in the equity levels. Reserves also
showed rapid rise in the post reform period.

11. Deposits

Total Deposits of banks showed a massive jump

from Rs.231975 crores in 1990-91 to Rs.900307
crores in 1999-00.

12.Credit

Bank advances shot up from Rs.143961 crores in

1990-91 to Rs.443661 crores in 1999-00.

13.Income

Income increased manifold from Rs.27448 crores in

1990-91 to Rs.115855 crores in 1999-00.
Contd.

71

Contd.
Economic Reforms Since
1991

72

14.Profit

Net Profit of the banking sector showed an impressive

jump from Rs.640 crores in 1990-91 in 1999-00.

15.Profitability

Net Profits as a percent of Working Funds showed a

sharp rise from 0.22 in 1990-91 to 0.66 in 1999-00.

16.Productivity

Business Per Employee registered a robust growth

from Rs.40.38 lakhs in 1990-91 to Rs.140.93 lakhs
in 1999-00.

17.Non-Interest
Income

Non-Interest Income as a percent to total income

increased from 9.85 percent in 1990-91 to about
13.70 percent in 1999-00.

18.New Business

Post reforms period in Indian banking unleased a

wide range of new products and services. Driven
by technology a number of new generation
products such as electronic fund transfers, debit
cards, smart cards, electronic clearing service, farm
and consumer credit cards etc., are introduced.
Retail banking received greatest thrust in the post
reform period. Deregulation of the insurance
sector is envisaged to lead to further proliferation
of the products.

19.Competition

Competition intensified with a larger base of

players and non-banking financial institutions
emerging stronger in a liberalized and deregulated
environment.

20.Consolidation

Evidence of consolidation is found in the private

sector with the merger of HDFC Bank and Times
Banks, ICICI Bank and Bank of Madura, UTI
Bank and Global Trust Bank (yet to be finalized)
etc. The only exercise of consolidation of the
public sector banks was at the beginning of the
reforms with merger of New Bank of India with
the Punjab National Bank. The pace of
consolidation is expected to intensify in the process
of second generation reforms.

21.Globalization

Indian banking is gearing up for absorbing the

challenges of global finance. Starting with
harmonization of the operational norms and
procedures, endeavours are being made to enhance
the quality and content of the efficiency
parameters, which is essential to withstand the
impact of global competition. The ushering in of
the second-generation reforms is envisaged to
strengthen the role and performance of Indian
banking in this regard.