Banking Sector Reforms
The Indian banking system in the pre-reform period largely operated according to the needs of mixed economy in which the public sector enjoyed a commanding role. The bank nationalization in India was geared towards meeting the unique socio-economic needs of society afflicted by widespread poverty and gross under-development. In such a framework, planned economic development involved enormous development expenditure. Such expenditure was met through the government ownership of banks, the instruments like statutory liquidity ratio (SLR) and cash reserve ratio (CRR), priority sector lending norms, administered interest rates underpinned by social concerns etc.
Areas of banking reforms in India
- Reforms were undertaken to remove the external constraints on banks like administered interest rates, high levels of reserve requirements like CRR and SLR, interest rate deregulation etc. The need for the continued relevance of the priority sector lending (PSL) norms has been subjected to continuous scrutiny and debate.
- The entry of new banks has been another area of banking sector reforms. There are guidelines stipulated by the RBI to start new banks and the entry for foreign banks have been liberalised. It is meant to increase efficiency and productivity through promoting competition in the sector. In the post-reform period many new private sector banks have been set up. Moreover, private shareholding in public sector banks has been promoted through reduction in the government shareholding in public sector banks to 51 per cent. The foreign direct investment is also permitted in private sector banks in order to increase competition and efficiency in the sector.
- Consolidation in the banking sector is another very important hallmark of the reform process through which some banks have been merged like different banks associated with the State Bank Group.
- The banking sector has undertaken wide-ranging reform measures leading to overall efficiency and stability. There has been improvement in the capital adequacy of Indian banks.
Historical Background of Banking Reforms
At the time of independence, the Indian banking system was not very sound. There were many private banks in India under faulty and exploitative managements. Hence, in 1949 two major steps were taken from the point of view of structural reforms in the banking sector: Firstly, the Banking Regulation Act, 1949 was passed. It gave wide-ranging regulatory powers to the Reserve Bank of India (RBI) over the commercial banks in India. Secondly, the Reserve Bank of India (RBI) was nationalised in 1949. These two major developments were of critical importance as far as the evolution of commercial banking in India is concerned.
Developments in the Banking Sector (1949-69)
The above two steps taken in 1949 led to the development of the banking system in multiple respects. The banking system grew in India grew in geographical, structural and functional terms. However, the number of scheduled banks was reduced from 94 to 76 over the period. There was a gradual decline in the importance of the non-scheduled commercial banks. The RBI got wide regulatory powers as a result of the enactment of the Banking Regulation Act, 1949. Hence, it became possible for the RBI to carry out various structural reforms in the banking system. The commercial banks made rapid progress in this period if the parameter of deposit mobilisation is employed. There was also an increase in the number of personal accounts relative to business accounts. The State Bank of India (SBI) was established in 1955. Later the State Bank Group was created by nationalising eight regional banks in 1960 which added another dimension to the evolution of banking in India. These banks opened new offices in semi-urban and rural areas under statutory obligation. Such local branches helped them in serving vulnerable segments of population in the hitherto under-developed and unbanked areas. The period also saw an increase in lending to industries by the commercial banks. A very significant step was taken in the form of establishment of the Deposit Insurance Corporation on 1st January, 1962. It was meant to provide some protection to the depositors. It immensely helped in mobilisation of deposits by enhancing the confidence of people in banks which was surely needed during the periods of large-scale bank failures.
Nationalisation of Banks
In a free enterprise economy, commercial banks operate like any other business and are mainly concerned with the maximisation of their private gains. They are divorced from any social purpose. They tend to divert funds to business units in which the management has its interest leading to creation of monopolies. It also led to the concentration of economic and political power. Consequently, it was also a causal factor in the adversity faced by economic activities as priority sectors and industries were not able to get adequate funds. Hence, it was felt that too much freedom was not in consonance with the spirit of socialistic developmental goals of India to create an egalitarian society. A report submitted to the Planning Commission in 1967 pointed out: “It would be difficult to undertake credit planning unless the linked control of industry and banks in the same hands is snapped by nationalisation of banks”. The government opted for social control which later paved the way for nationalisation of banks. It was on July 19, 1969 that fourteen commercial banks with deposits worth Rs 50 crore or more were nationalised. The then Prime Minister of India, Mrs. Indira Gandhi, pointed out the following objectives of such a massive change in the banking sector:
- “Removal of control by a few;
- Provision of adequate credit for agriculture and small industry and export;
- Giving a professional bent to management;
- Encouragement of a new class of entrepreneurs; and
- Provision of adequate training as well as terms of service for bank staff”.
The Underlying Rationale for Bank Nationalisation
There was the control of big business houses over commercial banks which logically resulted in concentration of wealth and economic power. The Mahalanobis Committee on the Distribution of National Income in India had exposed the nexus between the banks and the big business in a crystal clear way. Following were the broader objectives for the bank nationalisation:
- The commercial banks had a very discriminatory lending policy before nationalisation. The genuine claims of loans for the agricultural sector were always turned down on the pretext that agricultural credit did not fall within their purview.
- The commercial banks in the pre-nationalisation phase also ignored the claims of small industrialists in respect of credit. The priority sector industries became capital-starved in those times adversely impacting upon the economic development of the country.
- The earlier credit policy of the commercial banks until their nationalisation encouraged some socially undesirable activities, such as hoarding, black-marketing etc.
- Prior to their nationalisation, commercial banks had shown virtually no interest in establishing offices in semi-urban and rural areas. There was a disproportionate concentration of banks in cities. There was a lack of commercial banks in the rural areas due to lack of profitability. The Nationalisation of commercial banks was the only answer to this problem.
There was another phase of bank nationalisation. On 15th April, 1980, six more private- owned commercial banks were nationalised. Thus, we see that the nationalised banks were expected to play a dynamic and catalytic role in the economic development of the country in sync with the egalitarian ideals espoused in the Indian Constitution.
Regional Rural Banks (RRBs)
The nationalisation of major banks had many beneficial aspects but it could not remedy the problem of rural indebtedness. The countryside and ignorant villagers remained in the tight grip of money-lenders amidst the presence of an amplified level of rural indebtedness. Hence, the working group on Rural Banks chaired by M. Narasimham recommended the setting up of these banks as a part of multi-agency approach to rural credit. These banks are called regional rural banks and have been set up under an Act of 1976. A regional rural bank is sponsored by a public sector bank which also subscribes to its share capital. Assistance is also given in the form of managerial personnel. In terms of ownership, the RRBs are predominantly government undertakings. These RRBs are expected to meet the differential credit requirements of weaker sections, small and marginal farmers, landless labourers, artisans and small entrepreneurs.
Lead Bank Scheme (LBS)
The area approach in respect of bank financing was proposed by the Gadgil Study Group towards the end of 1969. It finally culminated in the Lead Bank scheme. It had the backing of the Nariman Committee also. The Governor of the Reserve Bank had appointed a Committee of Bankers under the Chairmanship of F.K.F Nariman in August 1969 to prepare a programme for creating adequate banking facilities, particularly in districts/regions where such facilities were lacking at the time of nationalisation. The Committee favoured a coordinated approach and was of the view that the banks should be allotted particular districts where they would take the lead in surveying the scope for banking development, particularly expansion of credit facilities. The Reserve Bank of India (RBI) accepted the recommendations of the Nariman Committee and prepared the “Lead Bank” scheme. Under the Lead Bank scheme districts were allotted to the State Bank Group, fourteen nationalised banks and three private Indian banks.
Key tasks undertaken by the Lead Bank
- The Lead Bank was assigned a major development responsibility in the district allotted to it.
- It was expected to familiarise itself with the socio-economic conditions prevailing in the district.
- It was supposed to undertake a survey of techno-economic nature in order to get acquainted with the problems of the district.
- From these surveys, the Lead Bank was expected to collect beneficial information about resource endowment, economic and social infrastructure, pattern of different types of production, development schemes and hindrances in the path of development.
- It had to identify prospective centres for banking development.
- After completing the surveys for all districts of the country, the district level consultative committees for coordinating banking developmental activities were constituted by the Lead Banks.
Why the Lead Bank Scheme (LBS) was not successful?
The scheme could not attain its targets due to the following flaws:
- Shift in policies and complexities in operations;
- Lack of coordination between district planning authorities and banking institutions operating in a district;
- Lack of coordination between the NABARD and the Lead Bank on the other.
- Duplication of efforts in credit plan preparation.
Gradually the scheme came on the verge of becoming inactive. The system of lead bank scheme and associated district-level coordination committees of bankers has apparently become inactive. Experts have called for undertaking drastic steps to revitalize the scheme.
Usha Thorat Committee on Lead Bank Scheme (LBS):
In 2009, Government of India constituted a High-Power Committee headed by Mrs Usha Thorat, Deputy Governor of the RBI, to suggest reforms in the LBS. The task of this penal was recommend steps to revitalize the LBS, given the challenges facing the banking sector, especially in an era of increasing privatization and autonomy. It gave the following recommendations:
- The committee recommended the enhancing of the scope of the scheme.
- It suggests a sharper focus on facilitating financial inclusion rather than going for a mere review of the government sponsored credit schemes.
- LBS should be continued to accelerate financial inclusion in the unbanked areas of the country.
- Private sector banks should be given a greater role in LBS action plans, particularly in areas of their presence.
- Enhance the business correspondent model, making banking services available in all villages having a population of above 2,000, and relaxation in KYC (know your customer) norms for small value accounts.
Thus, we see that the lead bank scheme (LBS) has a focus on financial inclusion and has a stellar role to play in this domain. It assumes enhanced significance in the light of the recent developments in the banking sector. The Usha Thorat committee favoured the further continuance and revitalization of the scheme for the sake of the financial inclusion in the country.
Narasimham Committee (I) Recommendations (1991)
India was faced with a balance of payment crisis in 1991 and hence the then P.V. Narsimha Rao government introduced major changes in economic policies through the process of economic liberalisation. Such economic policies came to be known as structural reforms. Some of the important steps undertaken were the devaluation of the Indian rupee, new EXIM Policy, new industrial Policy. In the aftermath of the reforms, the Indian economy became more free and competitive. In this context, a Committee under the chairmanship of M. Narasimham was set up by the Government of India to examine the country’s financial system and its various components and to make recommendations for reforming and improving the country’s financial sector. The report was placed before the Parliament in December 1991.
Its major recommendations were:
(a) Establishment of a four-tier hierarchy for the banking sector:
(i) 4 to 5 large commercial banks which could be of international character. One such bank is the State Bank of India;
(ii) 8 to 10 national banks having nationwide branches engaged in universal banking;
(iii) Small banks where business would be confined to specific regions; and
(iv) Rural banks whose operation would be confined to rural areas only.
(b) Abolition of branch licensing system. Banks themselves would be allowed to open or close branches.
(c) Entry of private banks, easing of restrictions on foreign banks and consequent restriction on further nationalisation of banks.
(d) Allowing nationalised banks to issue fresh capital to the public through the capital market.
(e) Phased reduction of statutory liquidity ratio (SLR) from 38.5 percent to 25 percent over 5 years; reduction of cash reserve ratio (CRR) from 15 percent to 3-5 percent over the next five years, and payment of interest on CRR to commercial banks.
(f) Phasing out of directed credit to priority sectors down to 10 percent of the aggregate bank credit.
(g) Deregulation of interest rates and bringing them on government borrowing in line with the market-determined rates.
(h) Tightening of prudential norms and strengthening of banking supervision and the issue of prudential guidelines governing the financing of financial institutions.
(i) Proper classification of assets and full disclosure and transparency of accounts of banks and other financial institutions.
(j) Attainment of a minimum 4 percent capital adequacy ratio in relation to risk weighted assets within three years.
(k) Increased competition in lending between ‘development financial institutions’ and banks.
(l) Setting up of an institution to be called Asset Reconstruction Fund with a view to taking over a portion of the loan portfolio of banks which has become bad and doubtful and whose recovery is not easy.
(m) Ending of dual control: – duality of control by RBI and Ministry of finance should be ended. Only RBI should have control over the banks.
(n) Capital market should be liberalized.
Narasimham Committee (II) Recommendations (1998):
The major recommendations of the Narasimham committee (II) on banking sector reforms are as follows:
- Need for Stronger Banking System: It had argued for a stronger banking system in country, especially in the context of capital account convertibility (CAC). This would involve large amount of inflow and outflow of capital and consequent complications for exchange rate management and domestic liquidity. To handle this India needed a strong resilient banking and financial system.
- Experiment with the Concept of Narrow Banking: It was seriously concerned with the rehabilitation of weak public sector banks which had accumulated a high percentage of Non-Performing Assets (NPAs).They suggested the concept of narrow banking to rehabilitate such weak banks.
- Small Local Banks: It had argued that “While two or three banks with an international orientation and 8 to 10 of larger banks should take care of their needs of the large and medium corporate sector ad larger of the small enterprises, there will still be a need for a large number of local banks.” The committee has suggested the setting up of small local banks which should be confined to states or clusters of districts in order to serve local trade, small industry etc.
- Capital Adequacy Ratio: It had also suggested that the government should consider raising the prescribed capital adequacy ratio to improve the inherent strength of banks and to improve their risk taking ability.
- Public Ownership and Real Autonomy: It had argued that government ownership and management of banks does not enhance autonomy and flexibility in working of public sector banks. Accordingly, the committee had recommended a review of functions of banks boards with a view to make them responsible for enhancing shareholder value through formulation of corporate strategy.
- Review And Updating Banking Laws: It had also suggested the urgent need to review and amended the provisions of RBI Act, Banking Regulation Act, State Bank of act etc so as to bring them on same line of current banking needs.
- Apart from these major recommendations, the committee has also recommended faster computerization, technology up-gradation, training of staff, depoliticizing of banks, professionalism in banking, reviewing bank recruitment etc.
Effects of these recommendations
- The Government of India has taken a slew of measures following the recommendations of the Narasimham Committee. Initially the government tried to rectify the financial repressions and undue interference into the banking system.
- There has been remarkable progress in several areas of the banking sector. There have been significant structural reforms and the capital markets became deeper and more liquid. The equity markets also underwent significant transformation.
- The norms for income recognition, classification of assets and provisioning of bad debts were introduced. These steps led to the improvement of the asset quality of banks as exemplified by the raising of capital adequacy ratio (CAR) of banks over the years. Later, it also led to improvement in the capital to risk weighted assets ratio (CRAR) which ensures that banks can absorb a reasonable level of losses. Robust level of CRAR leads to the protection of the interest of depositors and promotes stability and efficiency of the financial system.
- In the aftermath of these recommendations, there occurred a reduction in the level of NPAs consequent upon the improvement in the asset quality of banks. The setting up of the Asset Reconstruction Companies provided a great boost to banks’ efforts to recover dues from the defaulting borrowers.
- One of the significant milestones in the reform of the financial sector was the enactment of the securitisation and reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act of June 2002. This act is actually geared to “facilitate foreclosures and enforcement of securities in cases of default and to employer banks and other financial institutions to recover their dues, even without court/tribunals’ intervention”.
Thus, we see that the banking system, which was over-regulated and over administered in the pre-reform era, was freed from all restrictions and entered into an era of dynamic competition since 1992. The entry of modern private banks and foreign banks increased the level of competition. Deregulation of interest rates had also increased competition leading to the improvement of financial health of banks. Additionally, there has been a marked improvement in the profitability of banking system. Indian banking system has been made robust and there has been no major banking crisis as the reform measures were implemented successfully since 1992.
Key Recommendations of the P.J. Nayak Committee report
Public sector banks have been in under stress and are in need of complete reboot. Hence, the government set up a committee in the year 2014. The major recommendations of the P.J. Nayak Committee report are following:
(a) It called for radical reforms in the structure and governance of bank boards. It asked the government to design a radically new governance structure for public sector banks to remedy several internal weaknesses harming their competitiveness.
(b) There is a need to upgrade the quality of board deliberation in public sector banks to provide greater strategic focus on key areas like business strategy, financial reports and their integrity, risk measures, customer protection, financial inclusion and human resources.
(c) As the quality of board deliberation across firms is sensitive to the skills and independence of board members, it is imperative to upgrade these skills in boards of public sector banks by reconfiguring the entire appointments process for boards. Otherwise it is unlikely that these boards will be empowered and effective.
(d) The Government needs to move rapidly towards establishing fully empowered boards in public sector banks, solely entrusted with the governance and oversight of the management of the banks.
(e) The Government should set up a Bank Investment Company (BIC) to hold equity stakes in banks which are presently held by the Government. BIC should be incorporated under the Companies Act.
(f) While the Bank Investment Company (BIC) would be constituted as a core investment company under RBI registration and regulation, the character of its business would make it resemble a passive sovereign wealth fund for the Government's banks. The Government and BIC should sign a shareholder agreement which assures BIC of its autonomy and sets its objective in terms of financial returns from the banks it controls.
(g) The CEO of the Bank Investment Company (BIC) would be tasked with putting together the BIC staff team. BIC employees would be incentivised based on the financial returns that the banks deliver. If it requires the Government to hold less than 50 per cent of equity in BIC, the Government should consider doing so, as it will be the prime financial beneficiary of BIC’s success.
(h) The Government should cease to issue any regulatory instructions applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the sole regulator for banks, with regulations continuing to be uniformly applicable to all commercial banks.
(i) The Government should also cease to issue instructions to public sector banks in pursuit of development objectives.
(j) The transfer of the government holding in banks to the Bank Investment Company (BIC), and the transitioning of powers to bank boards with the intent of fully empowering them, needs to be implemented in phases.
(k) The Chairman and each member of Bank Board Bureau (BBB) should be given a maximum tenure of three years.
(l) It is desirable to ensure minimum five-year tenure for bank Chairman and minimum three year tenure for Executive Directors. These recommendations were really meant to cater to the overall needs of the banking systems as per the changing dynamics of a market-driven economy.
Nachiket Mor Committee Recommendations
The “Committee on Comprehensive Financial Services for Small Businesses and Low Income Households” was set up by the RBI in September 2013 under the chairmanship of Nachiket Mor, an RBI board member. Critics have termed these recommendations as too ambitious and unrealistic. However, they have sparked an informed debate on creating a modern, inclusive financial system in India. Key Recommendations: (a) To provide a universal bank account to all Indians above the age of 18 years by January 1, 2016. (b) Aadhaar will be the prime driver towards rapid expansion in the number of bank accounts. (c) Monitoring at the district level such as deposits and advances as a percentage of gross domestic product (GDP). (d) Adjusted 50 per cent priority sector lending target with adjustments for sectors and regions based on difficulty in lending. (e) Allow differentiated licensing for banks to establish new categories of banks like Payment banks.
Nachiket Mor Committee recommendations on NBFCs:
- It had argued for convergence of certain regulatory aspects between banks and non-banking financial companies (NBFCs) based on the principle of neutrality in line with the Usha Thorat Committee recommendations.
- It had argued that wide number of NBFC categories add to the complexity in the entire regulatory architecture. Further, it stressed that such complexity led “to scope for arbitrage” apart from putting obstacle in the path of robust evolution of the NBFCs.
- It also opined that there is a need to shift from entity-based regulation of NBFCs to activity-based regulation of NBFCs.
- It called for increasing the borrowing limits for an individual, income limits of borrowers, and disbursement amount for NBFC- microfinance institutions (NBFC-MFIs). The RBI has implemented this recommendation which is expected to give a boost to the microfinance industry.
- It suggested that the priority sector lending norms and the lender of last resort facility should not be made applicable to NBFCs.
- NBFCs should adopt core banking systems so as to enable better off-site supervision.
- The wholesale funding constraints faced by the NBFCs should be addressed in a systematic manner with the involvement of institutions like the RBI, SEBI, NABARD, NHB, SIDBI etc. and other related steps.
- There is a need to abandon the statutory liquidity requirement (SLR) for the NBFCs.
A Critical Appraisal of the Nachiket Mor Committee recommendations
- The RBI has been rightly emphasising the enormous benefits of financial inclusion. It has sought to bring a large number of people into the formal banking system. In this context, the Nachiket Mor committee has added another layer into the multi-dimensional efforts of the RBI to bring about financial inclusion.
- The Mor committee has also recommended that the priority sector lending mandate for banks should be raised from 40 per cent to 50 per cent. Apart from this the committee said that the banks should be freed from all pricing and other restrictions.
- The committee has emphatically argued the case of differentiated banking licences. It has proposed that three new categories of banks viz. payment, wholesale investment and wholesale consumer should be allowed. It has also called for streamlining the regulations for non-banking financial companies (NBFCs). The committee has overlooked the critical dimension of business viability of such banks.
- It has argued for two specific district-level penetration metrics viz. the credit- GDP and life cover-GDP ratios to monitor meaningful financial inclusion. This new formula is distinct from conventional practices. It is a meaningful recommendation worthy of being implemented.
Usha Thorat Committee (2011) recommendations on the NBFCs:
- NBFCs are to be classified under two categories: Exempted NBFC (based on asset size) and registered NBFCs.
- All registered NBFCs should maintain high quality liquid assets.
- Statutory Liquid Ratio (SLR) requirement for deposit taking NBFCs should continue.
- It argued for raising the provisioning for standard assets regarding the NBFCs.
- The classification of loans to NPA should be brought in line with that of banks for all registered NBFCs. It means that the criteria of 90 days should be followed for deciding NPAs in NBFCs like that of banks. It was supposed to be implemented in a phased manner.
First Tarapore Committee Report (1997)
The Committee on Capital Account Convertibility (CAC) or Tarapore Committee was constituted by the Reserve Bank of India for suggesting a roadmap on full convertibility of the rupee on Capital Account. The committee submitted its report in May 1997. The committee remarked that there was no clear definition of CAC. However, the CAC refers to “the freedom to convert the local financial assets into foreign financial assets or vice versa at the market determined rates of exchange”. The Tarapore committee opined that the capital controls can be helpful in shielding the economy of the country from the volatile capital flows during the transitional periods. Full capital account convertibility is a slippery slope and cannot hastily implemented. There was a need to consider the negative implications of full capital account convertibility for the economy. The CAC Committee had recommended the implementation of Capital Account Convertibility for a 3 year period viz. 1997-98, 1998-99 and 1999-2000. However, it laid down some pre-conditions for the same which are as follows:
- Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in 1997-98 to 3.5% in 1999-2000.
- Gross NPAs of the public sector banking system needs to be brought down from the present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be brought down from the current 9.3% to 3%.
- A consolidated sinking fund has to be set up to meet government’s debt repayment need which was to be financed by increased in RBI’s profit transfer to the govt. and disinvestment proceeds.
- RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate RBI should be transparent about the changes in REER.
- External sector policies should be designed to increase current receipts to GDP ratio and bring down the debt servicing ratio from 25% to 20%.
- Inflation rate should remain between an average 3-5 per cent for the 3-year period 1997-2000.
- Four indicators should be used for evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law in the RBI Act.
The report was not accepted. India is still a country with partial convertibility. However, some important measures in the direction of convertibility were taken which are as follows:
- The Indian corporates have been allowed full convertibility in an automatic route up to the $ 500 million in overseas ventures. This means that the limited companies were allowed to invest in foreign countries.
- Indian corporates were allowed to pre-pay their external commercial borrowings via automatic route if the loan is above $ 500 million.
- Individuals were allowed to invest in foreign assets, shares up to $ 2,00,000 per year.
- Unlimited amount of Gold was allowed to be imported. This step was akin to “allowing unlimited amount of Gold is equal to allowing the full convertibility in capital account via current account route”.
The Second Tarapore Committee on Capital Account Convertibility (2006)
The vexed issue of full capital account convertibility continued to debated. The Reserve Bank of India (RBI) appointed the second Tarapore committee to set out the framework for fuller Capital Account Convertibility. The committee was established by RBI in consultation with the Government to revisit the subject of fuller capital account convertibility in the altered context of the marked upswing in economic reforms, the stability of the external and financial sectors, quickened pace of economic growth and global integration. The Committee submitted this report in 2006. In this report, the following key recommendations were made:
- The committee suggested three phases of adopting the full convertibility of rupee in capital account: first phase in 2006-7; second phase in 2007-09 and third phase by 2011.
- The ceiling for External Commercial Borrowings (ECB) should be raised for automatic approval.
- NRIs should be allowed to invest in capital markets.
- NRI deposits should be given tax benefits.
- It stressed the need for improvement of the Banking regulation.
- Foreign Institutional Investors (FIIs) should be prohibited from investing fresh money raised to participatory notes (PN).
- Existing PN holders should be given an exit route to phase out completely the PN notes.
However, again this report also did not lead to implementation of fuller capital account convertibility. At present the rupee is fully convertible on the current account, but only partially convertible on the capital account.
Urjit Patel Committee Recommendations
The Union Budget Speech 2014-15 stressed: “it is essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy and that the Government will, in consultation with the Reserve Bank, put in place such a framework”. Accordingly, the Reserve Bank of India (RBI) constituted an expert committee to revise and strengthen the monetary policy framework under the chairmanship of Dr. Urjit R.Patel. The committee submitted its Report to RBI on January 21, 2014. The committee has made in all 45 recommendations. Gist of major recommendations:
- RBI should adopt the new Consumer Price Index (CPI) for anchoring the monetary policy.
- It should set the inflation target at 4% with a band of +/- 2% around it.
- It sought to curb the unitary power of the RBI Governor regarding formulation of the monetary policy. It said that decision making regarding monetary policy should be done by a Monetary Policy Committee (MPC) headed by the Governor.
- It asked for the discontinuance of two schemes namely the Market Stabilisation Scheme (MSS) and Cash Management Bills (CMBs). Then, the task of government debt and cash management must be taken over by the government’s Debt Management Office.
- The open market operations (OMOs) should be detatched from the fiscal operations. Instead, they should be linked exclusively to the liquidity management.
Thus, we see that the major objective of the Urjit Patel Committee revolved around recommendations meant for strengthening the monetary policy framework to make it transparent and predictable.
Recapitalisation of Banks
The banking sector is afflicted with the overload of NPAs and other related problems worsening the asset quality of banks. In the year 2017, the Central government launched a bold and spirited plan to infuse ₹2.11 lakh crore capital over a period of two years into public sector banks (PSBs). Out of this 1.35 lakh cr. will be through sale of recapitalization of bonds. The government’s capitalisation package for public sector banks is expected to provide a strong booster dose of relief for the capital starved public sector banks.
Recapitalization of PSBs: Why?
- India’s economic growth has been adversely affected in the last couple of years. The government has been taking various steps to stimulate the economy like demonetisation and introduction of GST. These steps are expected to create long-term rewards for the Indian economy.
- Recapitalising public sector banks (PSBs) and increasing the flow of credit is critical for improving India’s growth momentum at a time when the global economy is recovering.
- The move is important for the slowing economy as private investments remain elusive because of the “twin-balance sheet problem”. This problem is a source of misery for corporate India as well as public sector banks reflected in slow bank credit growth.
- Twin Balance Sheet Problem (TBS) is about two balance sheet problems. It is a two-fold problem for Indian economy which deals with over-leveraged companies (Debt accumulation on companies is very high and thus they are unable to pay interest payments on loans) and bad-loan-encumbered-banks.
Critics allege that the step of banking recapitalisation is a risky one and can increase fiscal deficit of the Indian economy. In this context, it is a courageous step meant to restore the health of the banking system and a “monumental step in safeguarding the country’s economic future”.
Contemporary Crisis in the Banking system
The banking sector is afflicted by the NPA problem worsening its asset quality. There are bigger issues of crony capitalism in the banking sector. Crony capitalism is said to be happening in an economy when businesses thrive not as a result of their enterprising spirit and the propensity to take risks but through a nexus between a business class and the political class. The regulatory structures in India have struggled to keep pace with the fast-paced demands of the economy post-1991 with the onset of economic reforms. The sector has been rocked by scams.
How to Prevent Banking Frauds?
- The role of technology can be the bedrock of an appropriate strategy for preventing banking frauds. It can minimize chances of the complicity of humans and can also impartially detect fishy financial transactions. A robust technology system will make it highly unlikely for individual employees to circumvent supervisory hierarchical controls.
- The role of technology can also be systematically harnessed for streamlining of the process of auditing. The bank boards and especially the audit committees should have clearly defined responsibilities.
- Blockchain technology can also be utilized to control banking scams by making transactions more transparent. This will be possible as the unique feature of blockchain technology will ensure that every link in the chain can be scrutinized publicly.
- A special fraud monitoring agency can also be set up by banks with officials specially trained to detect incipient frauds.
- One member of the board can also be appointed to oversee fraud risk management.
- In order to maximize the chances of detecting frauds at an early stage banks will need to improve their human resource management policies.
- The role of external actors like chartered accountants, auditors, and advocates who figure in bank frauds should also be seriously analysed.
- There is a need for the regulator to revisit the role of auditors both in the case of borrowers and lenders. Robust systems should be designed where auditors are not able to get away with deceitful financial statements meant to cover up the scams.
- The Reserve Bank of India (RBI) should also focus on capacity building- both in terms of designing rules and making sure that they are effectively implemented.
Currently, the RBI has taken the right step to constitute an expert committee to look into the rising incidence of frauds, among other things, in the banking system.
Is Privatisation the panacea for the ailing banking sector?
- The current crisis in the banking system has incentivised the demand of the privatisation of the public-sector banks. However, privatisation cannot be a silver bullet for curing all the problems of the banking sector.
- There are larger issues of poor regulation in the banking sector which has little to do with the issue of ownership. The poorly regulated private banks are more likely to fail and scams may occur in them as exemplified by the banking failures in Western countries. The financial sector is structurally filled with ‘information asymmetries’ and ‘market imperfections’ which has to be taken into account.
- There are more proclivities for private sector banks to aim at large profits which can incentivise them to exploit loopholes in the rules and engage in risky as well as deceitful behaviour as exemplified by the subprime mortgage crisis of 2008 in the USA in which major private banks played an over-determining negative role.
- The NPA issue also plague private sector banks as exemplified by the fact that Axis bank and ICICI bank also face large NPAs. There is a degree of opacity in banking practices and so public-sector banks are actually easier to regulate.
India’s banking system in the pre-reform era had many of the adverse issues typical of unreformed banking systems. The problematic situation was marked by extensive financial repression, large re-direction of bank resources to finance the government deficit through the imposition of high statutory liquidity ratio (SLR). The banking landscape was also marked by the dominance of public sector banks which accounted for 90 percent of total banking sector assets. Earlier there were two rounds of nationalization of private sector banks first in 1969 and again in 1983. These banks were nationalized because it was necessary to impose a developmental thrust, with particular emphasis on extending banking in rural areas. The system was afflicted by laxity in prudential regulations, mediocre accounting practices and even weak supervision by the Reserve Bank of India (RBI). Banking sector reforms were a significant part of the broader agenda of structural economic reforms introduced in India in 1991. The first stage of reforms was shaped by the recommendations of the Committee on the Financial System (Narasimham Committee), which submitted its report in December 1991. After that the East Asian financial crisis in 1997 led to a magnified appreciation of the importance of a strong banking system. The Narasimham Committee (II) was appointed by the government in 1998 to suggest further reforms. There were other committees like the P.J. Nayak Committee report, Urjit Patel Committee report and Nachiket Mor Committee report. Thus, we see that with economic liberalisation and growing trend towards globalisation various steps have been taken in the area of banking sector reforms. Such reforms were introduced in India to bolster the efficiency and vitality of banks so that Indian banks can meet internationally accepted standards of impeccable performance.