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A brief history & development of Banking in India

and its future
by Prof. Narasimha Prakash

Abstract
An efficient banking system is of paramount importance in the
development of any economy. In India, it has evolved in an organised
way over the last two centuries. The growth is more pronounced after
India’s independence and especially after nationalisation of some large
banks. There has been a significant growth and transformation since
1990s contributed by the liberalisation and banking sector reforms. This
has helped the banks in India to stand in good stead in the face of the
recent crisis in the financial and banking systems around the world. The
RBI needs to be given all the credit for steering the banking system with a
tight grip. While risk management is occupying a centre stage, banks are
also competing for growth and sustaining their business. Here is an
attempt to walk through the history of Banking in India and also try and
gauge the likely shape of things to come in the next few years.

Origin of Banking in India

William Shakespeare’s Merchant of Venice takes us back to 14th century,
depicting the art of money lending when Shylock lent money to Bassanio
on the guarantee of Antonio’s pound of flesh – effectively Antonio’s
death in case Bassanio fails to repay the money borrowed and if Antonio
cannot fulfil his obligation as a guarantor.

It is said that by Shakespeare’s time, (1564-1616) Jews had been

providing commercial credit in Venice, for nearly a century. They did
their business in front of a building once known as Banco Rosso, sitting
behind their tables – their tavule on their benches, their banci. The words
“broke” and “bankrupt” also had their origin from the words “banca” and
“rota” meaning a bank which is out of business or literally a broken
bench.

The origin of Banking in India can be traced back to the Vedic ages. It is
believed that money lending started even before Manu, the great Hindu
Jurist who devoted a section of his work to deposits and lending and laid
down rules relating to rates of interest.
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Modern banking in India commenced during the later part of the 17 th

century. The traditional money lenders were the only dominant force
prior to this period who were engaged in money lending and financing of
trade.

The lone surviving bank which has seen more than 200 years of its
existence in India is State Bank of India which started its operations in
1806 as Bank of Calcutta which later became Bank of Bengal. This was
the first ever joint stock bank in the country. Around the time two other
presidency banks were started through a charter of the East India
Company in the western and southern parts of the country viz. Bank of
Bombay (1840) and Bank of Madras (1843). All these three banks were
merged together in 1921 to form Imperial Bank of India which after
India’s independence became State Bank India.

The seven associate banks of State Bank of India which were started by
the princely states were nationalised during the period 1959-60 and made
as subsidiaries of State Bank of India.

During the later part of the 18th century and in 19th century, a number of
banks were set up across the country by private groups and many of them
did not survive for too long. One of the long surviving commercial bank
is Allahabad Bank which commenced its operations in 1865. All those
surviving banks are a witness to more than a century of economic and
social transformation in the country.

Post-independence era
The RBI which until then was a private bank was nationalised in 1949
and became a government central bank. The era of post independence
saw the government taking measures to play an important role in the
economic development of the country. The Industrial Policy Resolution
adopted by the government in 1948 envisaged a Mixed Economy,
necessitating the government and the public sector playing a dominant
role in creating the productive assets. The government had to address
many complex problems facing the country. The important ones which
needed programmed solution were providing support to agricultural
sector, start basic industries, build facilities for generating power, provide
transport and communication and build an effective educational
infrastructure. Thus came the 5 year plans to develop these focussed
sectors of the economy.
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As any economic developmental activity would necessarily involve active

participation from banks and financial institutions, the government had to
face this handicap with most of the commercial banks in the hands of the
private sector. These banks belonged to the industrial houses of Tata,
Birla, Bangurs etc. or the community groups like the Chettiars, Vysyas,
Brahmins, Nadars, and others and the flow of credit was selective and
did not support the causes for which the government would have desired.

The natural course of action to gain control over management of private

sector banks was nationalisation of some of these banks. The first batch
of 14 large commercial banks were nationalised in July 1969 and 6 more
banks were nationlised in 1980. With the merger of New Bank of India
with Punjab National Bank in 1980, there are now 19 banks continuing as
government owned banks apart from the State Bank group.

Whether the objectives of nationalising the large banks were achieved

over the last 4 decades is a moot question and depends on one’s
perspective. The positive impact is the spread of bank branches into the
semi urban and rural areas, credit delivery to priority sector, reduction of
regional imbalances, generating employment, aiding commerce and
industry and generally promoting economic and social welfare. However,
are they measuring upto other private sector and foreign banks in terms of
employee efficiency, technology upgradation, customer satisfaction,
upkeep of branches, profitability, etc., ? The answer is perhaps in the
negative.

Significant Regulations
The era of post-independence, saw a number of regulations brought about
by the government with a view to control and regulate the activities of
banks. As banks and financial institutions are the machinery required to
promote economic development, several enactments were brought in and
some significant ones are:
 The Banking Regulation Act of 1949 aimed at providing operating
guidelines to banks in India.
 State Bank of India Act 1955 by which the bank was nationalised.
 The Deposit Insurance and Credit Guarantee Corporation Act 1961: A
wholly owned corporation of the Reserve Bank of India to provide
guarantee to depositors.
 Regional Rural Banks Act 1976 to establish RRBs.
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Events leading upto liberalisation and banking reforms

The country has perennially been an export deficit country because of
high dependence on imported oil. The situation had reached alarming
proportions during 1991 with foreign exchange reserves depleting to a
level of $ 1.2 billion just enough to take care of 2-3 weeks of essential
imports (forex reserves at the end of Oct. 2011 was 320 billion). Added to
this was the growing fiscal deficit which had scaled upto 13% of GDP
during FY 1990-91. As the deficits had to be met by borrowing
programme, there was no much leeway left as the government had
already accumulated debt of 53% of GDP during FY1990-91 from a level
of about 35% of GDP during FY 1980-81. With no further scope to
borrow internally, the government had to look to external sources and
IMF came to the rescue, but with riders. In May 1991, Government had to
ship out 67 tons of gold from its reserves as pledge for the loan of $ 2.2
billion, with 47 tons going to Bank of England and 20 tons to Union Bank
of Switzerland. There was a public outcry given the sentimental value
attached to gold. In November 2009, given the comfortable situation,
India bought about 200 tons of gold from IMF valued at $ 6.7 billion.

Post 1991 crisis, a number of measures were initiated by the then PM

Narasimha Rao and FM Manmohan Singh which included reforming the
banking sector, being a major contributor to the economic development.
The objectives of banking sector reforms were to bring about competition
and enhance efficiency and productivity. A committee headed by
Narasimham was appointed in 1991 to study the structure, organization,
functions and procedures of the financial systems and to recommend
improvements in their efficiency and productivity. The recommendations
of the committee which was placed in the Parliament in November 1991
set the tone for bringing about much needed reforms in the banking
sector.

Some of the noteworthy recommendations were (a) greater autonomy for

public sector banks by reducing the government stake to 33%, appointing
professionals to the Boards of banks instead of political appointments,
review of recruitment, training and remuneration policies to bring the best
market practices. (b) stronger banking system by creating a three tier
structure of banks through establishment of three large banks with
international presence, eight to ten national banks and large number of
regional and local banks. Creation of large sized banks was set to be
achieved by merger of banks. (c) reduction and control of non-performing
assets by phasing out priority sector lending, creation of Asset
Reconstruction companies to takeover the bad loans. (d) capital adequacy
ratios and provisioning requirements
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Most of the recommendations were adapted leaving aside some like the
dilution of government’s ownership, appointment of directors etc.

What has been the impact of these reforms? According to Dr. Y.V Reddy,
former Governor of RBI, there has been a major impact on the overall
efficiency and stability of the banking system in India. The capital
adequacy of banks in India is comparable at the international level. Also,
there has been a remarkable improvement in the asset quality with
reduction in percentage of gross NPAs to gross advances. The reform
measures have also resulted in an improvement in the profitability of
banks. Over the last few years the business per employee for public-
sector banks has more than doubled.

Entry of new Private Sector Banks

New Banks licensing policy in the early 1990s saw the Reserve Bank of
India allowing new banks to be set up in the private sector. Licenses were
given selectively with a minimum capital of Rs. 200 crores to start with.
FDI was initially allowed upto 20% with in the minimum participation of
40% equity to be brought in by the promoters. The New Generation
Private Sector Banks as they are called brought in computerised and
swanky branches from the day one of their operations. These new banks
were licensed to bring about competition in the banking system to
improve productivity and efficiency. It has helped in setting up world
class banks like HDFC Bank, ICICI Bank and Axis Bank (earlier UTI
Bank) in terms of technology and products, bringing an element of
customer delight in their services. Thanks to these new private sector
banks, the retail banking segment saw a phenomenal growth in the last 2
decades. The reasons attributed to this are improved processes, reduced
turnaround time (TAT), segmentation, customer specific products, and
generally everything working around customer’s aspirations.

This prompted other banks in both public and private sector to implement
core banking system – a comprehensive computerisation of their
operations. The task of computerising the operations of the existing banks
proved to be a daunting task and this is always the case when you have to
migrate from a totally manual set up to a fully computerised environment.
This has caught up with even co-operative banks and today one would
find many of them operating on a fully computerised platform.

While the objectives of licensing new private banks were to a great extent
achieved, one also witnessed some amount of shakeout and consolidation
of banks in the private sector in a very short period of time. Some of the
new generation banks had to be taken over by other banks like The Times
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Bank was taken over by HDFC Bank. Bank of Punjab was merged with
Centrurion Bank to create Centurion Bank of Punjab which was
eventually taken over by HDFC Bank. Global Trust Bank which was the
first new generation private sector bank to start operations in 1994 had to
be forcibly merged with Oriental Bank of Commerce in 2004 for their
mis-management. Only those banks which played by the rules of the
game survived and banks with too aggressive growth plans but with
minimal internal controls and risk management systems failed to stay put.

The entry of new generation private banks has indirectly helped the
otherwise sleepy public sector banks to wake up and take notice. To a
great extent the public sector banks have put their houses in order since
the last decade by streamlining their operations. It is also witnessed that
migrating to a computerised set up had resulted in excess staff and the
banks had to freeze fresh recruitments of staff for sometime. There is still
a lot to catch up by the public sector banks in terms of revamping their
branches to match with the private sector banks, improve staff efficiency,
bring customer focus and many more virtues of the private sector banks.

The computerisation of banking operations and the phenomenal growth in

the usage of internet has brought about significant changes the way
customers operate their bank accounts. There is no need to wait in long
queue to withdraw money, get a new cheque book, to order for a demand
draft, for stop payment of cheques etc to name a few. Bank branches
have only become marketing hubs with many of the back office functions
relocated to a central place which caters to the entire bank. Customers
are now encouraged to use ATMs, Net banking and mobile banking which
brings a lot of relief to the bank branches in terms of that many customers
not crowding at the branch counters.

Emergence of Universal Banking

Every bank would like to offer a one stop solution to their customers’
banking and investment needs essentially becoming a Financial
Supermarket. The development was to some extent prompted by the
transformation of two of the DFIs – the ICICI Bank and the IDBI Bank
into commercial banks. The line of demarcation between term lending
institutions and commercial banks was quite evident. However,
considering the resource constraint and financial institutions’ inability to
tap deposits from the public, they had to look for a solution which
resulted in converting themselves into commercial banks. Now one
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cannot miss noticing banks promoting several other products as an

intermediary like mutual funds of not only those offered by their own
associates by all others as well, life and general insurance, depository
services, etc.,

What is in store?

It is difficult to do a crystal ball gazing into the future of banking and

financial system in India for the next decade, but here are some thoughts
on the way things may move keeping the continuity of actions given the
current scenario in India and the picture presented by the global
environment.

Risk Management
Indian banking system has successfully weathered several turmoils in the
international banking and financial system in the past. Though Indian
banks have adopted Basel norms on the Risk Management Systems
propounded and developed by the international banks, it is the RBI and
the banks in India seem to have implemented them more effectively and
gaining from its benefits. Are the Indian banks better placed in terms of
risk management? The answer is definitely in the affirmative when
compared to the self inflicted damage by the banks in US and Europe. It
is worth recalling a dialogue between Eddie (the English guy) and Bill
(an African) while playing a game of cricket in the movie “Love thy
Neighbour”, when the Eddie argues “we invented it” to which Bill replies
“but we play better”.

There have been several instances of the international banks getting badly
affected to the extent of their existence being threatened due to the rogue
trading in supposedly exotic derivative products. Huge positions taken by
their traders have hit banks like Societe Generale in 2008, UBS in Sept.
2011, not to mention the liquidation of the Barings Bank back in 1995.
Fortunately, banks in India have never got into such situations, though in
recent times, banks like Global Trust Bank had to be forcibly merged
with Oriental Bank of Commerce to save the bank from falling apart and
thus risking the depositor’s moneys.

At least two recent instances of turmoil in banking and financial system

merit special mention - the South East Asian crisis and the sub-prime
crisis in the US.
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There has been a tremendous negative impact on the banking and

financial system in United States and Europe arising out of the sub-prime
crisis in 2008. According to Dr. Y.V. Reddy, former governor of RBI
“…..the source of the problem was perhaps not the macro-global
imbalances, but the significant mispricing of risks in the financial system.
Easy monetary policy in major financial centres, the globalisation of
liquidity flows, widespread use of highly complex structured debt
instruments and the inadequacy of banking supervision in coping with
financial innovations contributed to the severity of the crisis…” The
malady of the system is very well brought out here and we should
appreciate the approach of the Reserve Bank of India in management of
the affairs of banking and financial system in the country.

The Indian Banking system will continue to be closely regulated by the

RBI though with some minor relaxations like deregulating the interest
rates on savings bank accounts which happened recently and possibly
allowing interest to be paid on current accounts as well with some riders.
As far as the buffet of offerings on the lending side is concerned, the
country has to be content with the present available products. With the
financial crisis in 2007-08 stemming from the exotic derivative products
offered by banks in the developed countries especially in the US, the

lessons learnt are good enough to keep a check on aping such products in
India. Country may not witness such products in the near term and the
RBI will also in all its wisdom may not permit such offerings by banks
operating in India.

Capital Account Convertibility

Whether capital account convertibility will see any further steps forward?
May not!! Given the financial crisis experienced in South East Asian
countries (in particular Thailand, Malaysia, Indonesia, South Korea and
Philippines) in 1997 when their local currencies were battered and the
continuing financial instability around the globe since the sub-prime
episode and the crisis in PIIGS (Portugal, Italy, Ireland, Greece and
Spain) countries in the Euro Zone, RBI may still hold on to the view that
the time is yet to come for a free float of the Indian Rupee. On the hind
sight, this stand has perhaps insulated us from the happenings in the
financial sectors in the US and Euro Zone.

How does this impact the banking sector is to look at in simple terms.
Whatever is the policy decision on convertibility coming out of the RBI
or the GOI, it is the banks who will be involved in its implementation. As
the commercial banks are the channel through which the foreign currency
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flows, either in converting rupees into foreign currency or vice versa, the
banks will have additional responsibility to shoulder as and when the full
convertibility comes into effect.

Consolidation
Country can expect some consolidation in the Indian banking sector by
merger of the remaining five associate banks of SBI with the parent to
help SBI become one of the large players in the international field. The
already merged banks (State Bank of Saurashtra and State Bank of
Indore) were unlisted and small in size and therefore did not pose much
difficulty except for internal reorganisation. Merger of other associate
banks may also not pose much difficulty in terms of either culture of the
employees or continuity of business for the merged banks, but for the
procedural issues since 3 of the remaining banks like SBM, SBT, SBBJ
are listed companies. One of the significant facilitator in the merger of
associate banks with the parent is that all the associate banks work on the
same technology platform. In fact this is one of the burning issues if the
entities to be merged work on different IT platforms.

Unlike the State Bank group, merger of other nationalised banks will be a
complex task for the authorities. Apart from taking the employee unions
into confidence, the merger of cultures will also be a daunting task. There
is always be a problem of “big brother attitude” in merger exercise and
will create the skirmishes in cultural integration. In spite of a few decades
after nationalisation, the cultures of each of the nationalised banks are
different. To minimise this impact on mergers, a merger of banks located
in each of the different regions will be attempted like a north based bank
getting merged with another north based bank and a south based bank
getting merged with another from the same region.

One can expect some actions in the private sector as well, as some of the
old private sector banks are candidates for takeover by new private sector
banks who can get the reach and spread quickly. Such takeovers have
already happened in the recent past like the United Western Bank was
taken over by IDBI Bank, Bank of Madura and Bank of Rajasthan were
taken over by ICICI Bank.

In the days to come, technology will continue to play a far more

important role in customer service. The country has already witnessed
several offerings in the internet and mobile banking space by the banks,
especially the private sector banks for improved customer convenience.
Banks in India can now boast of matching all the facilities which are
available to the customers abroad. It will be a matter of time that many of
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the services available on the internet and mobile phones are taken to the
remote locations and therefore penetration will be the issue on hand for
the banks.

Apart from this, banks which are lagging behind in technology especially
some of the nationalised banks and old private sector banks will be left
behind if they do not catch up very quickly with the front line banks. It is
not uncommon to find people having accounts with the new generation
banks and other tech savvy nationalised banks purely for the purpose of
the ease of banking using their net banking facilities though they may
continue to have accounts with other traditional banks.

Technology Play
One of the important factors in the growth of banking is adapting to
technology. The taste of convenience banking through ATMs, Internet
banking, and Mobile banking has led to a spurt in the number of banking
transactions. The latest entrant in the technology play in banking is the
Mobile banking. The mobile handset manufacturers say that internet will
happen on mobiles and their plan is to push sales with underlying internet
usage.

The country is the world’s second largest mobile phone users with over
865 million mobile connections as at the end of August 2011. Further 5
– 7 million new mobile users are being added every month.

As far as internet is concerned, India ranks 3 rd in the world after China

and US with an estimated 121 million users by the end of December
2011. The addition to the number of users is about 5-7 million every
month.

These figures should give an idea of the size of alternate channels of

banking that would be available though all the mobile and internet users
may not end up using the banking services through these medium.
However, these two mediums will get a big push from the banks as even a
fraction of users is good enough. This will not only reduce the paper work
drastically, but will reduce other cost of operations to a great extent
though it would involve initial investment in technology.

Green Banking
With a view to reduce the use of paper at the branches, some banks are
promoting the concept of Green Banking in a big way. It provides the
Customers with a simple, secure and quick way of executing daily
Banking transactions. With only the ATM cum Debit Card and PIN, a
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customer can operate his Bank Account at the branch. It is a counter

manned by a Teller where a Transaction Processing Device (TPD),
similar to a PoS machine, is attached to the terminal. Customer swipes
the Shopping cum Debit Card, selects a particular transaction and enters
the amount and the PIN. Post authentication, the transaction gets
transferred to the Teller’s terminal who enters denominations of cash to
be paid / received, then pays / receives cash and completes the
transaction. The Customer completes the transactions with no paperwork.
This facility has been existing in many other countries and Banks which
are yet to adopt this will implement it in a big way .

Sharing of ATM infrastructure

In the initial stages of introducing ATMs some of the private sector banks
were looking for a return from their ATM network – an acronym ROTI
meaning Return on Technology Invested. However, soon they realised
that ATMs are more of an extension of service what a branch does. It is
not only to enhance the customer convenience, but offers many hidden
benefits to the banks themselves.

A few years back, we could not have thought of banks sharing their ATM
network with other banks, but now it has now become a necessity as it
has been established that setting up their own network of ATMs by each
of the banks will be a costly proposition. The capital required for such an
infrastructure could well be used for other purposes like propping up the
capital adequacy requirement. Though individual banks will continue to
expand their own network of ATMs, one may not witness the same speed
at which they were opened a few years back.

Banks to lead the financial inclusion

The Government of India’s effort to bring financial inclusion and avoid
too many layers in reaching the subsidies to the poor and weaker sections
will offer a great opportunity for the banks to extend their services to the
rural segment of the country. While this may require branch expansion in
the interiors of the country, whether it will be a cost effective exercise for
banks will be a difficult question to answer. One can expect nationalised
banks to take up this task being a national and social requirement with
limited participation from the private sector banks.

Retail banking will continue to grow

The growth of retail banking in emerging market is said to be on account
of advance in IT infrastructure, financial sector reforms, younger
population, increase in affordability, change in lifestyles etc. Retail
banking refers to the banks dealing with individuals which include
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savings bank accounts and current accounts on the liabilities side and
housing loans, auto loans, personal loans, education loans, consumer
durable loans, debit and credit cards on the assets side. With the
deregulation of interest payable on savings bank accounts, one could
witness the competition hotting-up for the sharing of this vital source of
cheap funds for the banks. On the assets side, with the corporate sector
not showing any significant growth opportunities and with a very crucial
advantage of spreading the risk available in retail lending, banks will
spare no effort to grow this segment.

Conclusion
Banking sector has witnessed a tremendous amount of transformation in
the last 2 decades, much more than what one would have seen over the
several decades before that. Needless to mention that a well developed
banking system is as much essential for the growth of the economy as of
its citizens. With one of the best cental banks in the world, the RBI has
been steering the banking system with a well measured approach of
deregulation, but at the same time tightening the risk management
measures, so that the Indian banking system does not face similar crisis
situation as the rest of the world has witnessed at some point of time or
the other. RBI is currently looking at the possibilities of allowing more
new banks in the private sector, which is only expected to intensify the
competition further to the delight of the customers.

References
1. Reddy, Y. V. India and the Global Financial Crisis, Orient Black
Swan, 2009.
2. Ferguson Niall, The Ascent of Money, Penguin Books, 2009.
3. Sir William Jones, Institutes of Hindu Law (1796) - Digitalised by
Google.
4. RBI’s discussion paper on “Entry of New Banks in the Private
Sector” August 2010.
5. www.rbi.org.in
6. www.statebankofindia.com
7. www.icicibank.com
8. www.investopedia.com
9. www.trai.com

Originally published in AMBER (ABBS Management and

Entrepreneurship Review) Issue 2, Volume 2, April – September 2011.