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Reforms in the
Banking Sector |
India | Bank
Management
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In the context of economic liberalisation

and growing trend towards globalisation
(external liberalisation), various banking
sector reforms have been introduced in
India to improve the operation efficiency
and upgrade the health and financial
soundness of banks so that Indian banks
can meet internationally accepted
standards of performance.

Reforms in the banking sector were

 introduced on the basis of the
recommendations of different
committees:

(i) The first Narasimhan Committee

(1991),

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(ii) The Verma Committee (1996),

(iii) The Khan Committee (1997), and

(iv) The Second Narasimhan Committee

(1998).

The First Phase of Reforms:

The banking sector reforms are
directed toward improving the policy
framework, financial health and the
institutional framework:

(a) Change in Policy Framework:

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Improvement in policy framework has
been undertaken by reducing the Cash
Reserve Ratio (CRR) to the initial
standard and phasing out Statutory
Liquidity Ratio (SLR), deregulation of
interest rates, widening the scope of
lending to priority sectors and by linking
the lending rates to the size of advances.

(b) Improving Financial Health:

Attempts to improve the financial
soundness of the banking sector have
been made by prescribing prudential
norms. Moreover, steps have been taken
to re-duct the proportion of Non-
Performing Assets (NPAs).

(c) Improvements of Institutional

Framework:
Such improvements have been
achieved in three ways:

(i) Recapitalisation,

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(ii) Creating a competitive environment,

and

(iii) Strengthening the supervisory

system.

Second Phase Reforms:

The first phase of the bank sector reforms
is completed. The second generation
reforms which are underway concentrate
on strengthening the very foundation of
the banking system in three ways: by
reforming the structure of the bank
industry, technological upgradation, and
humaning resource development.

Prudential Regulation:

There are two types of banking

regulations—economic and prudential. In
the pre-reform era (before July 1991) the
Reserve Bank of India (RBI) regulated
banks by imposing constraints on
interest rates, tightening entry norms
and directed lending to ensure judicious
end use of bank credit.

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However, such economic regulation of

banks hampered their productivity and
efficiency. Hence, the RBI switched over
to prudential regulation which calls for
imposing minimum limit on the capital
level(s) of banks.
The objective is to maintain the wealth of
banks in particular and to ensure the
soundness of the financial system in
general. It allows much greater scope for
the free play of market forces than what
is permitted by economic regulations
alone.

On the basis of recommendations of the

Committee on Banking Sector Reforms,
April 1998 (the second Narasimhan
Committee) the RBI issued prudential
norms. The major objective of setting
such norms was to ensure financial
safety, soundness and solvency of banks.
These norms are directed toward
ensuring that banks carry on their
operations as prudent entities, are free
from undue risk-taking, and do not
violate banking regulations in pursuit of
profit.

The main focus of reforms was in three

areas:

(i) NPAs,

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(ii) Capital adequacy, and

(iii) Diversification of operations,

(i) Non-Performing Assets (NPAs):

One serious problem faced by the public
sector banks in the 1990s was a high
proportion of NPAs. An NPA is an asset
from which income is overdue for more
than six months. According to the second
Narasimhan Committee report (1998),
“No other single indicator reflects the
quality of assets and their impact on
banks’ viability than the NPA figures in
relation to advances.”

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The gross NPAs of scheduled commercial

banks (SCBs) increased over the period
March 31, 1998 to March 31,2002 from Rs
50,815 crores to Rs 70,904 crores. Gross
NPA of public sector banks (PSBs) were
also correspondingly higher. However,
the share of PSBs in total NPAs declined
from 90% to 80% during the period (1998-
2002).

Furthermore, there was a decline in the

ratio of gross NPAs and net NPAs,
measured as percentage of advances as
well as assets. These ratios represent the
quality of banks assets and are thus taken
as measures of soundness of the banking
system. Gross and net NPAs as a
proportion of gross advances and total
assets of SCBs declined substantially
during this period.
However, the ratio of gross and net NPAs
as a proportion of gross advances and of
total assets increased substantially for
new private sector banks from 2001-02
due to the merger of strong banks with
weak banks.

But the root cause of increase in NPAs is

the increasing proportion of bad debt. In
case of some banks, net NPAs even
exceeded their net worth. This means
that such banks had negative net worth.

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RBI Guidelines:

The RBI offered three options to banks

to restructure bad debts:

(i) Debt Recovery Tribunals (DRTs);

(ii) Settlement Advisory Committees

(SACs); and

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(iii) Recapitalisation from the

Government.

Guidelines on SACs were revised in July

2002 to provide a uniform, simplified,
non-discriminatory and non-
discretionary mechanism for the
recovery of the stock of NPAs of all banks.
Altogether, seven DRTs have been set up
for speedy recovery of loans. Finally with
a view to enhancing the effectiveness of
DRTs, the Central government amended
the Recovery of Debts due to Banks and
Financial Institutions Act in Jan, 2002.

(ii) Capital Adequacy Ratio:

Banking sector reforms were initiated by

implementing prudential norms
consisting of Capital Adequacy Ratio
(CAR). The core of such reforms has been
the broadening of prudential norms to
the internationally accepted standards.

In 1988 the Basle Committee for

international banking supervision made
an attempt worldwide to reduce the
number of bank failures by tying a
bank’s CAR to the riskiness of the loans it
makes. For instance, there is less chance
of a loan to a government going bad than
a loan to, say, an internet business. So,
the bank will not have to hold as much
capital in reserve against the first loan as
against the second.

Throughout the world, commercial banks

are under the legal obligation to maintain
minimum capital funds for the sake of
safety. The reason is that a bank’s capital
base is vitally important for its long-term
variability. It also acts as a shock
absorber in the medium term since it
gives the power to absorb shocks and
thus avoid the risk of bankruptcy.

A bank’s capital funds must be equivalent

to the prescribed ratio on the aggregate
of the risk weighted assets and other
exposures. CAR is a measure of the
amount of a bank’s capital expressed as a
percentage of its risk weighted credit
exposures. It is related to risk weight
assigned to asset acquired by banks in
the normal process of conducting
business. It is also related to the
proportion of capital to be maintained on
such aggregate risk weighted assets.

CAR is calculated on the basis of risk

weightage on assets in the books of
accounts of banks. Any type of business
transaction carried out by a bank
involves a certain specific type of risk. So,
for the sake of safety, a portion of capital
has to be set aside to make provision for
this risk. This portion acts as a hedge
against uncertainty, i.e., a ‘secret reserve’
to absorb any possible future loss.

Higher Capital Adequacy will improve

the efficiency of banks in two ways:

(i) By forcing banks to reduce operating

costs, and

(ii) By improving long-term viability

through risk reduction.

Capital adequacy enables banks to

mobilise more capital at reasonable cost.

The two important new parameters

which are crucial for the growth of banks
are asset quality and risk weightage.

On the basis of the Basle Committee

proposals (1988), two tiers of capital
have been prescribed for Indian SCBs:

Tier I—capital which can absorb losses

without forcing a bank to stop trading,
and

Tier II—capital which can absorb losses

only in the event of a winding up.

Following the recommendations of the

first Narasimhan Committee (1991) the
RBI directed the banks to maintain a
minimum capital of 8% as the risk-
weighted assets; the second Narasimhan
Committee (1998) suggested raising the
ratio further. In March 2002, the capital
to risk-weighted asset ratio (CRAR) was
raised to 9%. It was subsequently raised
to 10% with a view to tightening of the
capital adequacy norm further.
At the end of March 2002, all SCBs (except
five) had CRARs in excess of the
stipulated 9%. The capital of PSBs has
increased through government capital
infusion, equity issues to public, and
retained earnings.

(iii) Diversification in Bank

Operations:

During the period of economic

liberalisation PSBs have diversified their
activities considerably. They have moved
in new areas such as mutual funds,
merchant banking, venture capital
funding and other para-banking activities
such as leasing (lease financing), hire-
purchase, factoring and so on.

The main objective has been to make

profits by deriving maximum economies
of scale and scope, enlarging customer
base and providing various types of
banking services under one umbrella
(both directly as also through
subsidiaries). Many banks such as the SBI
have become a one-stop financial
services centre.

Related Posts:
1. Top 12 Functions of the Central Bank |
Banking
2. Banking Sector Reforms in India: A
 Survey
3. Financial Sector Reforms in India
Since 1991
4. Public Sector: Guidelines and Reforms
in India

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