Chapter 2 Banking Sector in India

2.1 Introduction of Indian Banking

Industry

2.2 Structure of Indian Banking Industry

2.3 Functions of the Banking Industry

2.4 Challenges of Indian Banking

Industry

2.5 Governance in Banks

2.6 Banking Sector Reforms

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 Chapter 2
Banking Sector in India

As the new Indian market is changing its dynamics, the Indian banking system is
changing according to the new challenges and the competitive realm. The Banking System
of India works like a backbone for our economy. Its working and structure are integral to
the country‟s performance. Indian Banking Industry had undergone many stages of
development and now it has been recognized as one of the largest banking systems in the
world. New dimensions been achieved in the areas of profitability and liquidity.

Zafar (2012) said that the banks form the largest share in the Indian financial
system in comparison to insurance, non-banking financial institutions, and mutual funds
etc. With respect to the Indian Banking System, public sector banks dominate the most of
the market share of the assets and the number of branches. Rural and Urban co-operative
banks have a very small share in the banking system but they play an important role in
terms of providing financial services to the low and middle-income people in rural and
urban areas. According to Duvvuri (2013), the per capita deposit has expanded 600 times
in the banks and the per capita credit. The scenario of banking industry changed after the
financial reforms in 1991.

The deep-rooted banking system of banking existed in India from many centuries
and it had catered to the credit and saving needs of the economy of that time (Leeladhar,
2007). The famous Kautilya‟s Arthashastra, which also mention and contains references
to creditors and lending. For instance, it says, “If anyone became bankrupt, debts owed to
the state had priority over other creditors.” Similarly, there is also a reference to “Interest
on commodities loaned” (Prayog Pratyadanam) to be accounted as revenue of the state.
Even Manu, the great Hindu jurist, devoted a section of his work to deposits and advances
and laid down rules relating to rates of interest be paid or charge (Bedi & Hardikar, 1983).
Thus, in the medieval India, it appeared that the concept of commodity lending, saving and
priority of claims of creditors were established business practices even during that time.

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 For more than a century, in many developing countries, the Banking system
remains the focal point in its financial set-up and as such, banks regarded as special in
view of their specialized functions in the financial intermediation and payment system of a
country (Samal, 2001). The Indian Banking System is no such exception and in fact, in
India too, economic development has evolved around the banking system. However, the
Indian Banking System is unique and perhaps has no parallels in the banking history of
any country in the world (Velayudham, 2002).

Important benchmark in the Indian Banking System was the follow of

recommendations of first Narasimham Committee on Financial System. This Committee
set up in August 1991 by the Government of India as a part of its economy-wide structural
adjustment program, and in response to the unsatisfactory economic and qualitative
performance of the Public Sector Banks (Sarkar, 1999) owing to lack of competition, low
capital base, low productivity, and high intermediation cost. These financial reforms
excluded all the outdated rules and regulations of the Banks and gave them the freedom to
work with cutthroat competition. However, in India regulations regarding banking
industry are stringent. If a bank wants to convert itself in Universal Bank, it needs to
negotiate with many regulatory authorities like SEBI, RBI, and NHB etc. However, amidst
all this chaos India‟s banking sector has been amongst the few to maintain resilience.
(FICCI, 2010)

This chapter will focus on the history of Indian Banking sector, its structure,
functions, challenges, and the banking reforms that made the Indian banking sector more
competitive, and the importance of governance in banks.

2.1 Introduction of Indian Banking Industry

The Banking Industry of India is unique and different from the various other Asian
countries because of the unique economic, social, legal, and geographic traits. Banking
Industry had to achieve all the objectives of the economic policies and particularly have to
maintain the equilibrium related to the economic growth. The industry has to ensure that
there is elimination of private sector monopolies.

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 According to Lal (2014), the Banking in India originated in 18th century. The
Banks were The General Bank of India, which established in 1786, and the Bank of
Hindustan (1770-1829) and then they got defunct. Under the charters of British East India
Company there were three presidency banks, they were Bank of Calcutta, Bank of
Bombay, and Bank of Madras. Then these three Banks merged to establish the Imperial
Bank of India, which, after the independence of the country became the State Bank of
India in 1955. These all banks worked as a quasi-central Bank until the time the Reserve
Bank of India was form in 1935.

As per the report issued by RBI in 2013 mentioned that the Indian government
announced 14 largest Banks as nationalized banks in 1969; they allowed competing and
doing all the functions of commercial banks (RBI, 2013). At that time, the structure of
Indian Banking Industry was running on „Profit making public sector undertaking‟. The
first Joint stock Bank in India was the Bank of Upper India, which was established in 1863
and failed in 1913. Then Allahabad Bank continued this form of ownership since 1865. At
the time, of the partition in 1947, the banks majorly affected and the economy of West
Bengal and Punjab. The Government of India took major changes to bring back the
economy. There were many regulations that took place like establishment of central
authority i.e. RBI in 1935 and the Banking Regulation Act in 1949 (Gajdhane, 2012).

After the liberalization in the early 1990s, there were many licenses issued to the
small banks. These all banks then became the tech savvy banks like HDFC Bank, ICICI
Bank, UTI Bank etc. The rapid growth was observed by the ownership existence of
public, private, and foreign banks. As a result, foreign direct investment grew. All this led
to increase in the demand of retail banking. Various mergers took place between the banks
like ANZ Grindlays Bank merged with Standard Chartered Bank in 2000, Sikkim Bank
ltd. merged with Union Bank of India in 1999, Times Bank Ltd. merged with HDFC Bank
Ltd in 2000 (Ratti, 2012).

The Indian Banking Industry has fairly matured in the sense of customer reach,
number of different financial products and supply. The Indian government has taken many
initiatives related to the up gradation of the Banks. The State Bank of India has expanded
its Branches all over India and reached the masses. NABARD has helped in microfinance

23
for the population. In 2012-13, the net profit of the whole industry was Rs. 1027.51 Billion
and growing magnificently employing 1,175,149 employees.

As the turning of 20th century took place, there was stability in the Indian Banking
Industry. The Indian Government established the culture of small banks to serve the
economy. There is less pressure on Reserve Bank of India from the side of the Indian
Government as it is autonomous institution.

Phase I: Pre Nationalization Phase (Prior to 1955)

During the pre-independence era, India witnessed a turbulent politico-economic

scenario due to the outbreak of Second World War and subsequent intensifying of national
freedom movement of India (Bhasin, 2007). The spread of institutional banking started in
1990, this phase focused on the birth of joint stock banking companies, and there was an
introduction of deposit banking and bank branches. Presidency banks and other joint stock
banks were formed setting the foundation of modern banking system.

Phase II- Era of Nationalization and Consolidation (1955-1990)

The Commission did not have much time to complete its task as it was overtaken
by swift politico-economic developments, which culminated in the nationalization of
banks in 1969 (Velayudham, 2002). In fact, the Indian Banking system gained much
strength and cohesiveness after the first round of nationalization of banks as
nationalization improved the environment in respect of formulation and implementation of
the monetary and banking policies (Dhar, 2004). Nationalization of Imperial banks and 20
other scheduled Commercial Banks took place in 1969. At that, time State Bank of India
formed out of Imperial Bank. The directed credit programs were rising. There was an
introduction to social banking. The phenomenal growth of the Indian Banking system over
the last two decades prior to reforms, gave rise to several problems which became more
visible from the mid-eighties (Velayudham, 2002).

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Phase III- Introduction of Indian Financial & Banking Sector Reforms and Partial
Liberalization (1990-2004):

There was acceptance of recommendations of Narasimham Committee and there

were changes in the prudential regulations. Interest rates were deregulated.

Phase IV- Period of Increased Liberalization (2004 onwards)

Foreign direct investment ceilings for the banking sector increased from 49% to
74%. There was a roadmap set for the inclusion of foreign banks. There was liberal branch
policy formulated and implemented.

According to the report given by Planning Commission in 2009, various

committees gave recommendations regarding the issue of structural changes of the
banking system. The committees that dealt with the issues of structural changes were - in
1991, under chairmanship of Shri M. Narasimham, the Committee on Financial Sector
Reforms; then in 1998, the Banking Sector Reforms under the Chairmanship of Shri M.
Narasimham and in 2009, the committee on the financial sector reforms under the
guidance of Shri Raghuram G. Rajan. All these committees suggested various approaches,
which helped to deal the issues related to the structure of the banking system (Planning
Commission, 2009). Few recommendations, given by these committees, were setting up of
small banks to cater people very easily, permitting more foreign and private banks to
foster healthy competition, and focusing on the corporate governance guidelines.

2.2 Structure of Indian Banking Industry

The structure of the Indian Banking Industry has changed and evolved during the
past several years. The structure divided into multiple layers and it is catering to borrowers
and customers in specific and varied requirements. The importance of the banking
structure is to help in economic development. Torre (2007) said that after the liberalization
phase of 1991, the growth and performance of the structure of Banking Industry has
improved.

Since 1991, in terms of GDP at market price the size of the Indian economy has
almost increased by 15 times. As our economy is dynamic, banking system needs to be

25
flexible so that the objectives are achieved. If we talk about the financial aspects, then
banking services need to reach to the untouched segment of the economy. Today, there is a
lot of scope for the banking industry to grow in respect of strength and size. To support the
changes in the economy the financial system becomes the base to support the economy.
The structure of Indian Banking system will reflect the financial system of the country.
When the Indian economy underwent the liberalization phase, it affected the banking
industry. Before liberalization the banking, industry was working under a regulated
environment and after that, it shifted to the competitive environment. Increase in the
technology sector has also affected and changed the structure of the Banking Industry. To
meet out the difficulties of the financial crisis and recession there needs to be change in
the structure of banking industry. Increased participation of foreign players had totally
changed the scenario of Banking Industry and vice versa our financial players entering
into foreign markets.

To bring change in the structure of the Indian Banking Industry and to fight against
cautious scenario the RBI, the Ministry of Finance, and the other regulatory bodies
regulate all. Continuous improvement needed not only at the overall structure of the
Banking Industry but also at each entity, which is related with the whole structure. The
expected growth rates by the Banks are achieved when there is continuous development in
the structure of the Banks.

In comparison to other economies, the Indian Banking Industry exhibits different

structure on the demographic profile of the population. India is an agriculture driven
country and increase in percentage of illiteracy related to the financial instruments is
indicating the need for financial inclusion at each level of the society. In comparison to the
private sector banks, the public sector banks are dominating the structure of the Indian
Banking Industry. They have given support to the ownership structure, and growth of the
economy.

26
 Figure 1: Structure of Indian Financial System

(Source: http://www.indianmba.com/Faculty_Column/FC1063/Fc1063a.jpg)

Reserve Bank of India governs the structure of the Banks in the economy. It makes
rules, and regulations. RBI acts as a finance provider to the government and banks, and
regulates the monetary and fiscal policies. The basic functions of Reserve bank of India,
according to the Reserve Bank of India 2006, are to regulate the issue of currencies and
maintain the monetary stability in India. Regulate the financial stability of the country for
the developmental purposes and also looking the efficiency of the financial system.

As public sector dominates the commercial banking structure, State Bank of India
accounts for the highest number of the Branches and they also regulate the major part of
the rural areas and the weaker sections of the society (Basu, 2006). Private sector banks
and foreign banks focus on urban areas and, provide the improvement in banking industry.

Besides the primary function of the Banks like accepting deposits and lending, they
are giving lockers, exchange in foreign currencies, net banking, and letter of credit etc. To
cater the long-term needs of the economy there are Development Banks like IIBI, IDBI,
SFCs, and IFCI. To specifically help the development needs of economy there are EXIM
bank, SIDBI, and IDFC. For consultancy and brokerage services, there are Investment

27
Banks. There are banks, which are promoting mutual help for society they are cooperative
Banks. They operate at three levels i.e. State, District and Primary cooperative banks
(RBI, 1999). Non-banking financial companies are also performing several functions like
hire purchase and investments.

The classifications of Banks are based on – branch banking that exists in India
where one bank is having multiple branches. Secondly, unit banks that are most popular in
US which are serving specific localities and holding companies are large entities, which
are looking after many subsidiaries. Branch Banking has many advantages like efficiency
scale is more, entry is easy, flow of funds is easy, competition in the market exists, high
liquidity and most convenient to the customers.

The Banking Industry is classified on the basis of ownership like public, private
sector banks, and multinational banks. Banks classification is based on capital and deposit
size.

Bank Group As on March ‘31

2007 2008 2009 2010 2011 2012 2013

(1) (2) (3) (4) (5) (6) (7)

1 State Bank of India and 14691 15870 16940 18392 19341 20260 21315
its Associates
2 Nationalized Banks 37437 39287 41027 43675 46461 50729 54528

3 Public Sector Banks 52128 55157 57967 62067 65802 70989 75843

4 Old Private Sector 4840 4725 4955 5276 5093 5678 6290
Banks
5 New Private Sector 2599 3638 4336 5243 7009 8298 9718
Banks
6 Private Sector Banks 7439 8363 9291 10519 12102 13976 16008

7 Foreign Banks 272 279 295 310 318 323 334

8 Regional Rural Banks 14810 15054 15484 15776 16267 17032 17564

9 Local Area Banks 48 48 48 49 54 57 62

All Commercial Banks 74697 78901 83085 88721 94543 102377 109811

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 Notes :1. Data include '
Administrative Offices'.
2. Nationalized
Banks include "IDBI
3.
Bank Ltd".Data in respect
of 2013 are provisional.

Table 1: Growth of Number of Offices of Commercial Banks in India from 2007-13

(Source: “http://www.rbi.org.in/scripts/PublicationsView.aspx?id=15469,” accessed on

20th March, 2014)

In this competitive scenario the Banks need to change themselves according to the
needs of the customers, they need to utilize the new opportunities and make them self
sufficient to face the competition. The banks judged on the services, the size, and the
regulatory obligations. Banks need to align themselves on the change in the mindset of the
customers, the technological changes, change in the skills of the human resource, and
change in the services.

There are certain building blocks, which are there to address certain important
issues like increase in the financial inclusion, specialized services, facing and enhancing
the healthy competition. The issues are to promote financial inclusion, there is a discussion
going on from many years that do India need large number of small banks or small
number of large banks. It is very easy to reach out the customers by the small banks and
can provide the credit to the small entrepreneurs (Jenkins, 2007). However, if these banks
are preferred for our country then there need to be an intensive study on the capital
requirements, norms and regulations, corporate governance and regulatory frameworks.
To overcome the failures of the investment banks, there is a need of universal banking
model and as our economic environment is changing, there is a need for customized
banking and differentiated licensing. Promotion of investment banking should be there. To
extend the banking services in our country there is a need of changing the urban
cooperative banks into commercial banks. There should be stringent entry rules and
regulations. Authorization should be there and entries should be there from the proper
regulated bodies so that the quality of the banking services improved.

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 Strength of our Banking Industry is that it is the most valuable contributor to our
economy and gross domestic product. It supports the government and it works in a
regulatory environment. Still, there are opportunities for the Banking Industry to achieve
through upgraded technology and scope to reach out untapped market in our country. In
the last few years, we can see that there is a better performance of public sector banks in
respect to the private sector banks and foreign banks.

2.3 Functions of the Banking Industry

Earlier all the financial activities performed by the moneylenders. They use to
charge interest rates much higher than markets. However, there was no security related to
the financial transactions. For solving and overcome all these problems, the establishment
of organized banking industry. The government regulated the banking industry. The
banking sector worked under the rules and regulations of the financial system by accepting
the deposits, providing of loans etc. In 1949, the enactment of Banking Regulation Act
took place then in 1955 the nationalization of State Bank of India and in 1959 the
nationalization of SBI & its subsidiaries. 14 major banks were nationalized in 1969 (RBI,
2008).

The Banking Industry in India differs from other industries in respect of rules and
regulations, the asset structure and the legal obligations. Banks provide money in the
economy and through the credit creation and liquidity (UNCTAD, 2013). It provides the
facility of lending to the public. It accepts deposits from the public by giving them the
facility of saving and current account etc. Transfer of money from one place to another is
now very common and easy. Banks have earned the trust of people. Banks provide the
facility of dual locking system for the safe custody of the valuables of the public. To
receive tax and non-tax receipts banks act on behalf of the government. These day‟s banks
are focusing on marketing and sales activities as they are facing healthy competition.
Banks provided automated teller machine (ATMs) for easy access in any locality of the
country according to the need of the customers.

The boom in the information technology sector has also affected the Indian
Banking system. Online Banking had led many people to connect to banking facilities
from any side of the country. RBI had setup many committees for the use of information
30
technology in a much-defined way in Banking Industry; like in 1984, there was Dr. C.
Rangarajan led a committee on Mechanization that focused on MICR technology for
cheques that committee (Subbarao, 2013). The power of MICR technology standardized
the encoders, and then in 1988, the RBI went for computerization of Banking Industry by
setting up a committee under Dr. C. Rangarajan. Computerization helped in the settlement
process and there were opening of clearing houses in many cities.

Payment system and securities settlements issues in the Indian Banking Industry
were look upon by the recommendations given by the committee in 1994. They
emphasized on Electronic fund transfer (EFT). Automated Teller Machines (ATMs) had
made banking facilities very easy. There are more than 1.6 lakh ATMs machines by the
end of March 2014.

Now, most of the banks are providing services like SMS banking, internet banking,
and mobile banking. Banks are performing diversified services as they provide loan to
small businesses or individuals for example, home loan, auto loan, education loan etc.
these all services come under retail banking. Dealing in mutual funds, forex operations,
commodities etc, they all come under the division of treasury operations. Government of
India and Reserve Bank of India took various initiatives for the industry to grow; there
was growth in opening up of various branches of banks, setting up of small banks, and
facilities such as opening of one bank account in one family.

Banks are providing financial aid for enterprises for their commercial purposes,
access to payment systems, and a variety of financial services related to retail for the
economy at large. Some banks have a broader impact on the macro sector of the economy,
facilitating the transmission of monetary policy by making credit and liquidity available in
difficult market conditions (Hawkins & Turner, 2000). Financial regulation is necessary
because of the multiplier effect that banking activities have on the rest of the economy.
The large number of stakeholders (such as employees, customers, suppliers etc), are
dependent on the working of the health of the banking industry, depend on appropriate
regulatory practices and supervision. Indeed, in a healthy banking system, all the
regulatory bodies and the supervisors, are the stakeholders acting on behalf of society.
Their primary function is to develop substantive standards and other risk management
procedures for financial institutions in which regulatory risk measures correspond to the

31
overall economic and operational risk faced by a bank. Accordingly, it is imperative that
financial regulators ensure that banking and other financial institutions have strong
governance structures, especially in light of the pervasive changes in the nature and
structure of both the banking industry and the regulation, which governs its activities.

2.4 Challenges of Indian Banking Industry

In comparison to other economies, Indian Banking system is much better and
stable. However, it still has many challenges.

1. Losses related to Treasury Operations: In recent years, banking definition had

been reduced to trade in only government securities and the treasury operations of the
bank were falling due to the rise of the bond yields (RBI, 2007). Thus, Banks were facing
losses in their treasury operations. If the banks continue to face such losses, it will depict
in their books of accounts and banks then need to search for alternative investment.

2. Reduction in Non-Performing Assets: Non-Performing Assets (NPAs) are the

best indicator of the health of the banking industry. Few banks have managed to reduce
their NPAs. Oriental Bank of Commerce was a zero NPA bank. However, the challenge is
that the amount of NPAs should be reduced by the banks. Reduction in NPA of a bank
depicts that it has strong credit appraisal process. The reduction of NPAs can be by many
processes and only done by systematic structure of the organization (Mahesh, 2010).
Banks face high carrying cost related to non performing assets and accumulation of the
NPAs lead to loan portfolios.

3. Competition in Retail Banking: Major competition persists in retail banking.

Many foreign banks faced losses in the retail-banking segment due to competition given
by the private sector banks. Public sector banks are also losing their business in
comparison of the private sector banks.

4. Mergers of Banks: Banks are lacking in scale or in size. To face the

competition they are going for mergers. With the permission of the central government,
the public sector banks are also involved in the mergers. However, integration process is
quite difficult. Culture and technological compatibility is looked with sincerity.
32
 5. Increase in number of Branches and ATMs: Banks need to grow the number
of branches and the ATMs to serve to the huge addition in the bankable population. Low
cost bank network will help the customers to access it anywhere.

6. Issues related to lending: After the Basel II norms, Banks were able to set up
distinction between the customers that how much amount would be there for lending. The
major challenge for the bank will be to provide high opportunities to the lower and middle
class population for the financing of the affordable houses. (Balthazar, 2006).

7. Up gradation of Information Technology: Another challenge is up gradation of

information technology in making Banking Industry to grow much faster but still majority
of the customers of banks are not tech savvy. Still in many corners of the country, poor
bandwidth is there or connectivity is not uniform. Banks are still facing legacy problems
and facility of net banking used by small banks is not cost-efficient. Another Challenge of
internet banking is the security over which customers still do not trust completely. No
doubt, internet banking will prove itself the most effective delivery channel in the coming
years but it has advantages as well as disadvantages, which are to be considered as serious
challenge, by banks. This will result in better organizational performance.

8. Re-orientation of the Banking Structure: the increase in the banking business

which is envisaged in the 12th five year plan, there is enormous increase of the banking
structure to make it dynamic and flexible. That is possible through reinforcing of proper
corporate governance (RBI, 2013).

9. Financial Inclusion: Complex challenge that needs to address by the banks is

to find solution for the financial inclusion. Rangarajan's committee (2008) on financial
inclusion defines it as the process of providing financial aid and assistance towards the
credit policy for the weaker sections and the vulnerable groups at an affordable cost. There
are many measures taken by RBI for financial inclusion like simplified know your
customer (KYC) forms, easier credit availability, advancement of information technology
and use of regional languages. Dev (2006) stated that financial inclusion is significant
from the point of view of people who belong to the weaker sections and rural non-farm
enterprises. Apart from the banking institutions, the concept of financial inclusion could
be taken up by the microfinance institutions and the self help groups so that it can improve

33
the society at large. The study suggested that this requires new regulatory procedures and
de-politicization of the financial system.

10. Human Resource: Chakrabarty (2014) in its keynote address at conference of

human resource said that the RBI is working towards “Future Proofing of Banking
Personnel.” Proofing here means to prepare the employees for adverse developments in
the future. The entries of new banks are uplifting the concept and role of recruiting skilled
personnel and retaining the existing talent. There are certain challenges that need to be
addressed by the banks in relation to human resource:

 Defining of the job roles,

 Proper performance measurement system (PMS),
 Proper training and development of the employees and training in respect of
behavioral attitude,
 The main task of the HR policy of banks is to create a favorable atmosphere
where people get the opportunity to portray their potential and receive adequate
compensation,
 Proper recruitment system with different salary structures,
 The main challenge ahead of public sector banks is there are significant
numbers of employees are retiring in this decade. This will give HR managers a challenge
to recruit skilled people.

Gelade and Ivery (2003) examined relationships between human resource

management (HRM), work climate, and organizational performance in the branch network
of a retail bank. Significant correlations found the organizational performance, the
working culture, and the HR practices. It also showed that there is no direct impact of HR
factors on the working climate and the performance. The local area banks have inherent
weakness of retaining the talent and small banks have limitations with respect to
geographic constraints.

11. Corporate Governance: For enhancing corporate governance the banks need to
redefine the interrelationships between institutions within the broadly defined public
sector i.e., Government, the Reserve Bank, and PSBs to move away from “joint family”
approach originally designed for a model of planned development. Another issue related to

34
corporate governance is a good number of banks, that brings out competition and
competitions brings in its wake the weakness in financial reporting and accountability
(Kumar, 2007).

The Indian Banking system needs to face all the challenges and overcome those to
strengthen the economy.

2.5 Governance in Banks

In India the Corporate Governance practices, are improving year after year,
particularly in the banking sector, which is a good sign from the industry‟s perspective.
Indian banking has around 200 years of history and, undergone many transformations
since independence. However, Liberalization, Privatization, Globalization, and
Information Technology are currently changing the Indian banking radically.

In last decade, Indian Government initiated liberalization reforms, which had

considerable impact on the Indian financial sector. According to Reserve Bank of India
prior to 1991, Indian banking sector was under control of Indian government with
exception of 22 private sector banks and few foreign banks (Source: RBI). Indian financial
system moved from a unilateral administered sector to market driven system since 1991.
After the economic crisis, there have been a number of initiatives to implement
governance and disclosures practices in the Indian banking sector. In the recent past,
overall corporate governance in Indian banks has improved steadily. Internationally, the
influence of board governance on performance been discussed for a number of years, but it
is relatively new to Indian scenario, where corporate governance norms are implemented
in the recent past. Board governance is a subset of corporate governance in determining
financial performance of the bank (LSE, 2012).

The board of directors is the ultimate governing body on bank affairs. The main
task of bank board is to monitor and control management on behalf of owners. The board
of director is top executive unit of a company and charged with the responsibility of
supervising operations of the company‟s management (Hsiang-Tsai Chiang, 2005).
Normally, board performs variety of functions such as monitoring and controlling
management, approving dividend decisions, deciding business policies, and facilitating
35
development and implementations of corporate strategy. Boards are required to deliberate
on the strategic agenda of the company. Boards plays major role in corporate governance
in the bank.

Effectiveness of the board depends on the board directors. According to

Companies Act 2013, board comprises minimum of three directors in case of public
limited companies and two in case of private limited companies. Jensen (1993) found that
a board should have maximum of seven or eight members to function effectively. There is
no clear-cut evidence that smaller board performs effectively than larger board. According
to Lange et.al, (2000), in a smaller board, members are more likely to agree on a particular
outcome. In contrast to this view, larger boards may act as an increased pool of expertise
and a better ability to form reasonable judgment (Goodstein, Gautam & Bocker, 1994). It
is hard to arrived optimum number of directors for the board. Hsiang-Tsai chiang, (2005)
found insignificant relationship between board structure and firm performance. Ingrid
Bonn (2004) also found board size never leads to firm performance. He argued that it is
not board size, which was important for firm performance but rather composition of the
boards in terms of the ratios of outside directors.

According to SEBI, listing clause 49, not less than 50 % of the total number of
directors should be an independent non-executive director. In case of CEO as a
chairperson of the boards, at least half of board should have independent directors.
Lang.et.al (1999) found inside directors generally have a greater understanding of the
company‟s operations. However, outside directors are more professional and are in a
better position to exert control over management. Fama (1980) stated that independent
directors are better in managing and monitoring management self interest and
opportunism. Past research have shown mixed results on performance influence of outside
versus inside directors on firm performance. There is high degree of association between
executive ratio and firm performance. It found that board with high proportion of
independent director‟s works effectively. It is common practice that CEO of the bank may
act as chairman of the board of directors. There is contrasting opinion among researcher
regarding CEO of the firm concurrently act as chairman of the board. One set of
researchers argued against it, just because board effectiveness may come down drastically
due to lack of independence. On the other hand, CEO can give ultimate direction to the

36
boards regarding company‟s future strategy and able to run in a proper way. Past research
in the direction provide support for both argument.

Hsiang-Tsai (2005) found negatively related to performance if CEO assumes role

of chairman of the board. The same results were provided by Fama and Jensen (1983). On
the other hand, Anderson and Anthony (1986) argued that it may reduce conflict between
CEO and board of directors, and that leads to effective functioning of board. Board
meeting is an important element in the board governance. According to SEBI, listing
agreement Clause 49, minimum four board meetings must be held in a year with time gap
not exceeding 4 months between two meetings. Confederation of Indian Industry code on
corporate governance has recommended minimum of six meetings in a year. Each meeting
should be held at an interval of every two months. The logic behind this exercise is to
examine and question the executive actions. Executives held responsible for the way they
conduct the business in the board meetings. There is relationship exists between number of
board meetings held and firm performance.

Since banks play a very crucial role in the economy (financial and economic
system) of any developing country, hence any fault on their part due to immoral practices
creates a situation, which may adversely affect not only the shareholders but also the
people who have deposited money and the economy at large. The effectiveness of sound
banking system is being recognized by the standard of transparency in their performance
and the increased role of government and regulatory agencies to verify their actions
(Topalova, 2004). The lack of transparency tempts the management to resort to unethical
practices as well as siphon off funds. Inadequate action by regulatory agencies put blanket
on the omission and commission of such unethical practices, thus leads to bank failure and
loss of public faith.

The prevalence of banking system failure has been a common phenomenon in

developing and transition countries as in the industrial world (Honohon and Daniela,
2000). Banks face a more competitive and volatile global environment than so-called
stereotype situation of management. They are engaged in a number of innovative services
like providing required finances to commercial projects, fundamental financial services to
majority of the population and key to all the “payment systems in micro environment.”
Other than this, some banks provide additional credit in times of market crisis. The public

37
due to its nature of transactions and some bad precedents may closely monitor the banking
sector in the past. This sector is very sensitive as a small mistake can easily attract
negative publicity. It is a part of corporate governance with most of its management
obligations enclosed in regulatory regulations. However, particularly in Public Sector
Banks (PSBs), the government issues assume immense significance; but unfortunately,
these are less discussed and deliberated upon.

Although the primary reason identified for it is the prevalence of government

ownership across the institutions, another important reason is attribute to the multiplicity
of regulatory and supervisory legislations. In India, there are five legislations, e.g. RBI
Act, SBI Act, Bank Nationalization Act, Banking Regulation Act, and Companies Act,
which govern the banking sector. Because of this multiplicity of Acts and their enforcing
agencies, i.e. RBI and GOI, any concrete form of principles on bank governance is yet to
emerge (Pati, 2006).

The need for Corporate Governance in Banks is because they are important players
in the Indian financial system. The Reserve Bank of India, as a regulator, has the
responsibility on the nature of Corporate Governance in the banking sector. The Bank has
a well-defined Corporate Governance code. SBI is committed to the best practices in the
area of Corporate Governance. “The Bank believes that the proper Corporate Governance
facilitates effective management & control of Business. This, in turn, enables the Bank to
maintain a high level of Business Ethics & to optimize the value for all its stakeholders”
(SBI Annual Report, 2013). HDFC Bank has also defined the code of Corporate
Governance. It says, “The Bank believes in adopting & adhering to the best Corporate
Governance practices & continuously benchmarking itself against each other practice. The
bank has infused the philosophy of Corporate Governance into all its activities” (HDFC
Report, 2005).

The full applicability of corporate governance principles in Indian Banking sector

is less apparent. Firstly, there are definitional issues of serious nature, which should be
strictly adhere ding by Indian banking sector. Secondly, there are issues of temporal,
sectoral and structural nature that have bearing on their relationship. Although the
literature on corporate governance in developing countries has lately got a lot of interest
from the scholars in their research area (Oman, 2001; Goswami, 2001; Lin, 2001;

38
Malherbe and Segal, 2001), the execution of corporate governance characteristics of banks
in developing countries has been almost unnoticed by researchers (Caprio and Levine,
2002). Even research studies on corporate governance in banks rarely found in the
literature in developed economies (Macey and O‟Hara, 2001).

In developing countries, corporate governance in banks is of paramount

significance as they play a vital role in the economy‟s financial structure and act like a
catalyst in the economic growth of the country (King & Levine 1993 a, b; Levine 1997).
Second, banks in developing economies provide an easy source of financing to most of the
organizations, as their financial markets are yet to mature. Third, banks offer a universally
accepted mode of payment, hence they are considered as a warehouse of public‟s savings.
Fourth, due to liberalization/privatization, many developing countries have liberated the
economic regulations as a result managers are in search of proper governance mechanism.
Coming to a developing country like India, all attributes of governance mechanism easily
implemented due to many complexities involved in it. In a developing economy such as
India, the growth of efficient corporate governance principles in banks been partly held
back due to weak legal protection, poor disclosure prerequisites and overriding owners
(Arun and Turner, 2002a). Moreover, the private banking sector is purposely opting to
ignore certain corporate governance ethics as it has stake of some parties (Kalyan et al.
(2013).

2.6 Banking Sector Reforms

Before 1991, the Indian Banking sector suffered lack of competition, less
productivity, and less capital base. After the nationalization of the banks in 1969, the
government owned banks have dominated the banking sector. However, there was
minimum use of technology and less of quality in services. The banks did not follow the
prudential norms and the standards were too weak. All these parameters resulted in loss of
profitability, and poor asset quality.

Indian Banking System has made commendable progress in extending its

geographical spread and functional reach. The spread of banking system has been a major
factor in promoting financial inter-mediation in the economy and in the growth of

39
financial savings. The advent of nationalization of banks helped in increasing the number
of branches, volume of deposits and ensured wider dispersal of the advances. Despite
impressive quantitative achievements in resource mobilization and in extending the credit
reach, the following deficiencies, over the years, crept into the financial system:

 Decline in productivity and efficiency of the financial system,

 Erosion of the profitability of the financial system, which constrained it‟s
capability to expand.
 Depression in the profits through directed lending played a critical role.
 The directed investments in the form of SLR and CRR hindered operational
flexibility and income earning capability and potentials.
 Portfolio quality suffered due to political and administrative interference in
credit decision making.
 Technological backwardness continued resulting into increasing cost
structures.
 The system remained de-linked from sound international banking trends.

Realizing all these adverse effects, the effort made to bring reforms in the financial
system of the country.

The banking sector reforms in India were to enhance the efficiency, productivity
and bring stability of the banks. There were many reforms, and measures, which initiated,
and broadly classified into three main categories: institutional measures, enabling
measures and strengthening measures.

The institutional measures were there to make a legal framework for the
development of the banks and to increase the number of new institutions. Enabling
measures were there to help the banks to be proactive to all the changes, which were there
to happen in the environment. For example, change in the interest rates etc. Strengthening
measures were used to help the banks to be strong to face the fluctuations of the economic
environment.

40
 According to Singh (2007), the Financial Sector reforms touched a number of areas
such as:
 Introduction of capital adequacy norms,
 Prudential norms related to income recognition, classification and
provisioning of assets,
 Transparent accounting policies,
 Encouragement of competition by allowing entry of new banks,
 Liberalization of branch licensing,
 Changes in monetary and credit policy through a reduction of liquidity.

The first phase of banking reforms started after the release of the M. Narasimham
report on financial system in 1992. The report mainly focused on the strengthening and
enabling measures. The committee based on the assumption that the bank‟s resources
come from the depositors. The depositors trust should not be breached. This assumption
cannot be ignored by the government also as they also cannot hamper the interest and trust
of the depositors. According to this committee, there were low efficiency of the banks due
to excess of political interference and less of branch expansion. All the recommendations
given by the committee were been accepted by the government due to many hindrances by
the other political parties and all these recommendations were being implemented too.

The few recommendations, given by the committee, were that the financial reforms
should be undertaken early in the economic reform cycle and secondly, the reform should
be in the phased manner and strongly based so that it should be affected by any problems
or the crisis. Third, a consultative and interactive approach adopted for the policy
formulation; those policies lead us to match all the international standards. There was an
acceptance of the „stop-go‟ approach, which adopted by many of the Asian and Latin
American economies, but the Indian approach was to be on a gradual process and should
have accountability and transparency (Ahluwalia, 2002).

The first generation of the reforms was to create productive and profitable financial
industry and the second half after the 1990s, which aimed at introduction of proper
structural and governance improvements (Reddy, 2006). The regulatory institutions
focused on good governance and for hiring fir and proper managers, employees for
banking institutions. The focus has been for diversified ownership.
41
 In spite of over 10 years of financial reforms in India, the Indian government is yet
to play a crucial part in many aspects like board member appointment. However, they
have given some power to public sector banks to make them competitive. The impact of
these reforms has been that the private sector banks now have more independence in
formulating strategies for different sectors of business which include setting up branches
and introducing innovative products (Muniappan, 2002) yet this autonomy is limited, as
they have to abide by the rules and regulations given by the government and central bank
(AGCG, 2001).

The report of the Advisory Group of Corporate Governance (AGCG, 2001)

recommended that depositors being the major stakeholders in banks, whose interests may
not always be, recognized, sound corporate governance should consider their interests and
ensure that individual banks are conducting their business in such a way as not to harm
interests of depositors.

The financial reforms which were framed and been followed were all focusing on
the performance and the efficiency of the public sector banks. Talwar (2001) states that
“by giving some leverage to the public sector banks will be the first step towards the
flexibility and the functional aspect of the banks.” The Reserve Bank of India (2003)
stated, “The lesser the government stake in the bank‟s the more will be the increased
operational freedom which could increase the efficiency power.” This probably changes
the mindset of the government of India to change its stakes in the public sector banks. The
performance and efficiency of the banks partially privatized and stakeholders,
policymakers and researchers were interested.

The second set of banking reforms were in 1988, when the recommendations given
by the Narasimham report were given for the structural changes in the banks, levels of the
disclosures and the increase in the transparency level.

The ultimate goal of all the financial sector reforms is to promote the efficient,
diversified and the competitive system to achieve and up bring the international standards.
The flexibility in operations, financial viability, and strengthening of the institutions is of
utmost importance and the need of the hour.

42
 The increased globalization of the economy and the deregulation of the financial
markets had lead to the financial crisis and in the decade, many countries suffered from
the systematic banking crisis. However, the most crucial aspect was that India in the
financial crisis could stable its process of financial deregulation and maintained its
economy (WTO Report, 2010). Until now, the Indian economy is functioning smoothly
and efficiently. The new opportunities for the banking sector are increasing because
growth path of the economy is accelerating.

To conclude, the Indian banks need to expand fast, to strengthen their risk
assessment systems, and increase the growth of large firms so that they can help the
smaller firms. There were many policies framed to help the process and transition. Indian
banks are very significant players for the economy and they can go a very long way. There
are sufficient reasons to say that Indian Banking sector will have growth prospects and
proper policy framework will help the banking sector to match the international
counterparts too. Better financial performance of the Indian Banks will attract new players
in the market. However, sometimes better financial performance can also act as entry
barriers for the new players.

Subsequent chapters will cover highlights on the development of Corporate

Governance over the last few years & illustrate the importance of Corporate Governance
in Indian Banking Industry. The most accepted corporate mantra today is better the
corporate governance practice of an organization the better the shareholder & stakeholder
value creation. Therefore, stakeholder‟s relationship is of utmost importance for emerging
financial sector of the country particularly in the Banking Industry. To upbring the
society‟s expectation concept should now be moved from core competence to character
competence. For being corporate as „Social Institutions‟ these should be an integration of
core competence, corporate social responsibility and character competence.

43
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