History of the Indian banking system

The Indian banking system at the time of independence was fairly well developed. While the Reserve Bank of India was established in 1935, the nationalization of commercial bank took place much later in 1955. The Imperial Bank was rechristened as the State bank of India (SBI). A substantial amount of shares were then held by the RBI itself. By 1959, several erstwhile banks held by princely states were recognized as branches of SBI, as a part of their reorganization. Thus this period was also the start of public ownership of commercial banks.

Reorganization of the Indian banks

The second reorganization in the Indian banking system took place in 1966. It was found that the private banks in the country did not provide many with the required credit disbursal support, especially in the unorganized sector. Discrimination was the basis of the Indian banking industry. The organised sector, which consisted of well-established industries were deployed credit with the help of the deposits collected. Whereas the unorganized sector consisting of farmers, small scale industries, transporters, self-employed and professionals had to largely depend on private moneylenders who exploited them with extremely high interest rates. A step towards correction was made in February 1966. With the establishment of social controls which were required to regularly evaluate the demand for bank credit from the organised sector. It was to prioritize the sanction of loans, ensuring optimum utilization of resources. However, this scheme was a disappointment.

Banks for small scale industries and agriculture

It is often said in literature that the Indian banking system had achieved progress in the 1950’s and 60’s (Joshi, 2006; Reddy, 2002). The perception sustained that the Indian banking should undertake a stronger approach towards mobilization of resources for industries seen as more substantial in the economic development of the country. Some of these industries were agriculture and small scale industries. As a result, the government introduced the policy of social control over banks in 1967. The policy was initiated in order to bring about suitable changes in the allocation and management of credit granted by commercial banks (Reddy, 2002; ICRA, 2004; Shirai, 2002).

Nationalization in the Indian banking system

Due to inadequacies in social control, the government in 1969 initiated the Nationalization Act, nationalizing the 14 largest public sector banks. This raised the share of PSB (Public Sector Banks) deposits to 86% from the previous 31%. The objectives of initiating such an act was to rapidly expand the bank branches and channeling the credit in accordance with the targets set in the Five-year plans. These banks were given quantitative targets for the allocation of credit to specific sectors in the economy and for the expansion of their network through branches (Joshi, 2006; Arun and Turner, 2002; Ganesan, 2003; Bhide, Prasad and Ghosh, 2001; Hanson, 2001; Kumbhakar and Sarkar, 2003; Joshi and Little, 1997; Reddy, 2002).

Following this initiative, the government nationalized seven more scheduled commercial banks in 1980, raising the PSB’s share in deposits to 92%. This move gave the impression that in case a private bank grew to the cut-off size, it would come under the threat of nationalization (Joshi, 2006). The second nationalization took place in order to affirm more control over the Indian banking system. The Indian banking system was becoming increasingly important to expand presence to the poor parts of the country. It will also enable priority sector lending and raise funds for public deficits. Along with the nationalization of the Indian banks, the government also raised lending rates targets for priority sector to 40% (Hanson, 2001; Arun and Turner, 2002; Ganesan, 2003 and Sarkar and Kumbharkar, 2003).

Inefficiencies in the Indian banking system

Despite the growth in the number of branch networks in the 1980’s, these policies which were established to enable equal distribution of funds, fueled inefficiencies and defects in the Indian banking system. The government sought to address these negative issues through the first stage of liberalization, which started in the late 1980’s. Major changes in this phase included:

  • The formation of money markets.
  • Introduction of treasury bills.
  • And partial interest rate deregulation (Shirai, 2002; Bhide, Ghosh and Prasad, 2001).

Besides various substantial measures such as nationalization of banks and initiating priority sector lending, the government established further control over banks by increasing the Cash Reserve Ratio (CRR) and the Statutory Lending Ratio (SLR). While the CRR was raised from 2% in 1960 to 15% until 1991, SLR was increased from 25% to 38.5% during the same period (Joshi and Little, 1997).

The Indian banking system, through statutory preemption and directed credit rules was an important source of funds for key industries and fiscal deficit of the country. Besides controlling savings through CRR and SLR, the government also exercised control over the rate of interest on loans and savings (Mukherji, 2002).

References

  • Reddy, Y.V. (2002): Public Sector Banks and the Governance Challenge: Indian Experience, in: RBI Bulletin, May, pp. 337-356.
  • ICRA (2004): The Indian Banking Industry, New Delhi.
  • Shirai, Sayuri (2002b): Road from State to Market – Assessing the Gradual Approach to Banking Sector Reforms in India, in: Asian Development Bank Institute Research Paper, No. 32, pp. 1-73.
  • Arun, T.G./ Turner, J.D. (2002a): Financial liberalisation in India, in: Journal of International Banking Regulation, 4 (2), pp. 183-188
  • Ganesan, P. (2003): Impact of Priority Sector Advances on Profitability of Public Sector Banks in India, in: Journal of Financial Management and Analysis, 16 (2), pp. 14-27
  • Bhide, M. G./ Prasad, A./ Ghosh, Saibal (2001): Emerging Challenges in Indian Banking, in: Working Paper Stanford University, No. 103, pp. 1-61.
  • Hanson, James A. (2001): Indian Banking: Market Liberalization and the Pressures for Institutional and Market Framework Reform, in: Working Paper Stanford University, No. 104, pp. 1-37.
  • Joshi, Vijay/ Little, I.M.D (1997): India’s Economic Reforms 1991-2001, Delhi et al.
  • Kumbhakar, Subal C./ Sarkar, Subrata (2003): Deregulation, Ownership, and Productivity Growth in the Banking Industry: Evidence from India, in: Journal of Money, Banking, and Credit, 35 (3), pp. 403- 424.
  • Mukherji, Joydeep (2002): India’s Long March to Capitalism, in: India Review, 1 (2), pp. 29-60.

Priya Chetty

Partner at Project Guru
Priya is a master in business administration with majors in marketing and finance. She is fluent with data modelling, time series analysis, various regression models, forecasting and interpretation of the data. She has assisted data scientists, corporates, scholars in the field of finance, banking, economics and marketing.

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