In the last article, we discussed the First and Second Generation economic reforms in India, which are also known as the LPG (Liberalization, Privatization, and Globalization) reforms. These reforms were mainly aimed to enhance the Indian economy and make it more resilient. Numerous measures were taken in these ‘generations’ of economic reforms such as mitigating the ‘Licence Raj’ system to Liberalize and Globalize the economy and attract foreign investments. Other reforms included phasing many goods out of the APM (Administered Price Mechanism), strategic disinvestment in the PSUs(Public Sector Undertakings), fiscal consolidation, etc. And these reforms indeed played out well for India, taking it out of the Balance of Payments crisis in the short run and providing substantial economic growth in the long run. However, these measures wouldn’t have been successful if they were not accompanied by the financial sector reforms. So, in this article, we’d be discussing the financial sector reforms in India.
Financial Sector Reforms
In broader terms, financial sector reforms refer to the reforms in the banking sector and capital markets. The Economic reforms mainly facilitated the participation of the private sector in the economy, and further opened it up for private and foreign investments. However, to facilitate the desired private sector investment in the economy, a resilient financial structure, which would provide adequate investible capital, was a prerequisite.
But the main question is, whether the financial structure in India was resilient enough? The answer is no. The banking system in India was already in a bad position after the Independence, with very low capital availability and penetration. To cure this, the Indian Government nationalized numerous banks. After the nationalization, the capital availability and penetration, mainly in the rural areas, enhanced greatly. However, these reforms, along with some other reforms in the financial sector till the late eighties, were not enough. So, there was a need for restructuring the financial system, so that the financial system would be able to play an important role in making India a more efficient and competitive economy.
The planning for the financial sector reforms was initiated by setting up a high-level Committee on Financial System (CFS). This committee was set up on 14th August 1991. The main aim of the committee was to review and examine the structure, organization, function, and procedures of the financial system in India, and give recommendations for the reforms. This committee was headed by M. Narasimham, hence it was also called Narasimham Committee I.
The CFS recommended various measures to bring about a comprehensive reform in the banking sector. These recommendations of the CFC were based mainly on ‘assumptions’, basic to the banking industry in the country. The ‘assumption’ was-
The resources of the banks come from the general public and are held by the banks in trust that they are to be developed for the maximum benefit of the depositors.
This assumption mainly implied that-
- The government had no business to endanger the solvency, efficiency, and health of the nationalized banks under the pretext of using banks’ resources for economic planning, social banking, poverty alleviation, etc.
- The government also had no right to hold the funds of the banks at low-interest rates and use them for financing its consumption expenditure (revenue and fiscal deficit) and thus defraud the depositors.
Recommendations of the CFS
The recommendations of the Narasimhan Committee included-
During that time, the CRR (Cash Reserve Ratio) was used by the RBI as the main tool of monetary policy, in order to stabilize inflation and credit control. But however, this was seriously affecting the health, efficiency, and profitability of the banks, and also hurt their growth prospects. This was mainly because the banks has to maintain a Cash Reserve Ratio, as high as 15%, which meant that 15% of the banks’ deposited capital would be static, generating no return. And this was a direct loss to the banks as they had to pay interest to the depositors on this money.
*Cash Reserve Ratio- The certain minimum amount of deposits that a bank has to hold as reserves with the RBI.
So, the Narsimham Committee recommended-
- The CRR should not be used as a principal instrument of monetary policy by the RBI. Instead, it should use instruments like OMO (Open Market Operations).
- CRR should be reduced from the high of 15% to 3 to 5%.
- RBI should pay interest on the CRR of banks above the basic minimum at a rate of interest equal to the level of banks’ one-year deposit.
Apart from the CRR, Narasimham Committee I also recommended reducing the SLR (Statutory Liquidity Ratio) from the high of 38.5% to the minimum level, 25%. High SLR also hindered the profitability of the banks, as the banks were required to keep 38.5% of their total deposits in the form of liquid cash, gold, G-secs (government-issued securities), and other securities approved by the RBI. The banks do get some interest on these securities, but they are comparatively very less than the banks would’ve got if they invested in other securities or lent.
So, on the recommendation of the Narasimham Committee, SLR was cut down to 25% finally in October 1997.
With these reforms in place, the banks now had more available funds for lending and other activities, as the idle funds that the banks had in the form of CRR and SLR were reduced. Another major impact of these reforms was the reduction in interest rates charged by the banks, leading to more liquidity in the economy. The liquidity increased because the reduction in banks’ CRR and SLR obligations freed up more capital that could be lent or invested, ultimately increasing the profitability of the banks. And as their profits increased, they could afford to cut down interest rates on loans and attract more customers.
Directed Credit Programme
The Directed Credit Programme was introduced by the government, under which the banks were obliged to lend a certain portion of their total lending to the priority sector, called the Priority Sector Lending (PSL). The priority sector mainly included agriculture and small-scale industries. The priority sector got loans from the banks at a concessional rate of interest. This was good for these sectors, but greatly affected the profitability and financial health of the banks. So, the Narasimham Committee recommended-
- The Directed Credit Programme should be phased out gradually. The Committee recommended that the agriculture sector and small-scale industries did not require additional support anymore, the two decades of interest subsidy were enough and have grown these sectors to a mature stage. So, the concessional rate of interest should now be discontinued.
- Further, the Directed Credit Programme should not be a permanent and continuous support program. Instead, it should be implemented only in extraordinary conditions to support extremely weak sectors, and it should be temporary in nature.
- The term ‘Priority Sector Lending’ should be redefined to be less inclusive. The term should include only the weakest sections of the society such as the village and cottage industries, marginal farmers, rural artisans, and other tiny sectors.
- The composition of the PSL should be reviewed after every three years
- The redefined PSL should have a 10 percent fixed of the aggregate bank credit.
Before the reforms, there was a wide prevalence of the ‘administered interest rates’ mechanism. Under the mechanism, the interest rates on loans, instead of being determined by the market forces of demand and supply, were instead greatly influenced by the government through its policies. So, this again hindered the profitability of the banks and deteriorated their financial health. So, to prevent this, the Narasimham Committee recommended-
- Interest rates should be broadly determined by the market forces.
- The banks should be free to determine the interest rates on loans and deposits and all government controls of interest rates should be withdrawn.
- Subsidies on the IRDP (Integrated Rural Development Program) loans should be withdrawn.
- The Bank Rate would be the anchor rate and all other interest rates should be closely linked to it.
- The RBI should be the sole authority to simplify the structure of interest rates.
Reorganization of Banks
There were major changes required in the banking sector, whose penetration and capital availability increased after the process of nationalization, but efficiency and profitability remained stagnant. So, newer reforms and structural reorganization were needed to enhance the banking structure in India. The recommendations of the Narasimham Committee in this regard included-
- Due to nationalization, all the major banks in the country were owned by the Government, and there was very little space for private and foreign banks. To change this, the Narasimham Committee recommended a reduction in the number of PSBs (Public Sector Banks) through mergers or acquisitions, which would bring more efficiency to these banks.
- The Public Sector Banks should be made free and autonomous in their functioning.
- The RBI should examine all the guidelines and directions issued to the banking system in the context of the independence and autonomy of the banks.
- The RBI should be made the primary organization for the regulation of the banking system in the country, and the control of the Banking Division of the Ministry of Finance in the banking system should be transferred to the RBI, making it the sole and only regulatory authority.
- In order to be par with the wide range of innovations taking place abroad, and to become more competitive, there should be a radical change in the work technology and culture of the PSBs.
- The appointment of the Chief Executive of the Bank should be done on the basis of professionalism and integrity, rather than political considerations. And these appointments must be done by an independent panel of experts.
The problem of asset reconstruction isn’t a new phenomenon, but an ever-lasting problem of the Indian Economy. So, as the Government now initiated the formation of a Bad Bank to solve the problem of high NPAs (Non-Performing Assets), certain steps were recommended by the Narasimham Committee back then to solve the problem of high NPAs in the banks and financial institutions. And similar to the solutions proposed today, Narasimham Committee recommended the setting up of Asset Reconstruction Companies or funds. Other countries like the US also followed the same system and got the desired results. Hence, the Narasimham Committee, being inspired by the successes of asset reconstruction companies there, advocated their establishment in India.
The Narasimham Committee blamed the Government for the unhealthy state of the Public Sector Banks and stated that these banks were used and abused by the Government of India. And the bank employees and trade unions further contributed to the deterioration of these banks.
Other major recommendations include-
- Opening of new private sector banks
- Introduction of the capital adequacy norms
- Simplification in the banking regulation