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CHAPTER -1

INTRODUCTION

The development of 'Banking' is evolutionary in nature. There is no

single answer to the question of what is banking, because a bank performs a

multitude of functions and services which cannot be comprehended into a

single definition. For a common man, a bank means a storehouse of money,

for a businessman it is an institution of finance and for a worker it may be a

depository for his savings.

It may be explained in brief as "Banking is what a bank does." But it is

not clear enough to understand the subject in full. The Oxford Dictionary

defines a bank as "an establishment for the custody of money which it pays

out on a customer's order ". But this definition is also not enough, because it

considers the deposit accepting and repayment functions only. The meaning

of the bank can be understood only by its functions just as a tree-is, known by

its fruits. As any other subjects, it has its own origin, growth and development.

Let us briefly trace the evolution of Banking.

1.1 EVOLUTION OF BANK

It is interesting to trace the origin of the word 'bank' in the modern

sense, to the German word "Banck" which means, heap or mound or joint

stock fund. From this, the Italian word "Banco" meaning heap of money was

coined.

Some people have the opinion that the word "bank" is derived from

the French words " bancus" or "banque" which means a 'bench' . Initially, the

bankers, the Jews in Lombardy, transacted their business on benches in the

market place and the bench resembled the banking counter. If a banker failed,

his' banque' (bench) was broken up by the people, hence the Word "bankrupt"

has come. In simple term, bankrupt means a person who has lost all his

Money, wealth or financial resources.

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Thus, the origin of the word bank can be traced as follows:

Banck — German (Joint stock fund)

Banco — Italian (Heap of money)

Bancus/ — French (Bench/chest a place where valuables are kept)

Bank – English (Common meaning prevalent today, i.e., as an institution

accepting money as deposit for lending

In India, the Banking Regulation Act, 1949, under which banks are

regulated by the Reserve Bank of India, defines a banking company and

banking as under:

1.2 DEFINITION OF BANK Section 5(b) defines bank as accepting for the purpose of lending or

investment of deposits of money from the public, repayable on demand or

otherwise and withdrawal by cheque, draft, and order or otherwise. Section

49A of the Act prohibits any institution other than a banking company to

accept deposit money from public withdrawal by cheque. Students may note

that the essence of banking business is the function of accepting deposits

from public with the facility of withdrawal of money by cheque. In other words,

the combination of the functions of acceptance of public deposits and

withdrawal of the money by cheques by any institution cannot be performed

without the approval of Reserve Bank.

A bank is an institution which deals in money and credit. Thus, bank

is an intermediary which handles other people's money both for their

advantage and to its own profit. But bank is not merely a trader in money but

also an important manufacturer of money. In other words, a bank is a factory

of credit.

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Let us see the definitions of bank and banking, given by various

authorities.

Crowther defines a bank as, "one that collects money from those

who have it to spare or who are saving it out of their income and lends the

money so collected to those who require it".

Dr. L. Hart, says that the bankers are "one who in the ordinary

course of business ; honours cheques drawn upon him by persons from and

for whom he receives money on current accounts".

Sir Jhon Paget says that, "no person or body corporate otherwise

can be a banker who does not, (i) take deposit accounts, (ii) take current

accounts, (iii) issue and pay cheques, and (iv) collect cheques, for his

customers".

Sir Kinley, "A bank is an establishment which makes to individuals

such advances of money as may be required and to which individuals entrust

money when not required by them for use".

Prof. Sayers says that "Banks are not merely purveyors of money

but also in an important sense, manufacturers of money".

Although the above definitions have described the meaning of bank,

none of them precisely defined, 'Banking' incorporating its entire functions.

However, an attempt has been made in Section 5(1) (b&c) of the Banking

Regulation Act, 1949 to define 'Banking' and 'Banking Company'.

According to Section 5(1) (b), "Banking means accepting for the

purpose of lending or investment, of deposits of money from the public,

repayable on demand or otherwise and withdrawal by cheques, draft, order or

otherwise".

Section 5(1)(c) defines banking company as, "any company which

transacts the business of banking in India".

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SCHEDULED BANKS

Scheduled Banks are those banks which are listed in the Second

Schedule to the Reserve Bank of India Act, 1934. The Banks satisfying the

following conditions are only included in the Second Schedule.

(a) That the Bank’s paid up capital plus free reserves are not less than Rs. 5.00

lakh, and

(b) That the affairs of the Bank are not conducted to the detrimental interest of

the depositors.

The Reserve Bank also has powers to deschedule a bank, when the

abovementioned conditions are not satisfied. It may be noted presently, the

RBI has prescribed a minimum capital of Rs. 100 crores for starting a new

commercial bank.

DEFINITION OF BANKING COMPANY

The Banking Regulation Act, 1949 defines a banking company as a

company which transacts the business of banking in India [Section 5(c)].

The development of 'Banking' is evolutionary in nature. There is no single

answer to the question of what is banking, because a bank performs a

multitude of functions and services which cannot be comprehended into a

single definition. For a common man, a bank means a storehouse of money,

for a businessman it is an institution of finance and for a worker it may be a

depository for his savings.

It may be explained in brief as "Banking is what a bank does." But it is

not clear enough to understand the subject in full. The Oxford Dictionary

defines a bank as "an establishment for the custody of money which it pays

out on a customer's order ". But this definition is also not enough, because it

considers the deposit accepting and repayment functions only. The meaning

of the bank can be understood only by its functions just as a tree-is, known by

its fruits. As any other subjects, it has its own origin, growth and development.

Let us briefly trace the evolution of Banking.

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1.3. ORIGIN OF BANKING IN INDIA:

Banking in India is indeed as old as Himalayas. But, the banking

functions became an effective force only after the first decade of 20th century.

Banking is an ancient business in India with some of oldest references in the

writings of Manu. Bankers played an important role during the Mogul period.

During the early part of the East India Company era, agency houses were

involved in banking. Modern banking (i.e. in the form of joint-stock companies)

may be said to have had its beginnings in India as far back as in 1786, with

the establishment of the General Bank of India. Three Presidency Banks were

established in Bengal, Bombay and Madras in the early 19th century. These

banks functioned independently for about a century before they were merged

into the newly formed Imperial Bank of India in 1921. The Imperial Bank was

the forerunner of the present State Bank of India. The latter was established

under the State Bank of India Act of 1955 and took over the ImperialBank.

The Swadeshi movement witnessed the birth of several indigenous banks

including the Punjab National Bank, Bank of Baroda and Canara Bank. In

1935, the Reserve Bank of India was established under the Reserve Bank of

India Act as the central bank of India. In spite of all these developments,

independent India inherited a rather weak banking and financial system

marked by a multitude of small and unstable private banks whose failures

frequently robbed their middle-class depositors of their life’s savings. After

independence, the Reserve Bank of India was nationalized in 1949 and given

wide powers in the area of bank supervision through the Banking Companies

Act (later renamed Banking Regulations Act). The nationalization of the

Imperial bank through the formation of the State Bank of India and the

subsequent acquisition of the state owned banks in eight princely states by

the State Bank of India in 1959 made the government the dominant player in

the banking industry. In keeping with the increasingly socialistic leanings of

the Indian government,

To understand the history of modern banking in India, one has to refer to the

"English Agency Houses" established by the East India Company. These

Agency Houses were basically trading firms and carrying on banking business

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as part of their main business. Because of this dual functions and lack of their

own capital (Agency Houses depend entirely on deposits for their capital

requirements) they failed and vanished from the scene during the third

decade of 18th century, The East India Company laid the foundations for

modern banking in the first-half of the 19th century with the establishment of

the following three banks:

(i) Bank of Bengal in 1809

(ii) Bank of Bombay in 1840

(iii) Bank of Madras in 1843

These banks are also known as "Presidency Banks" and they

functioned well as independent units.

During the last part of 19th century and early phase of 20th century,

the 'Swadeshi Movement' induced the establishment of a number of banks

with Indian Management.

For example, Punjab National Bank Ltd. in 1895, The Bank of India

Ltd. in 1906, The Canara Bank Ltd. in 1906, The Indian Bank Ltd. in 1907,

The Bank of Baroda Ltd. in 1908, The Central Bank of India Ltd. in 1911 and

many other banks were established on the same line. But most of the weak

banks went bankrupt due to wrong policy decisions taken by the management

and due to severe banking crisis during 1913-18, the period of World War I.

However, the stronger and well managed banks like those mentioned above

survived, the crisis.

In 1920, the "Imperial Bank of India Act" was passed for

amalgamating the three Presidency Banks. As such, the 'Imperial Bank of

India' was established in 1921. It was given power to hold government funds

and manage the Public debt. The branches of the bank were functioning as

clearing houses (Agency for effecting settlement of funds among banks).

However, it was not authorized to issue currency.

Even though the need for a Central Bank was felt in the 18th century,

it could be materialized only in the 20th century. On the basis of the

recommendations of the Banking Enquiry Committee, the Reserve Bank of

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India Act was passed in 1934. Accordingly the Reserve Bank of India was

constituted in 1935 to regulate the issue of Bank notes, securing monetary

stability in India and to operate the currency and credit system of the country

to its economic development. Initially, it was constituted as a private

shareholders' bank with a fully paid up capital of Rs. 5 crores. . After

independence, there was a general attitude towards its nationalization. Thus,

the 'Reserve Bank of India' (Transferred to public ownership) Act was passed

in 1948. Accordingly, the entire Share Capital of the bank was acquired by the

Central Government from the private shareholders against compensation and

it was nationalised on January 1, 1949.

In 1955, the 'State Bank of India Act' was passed. Accordingly the

'Imperial Bank' was nationalized and 'State Bank of India' emerged with the

objective of extension of banking facilities on a large scale, specifically in the

rural and semi-urban areas and for various other public purposes.

In 1959, the 'State Bank of India' (Subsidiary Banks) Act was passed

by which the public sector banking was further extended. The following banks

were made the subsidiaries of State Bank of India:

(i) The State Bank of Bikaner

(ii) The State Bank of Jaipur

(iii) The State Bank of Indore

(iv) The State Bank of Mysore

(v) The State Bank of Patiala

(vi) The State Bank of Hyderabad

(vii) The State Bank of Saurashtra

(viii) The State Bank of Travancore

In 1963, the first two banks were amalgamated under the name of

"The State Bank of Bikaner and Jaipur". In 1969, fourteen major Indian

commercial banks were nationalized. These banks are Allahabad Bank, Bank

of Baroda, Bank of India, Canara Bank, Central Bank of India, Dena Bank,

Indian Bank, Indian Overseas Bank, Punjab National Bank, Syndicate Bank,

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Union Bank of India, United Bank of India, United Commercial Bank and

Vijaya Bank. And in 1980 six more banks were nationalized. These banks

constitute the public sector banks while the other scheduled banks and non-

scheduled banks are in the private sector.

1.4. FEATURES OF BANKING:

From the views of above authorities, we can derive the following

basic characteristics of Banking:

(i) Dealing in money: The banks accept deposits from the public and advancing

them as loans to the needy people. The deposits may be of different types –

current, fixed, saving etc. accounts. The deposits are accepted on various

terms and conditions.

(ii) Deposits must be withdraw able: The deposits (other than fixed deposits)

made by the public can be withdraw able by cheques, draft on otherwise, i.e.

the bank issue and pay cheques. The deposits are usually withdraw able on

demand.

(iii) Dealing with credit: The banks are the institutions that can create i.e., creation

of additional money for lending. Thus, “creation of credit” is the unique feature

of banking.

(iv) Commercial in nature: Since all the banking functions are carried on with the

aim of making profit, it is regarded as commercial institutions.

(v) Nature of agent: Besides the basic functions of accepting deposits and

lending money as loans, banks possess the character of an agent because of

its various agency services.

1.5. CLASSIFICATION OF BANKS :

Today is the age of specialization and we can find specialization in all

fields including banking. The banks have specialized in a particular line of

finance. Various types of banks have developed to suit the economic

development and requirements of the country. The principal banking

institutions of a country may be classified into following types:

(1) Central Banks

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(2) Commercial Banks

(3) Industrial Or Development Banks

(4) Exchange Banks (authorized dealers in foreign exchange)

(5) Co-operative Banks

(6) Land-mortgage Banks

(7) Indigenous Banks

(8) Savings Banks

(9) Supranational Banks

(10) International Banks

Central Banks: Central Bank is the bank of a country – a nation. Its

main function is to issue currency known as ‘Bank Notes’. This bank acts as

the leader of the banking system and money market of the country by

regulating money and credit. These banks are the bankers to the government,

they are banker’s banks and the ultimate custodian of a nation’s foreign

exchange reserves. The aim of the Central Bank is not to earn profit, but to

maintain price stability and to strive for economic development with all round

growth of the country.

Commercial Banks: A bank, which undertakes all kinds of ordinary

banking business, is called a commercial bank.

Industrial Banks or Financial Institutions: An Industrial Bank is

one which specializes by providing loans and fixed capital to industrial

concerns by subscribing to share and debenture issued by public companies.

Exchange Banks (Authorised Dealers in Foreign Exchange):

These types of banks are primarily engaged in transactions involving foreign

exchange. They deal in foreign bills of exchange import and export of bullion

and otherwise participate in the financing of foreign trade.

Co-operative Banks: They are organized on co-operative principles

of mutual help and assistance. They grant short-term loans to the

agriculturists for purchase of seeds, harvesting and for other cultivation

expenses. They accept money on deposit from and make loans to their

members at a low rate of interest.

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Land-mortgage Banks (Presently known as Agriculture and Rural Development Banks):They are agriculture development banks. The

Land-mortgage banks supply long-term loans for a period up to 15 years for

development of land to improve agricultural yields. They grant loan for

permanent improvements in agricultural lands. The National Bank for

Agriculture and Rural Development (NABARD) was constituted by the

Government to promote rural development.

Indigenous Banks: The Central Banking Enquiry Commission

defined an indigenous banker as an individual or film accepting deposits and

dealing in indigenous lending of money to the needy. They form unorganized

part of the banking structure, i.e., these are unrecognized operators in

receiving deposits and lending money.

Savings Banks: These are institutions which collect the periodical

savings of the general public. Their main object is to promote thrift and saving

habits among the middle and lower income sections of the society.

Supranational Banks: Special Banks have been created to deal with

certain international financial matters. World Bank is otherwise known as

International Bank for Reconstruction and Development (IBRD) which gives

long-term loans to developing countries for their economic and agricultural

development. Asian Development Bank (ADB) is another Supranational Bank

which provides finance for the economic development of poor Asian countries.

International Banks: International Banks are those which are

operating in different countries. While, the registered office/head office is

situated in one country, they operate through their branches in other

countries. They specialize in Banking business pertaining to foreign trade like

opening of letters of credit, providing short-term finance in foreign currency,

issue of performance guarantee, arranging foreign currency credits, etc. They

are the main traders in International Currencies like US 'dollars', Japanese

'Yen', the new-born European Currency 'Euro', etc.

1.6. BANKING SYSTEM :

The structure of banking system differs from country to country

depending upon their economic conditions, political structure and financial

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system. Banks can be classified on the basis of volume of operations,

business pattern and areas of operations. They are termed as system of

banking. The commonly identified systems are,

1. Unit banking

2. Branch Banking

3. Correspondent Banking System

4. Group Banking

5. Chain Banking

6. Pure Banking

7. Mixed Banking

8. Relationship banking

9. Narrow Banking

10. Universal Banking

11. Retail Banking

12. Wholesale Banking

13. Private Banking:

Unit banking: Unit banking is originated and developed in U.S.A. In

this system, small independent banks are functioning in a limited area or in a

single town i.e., the business of each bank is confined to a single office, which

has no branch at all. It has its own board of directors and stockholders. It is

also called as "localized Banking".

Branch Banking: The Banking system of England originally offered

an example of the branch banking system, where each commercial bank has

a network of branches spread throughout the country.

Correspondent Banking: Correspondent banking system is

developed to remove the difficulties in unit banking system. It is the system

under which unit banks are linked with bigger banks. The big correspondent

banks are linked with still bigger banks in the financial centers. The smaller

banks deposit their cash reserve with bigger banks. The bigger banks with

whom such deposits are so made are called correspondent banks.

Therefore, correspondent banks are intermediaries through which all

unit banks are linked with bigger banks in financial centers. Through

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correspondent banking, a bank can carry-out business transactions in another

place where it does not have a branch.

Group Banking: Group Banking is the system in which two or more

independently incorporated banks are brought under the control of a holding

company. The holding company may or may not be a banking company.

Under group banking, the individual banks may be unit banks, or banks

operating branches or a combination of the two.

Chain Banking: Chain banking is a system of banking under which a

number of separately incorporated banks are brought under the common

control by a device other than holding company. This may be:

(a) Through some group of persons owning and controlling a number of

independent banks. (b) Each bank retains its separate identity. (c) Each one

carries out its operations without the intervention of any central organisation.

Pure Banking and Mixed Banking: On the basis of lending

operations of the bank, banking is classified into :

(a) Pure Banking

(b) Mixed Banking

(a) Pure Banking: Under pure Banking, the commercial banks give only

short-term loans to industry, trade and commerce. They specialize in short-

term finance only. This type Of banking is popular in U.K.

(b) Mixed Banking: Mixed banking is that system of banking under which the

commercial ban s perform the dual function of commercial banking and

investment banking, i.e., it combines deposit and lending activity with

investment banking. Commercial banks usually offer both short-term as well

as medium term loans. The German banking system is the best example of

mixed Banking.

Relationship banking: Relationship banking refers to the efforts of a

bank to promote personal contacts and to keep continuous touch with

customers who are very valuable to the bank. In order to retain such profitable

accounts with the bank or to attract new accounts, it is necessary for the bank

to serve their needs by maintaining a close relationship with such customers.

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Narrow Banking: A bank may be concentrating only on collection of

deposits and lend or invest the money within a particular region or certain

chosen activity like investing the funds only in Government Securities. This

type of restricted minimum banking activity is referred to 'Narrow Banking’.

Universal Banking: As Narrow Banking refers to restricted and

limited banking activity Universal Banking refers to broad-based and

comprehensive banking activities. Under this type of banking, a bank will deal

with working capital requirements as well as term loans for developmental

activities. They will be dealing with individual customers as well as big

corporate customers. They will have expanded lines of business activity

combining the functions of traditional deposit taking, modern financial

services, selling long-term saving products, insurance cover, investment

banking, etc.

Regional banking: In order to provide adequate and timely credits to

small borrowers in rural and semi-urban areas, Central Government set up

Regional Banks, known as Regional Rural Banks all over India jointly with

State Governments and some Commercial Banks. As they are permitted to

operate in particular region, it may help develop the regional economy.

Local Area Banks: With a view to bring about a competitive

environment and to overcome the deficiencies of Regional Banks,

Government has permitted establishment of a one type of regional banks in

rural and semi-urban centers under private sector known as “Local Area

Banks”.

Wholesale Banking: Wholesale or corporate banking refers to

dealing with limited large-sized customers. Instead of maintaining thousands

of small accounts and incurring huge transaction costs, under wholesale

banking, the banks deal with

large customers and keep only large accounts. These are mainly corporate

customer.

Private Banking: Private or Personal Banking is banking with people

— rich individuals instead of banking with corporate clients. Private or

Personal Banking attends to the need of individual customers, their

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preferences and the products or services needed by them. This may include

all round personal services like maintaining accounts, loans, foreign currency

requirements, investment guidance, etc.

Retail Banking: Retail banking is a major form of commercial

banking but mainly targeted to consumers rather than corporate clients. It is

the method of banks' approach to the customers for sale of their products.

The products are consumer-oriented like offering a car loan, home loan

facility, financial assistance for purchase of consumer durables, etc. Retail

banking therefore has large customer-base and hence, large number of

transactions with small values. It may therefore be cost ineffective in a highly

competitive environment. Most of the Rural and semi-urban branches of

banks, in fact, do retail banking. In the present day situation when lending to

corporate clients lead to credit risk and market risk, retail banking may

eliminate market risk. It is one of the reasons why many a wholesale bankers

like foreign banks also prefer to go for consumer financing albeit for

marginally higher net worth individual.

1.7 RATIONALE

We have seen the evolution and development of banking sector in

india and found that the Indian Banking system has undergone tremendous

changes since the nationalization of major commercial banks. Nowhere in the

history of the world, the banking system has grown in similar dimensions as in

India in the past 25 years. Following the two phases of nationalization, there has

been considerable increase in the number of bank offices, quantum of deposits

and advances and number of transactions. Simultaneously, the banking system

has also shifted its focus from “Class Banking” to “Mass Banking” from

“Traditional Banking” to Innovative Banking” and from “Asset-nexus” lending to

“Production-nexus lending”. They have also done a commendable job in the

field of societal banking. These are, no doubt, great achievements of the

country’s banking system. But on the other side of the coin, it has to be

conceded that the Indian banking system today is confronted with many

problems. Deteriorating customer service in banks is a mater causing serious

concern. Due to increased social responsibilities and obligations and mounting

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over dues, there has been considerable decline in the profitability of some of the

banks. Further, they are facing stiff competition not only from the non-banking

companies but also from the corporate giants in mobilizing deposits. The recent

stock and other financial scams which have raised some doubts about the

integrity of the banking system have also added fuel to fire.

Bank customers are becoming more choosy in their preferences. The

intense competition among banks, other financial institutions, and the corporate

sector and greater awareness among bank customers have resulted in a

buyers’ market for banking products/services. This has aggravated the problem

of fierce competition and now banks face difficulties in attracting clientele. The

broad thrust of reforms in the banking sector has been clear enough to ease

norms that have weighted down profitability in the banking system to introduce

greater competitiveness; and to introduce greater operational efficiency. In the

first category are included those measures such as reduction of SLR and

simplification of administered interest rate belong to the second category. The

third category envelops the new capital adequacy norms as well as norms of

income recognition, freedom to close non-viable branches, mergers and tapping

the capital market to augment banks resources base.

It is evident to note that the banking sector is moving towards a market

driven pattern wherein efficiency, profitability and customer orientation have

become the watchwords. The complexion of the banking sector has undergone

a significant change in terms of their overall attitude towards products, services,

technology etc. Suddenly, banks find themselves in a market where the buyer

has more options than ever before and the seller (i.e. bank) has to constantly

review his package of services to suit the customer’s expectations. If

deregulation of interest rates was one fact of change, another has been the

introduction of various new instruments like certificate of Deposits, Commercial

Paper Money Mutual Fund. These are supposed to help the corporate and

individual investors in a variety of ways.

1.8 SPREAD OF BANKING IN INDIA

The Indian banking system has done extremely well in the past 25

years. There has been a spectacular spread of banking with an increase in the

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number of branches from 8,262 in June, 1969 to 74,852 at the end of March,

2010. The population per branch has come down from 64,000 to 11,000 during

this period. There has been an impressive growth of rural branches, the number

rising from 1,833 in June, 1969 to 55,379 at the end of March, 2010. The

number of semi urban branches has risen from 3,342 to 24,320 of urban

branches from 1,584 to 38,324 and or metropolitan branches from 1,503 to

18,929. The number of scheduled commercial banks has gone up from 73 to

381 during the period.

However, with the progress on various fronts, Indian banks had also

developed several weaknesses during the past nationalization period. The

deposit and lending rates were controlled, a large portion of bank resources was

steadily pre-empted through statutory liquidity ratio by way of low yielding

Government and other securities and high cash and reserve ratios. Banks have

had to operate under several constraints dictated by socio-economic objectives,

which have had a bearing of their profitability. These relate primarily to the rapid

and vast expansion of banking facilities with its associated costs, the allocation

of credit for priority needs and the element of class subsidization to asset

preferred sectors.

LIBERALIZATION

Liberalization (or liberalization) refers to a relaxation of previous government

restrictions, usually in areas of social or economic policy. In some contexts this

process or concept is often, but not always, referred to as deregulation. In the

arena of social policy it may refer to a relaxation of laws restricting. Most often,

the term is used to refer to economic liberalization, especially trade liberalization

or capital market liberalization.

LIBERALIZATION IN INDIAN BANKING SECTOR

Liberalization in Indian banking sector was begun since 1992, following the

Narsimham Committee Report (December 1991). The 1991 report of the

Narsimham Committee served as the basis for the initial banking sector reforms

.In the following years, reforms covered the areas of interest rate deregulation,

directed credit rules, statutory pre-exemptions and entry deregulation for both

domestic and foreign banks. The objective of banking sector reforms was in line

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with the overall goals of the 1991 economic reforms of opening the economy,

giving a greater role to markets in setting prices and allocating resources, and

increasing the role of the private sector. The Narsimham Committee was first

set up in 1991 under the chairmanship of Mr. M. Narsimham who was 13th

governor of RBI. Only a few of its recommendations became banking reforms of

India and others were not at all considered. Because of this a second committee

was again set up in 1998.As far as recommendations regarding bank

restructuring, management freedom, strengthening the regulation are

concerned, the RBI has to play a major role.

1.9 BACKDROP OF REFORMS Despite this commendable progress, serious problems have emerged

resulting in a decline in productivity and efficiency, and erosion of profitability

of the banking sector. While nationalization achieved the widening of the

banking industry in India, the task of deepening their services was still left

unattended. By the beginning of 1990, the social banking goals set for the

banking industry made most of the public sector banks unprofitable. The

Narsimham Committee attributed this state to: (a) directed investments (SLR

and CRR obligations), and (b) directed credit programmes (Priority sector

lending). By 1991 the administered interest rates have become highly

complex and rigid. Further, the inadequacy of capital in the banking system

was a cause for concern. Income recognition, asset classification and

provisioning were faulty. Since income was recognized on accrual basis, it

inflated profits. The balance sheets of banks did not therefore disclose the

true health of banks. Non-Performing Assets accumulated which has an

impact on income on the one hand and capital on the other. While the

quantitative restrictions on credit led to credit rationing for the private sector,

interest rate controls led to sub optional use of credit and low levels of

investment and growth. The resultant 'financial repression' led to the decline

in productivity and efficiency and erosion of profitability of the banking sector

in general.

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1.10 THEME OF THE STUDY

It is against the background of these circumstances, that the

development of a sound banking system was considered essential for the

future growth of the financial system. Financial sector reforms were initiated in

the country in 1992 with a view to improving the efficiency in the process of

financial intermediation, enhancing the effectiveness in the conduct of

monetary policy and creating conducive environment for the integration of

domestic financial sector with the global system

.The first phase of banking sector reforms was guided by the report of

the committee on the Financial System (presided over by M. Narsimham,

Governor of RBI), which was submitted to the Government in November

1991. The approach of the Committee was to ensure that the financial

services industry operates on the basis of operational flexibility and functional

autonomy with a view to enhancing efficiency, productivity and profitability of

the banking sector.

PROBLEMS IDENTIFIED BY THE NARASIMHAM COMMITTEE

i. Directed Investment Program : The committee objected to the system of

maintaining high liquid assets by commercial banks in the form of cash, gold

and unencumbered government securities. It is also known as the Statutory

Liquidity Ratio (SLR). In those days, in India, the SLR was as high as 38.5

percent. According to the M. Narasimham's Committee it was one of the

reasons for the poor profitability of banks. Similarly, the Cash Reserve Ratio-

(CRR) was as high as 15 percent. Taken together, banks needed to maintain

53.5 percent of their resources idle with theRBI. .

ii. Directed Credit Program : Since nationalization the government has

encouraged the lending to agriculture and small-scale industries at a

confessional rate of interest. It is known as the directed credit programme.

The committee opined that these sectors have matured and thus do not need

such financial support. This directed credit programme was successful from

the government's point of view but it affected commercial banks in a bad

manner. Basically it deteriorated the quality of loan, resulted in a shift from the

security oriented loan to purpose oriented. Banks were given a huge target of

19

priority sector lending, etc. ultimately leading to profit erosion of banks..

iii. Interest Rate Structure : The committee found that the interest rate

structure and rate of interest in India are highly regulated and controlled by

the government. They also found that government used bank funds at a

cheap rate under the SLR. At the same time the government advocated the

philosophy of subsidized lending to certain sectors. The committee felt that

there was no need for interest subsidy. It made banks handicapped in terms

of building main strength and expanding credit supply.

iv. Additional Suggestions : Committee also suggested that the

determination of interest rate should be on grounds of market forces. It further

suggested minimizing

The slab of interest. Along with these major problem areas M. Narasimham's

Committee also found various inconsistencies regarding the banking system

inIndia.

The first phase of reforms have been well calibrated and timed to

ensure smooth transition of the system from a highly regulated regime with

administered interest rate structure, quantitative requirements and preemption

of a significant proportion of lendable resources for the priority sector and

government sectors (Statutory Liquidity Requirements) to a market-based

system. The gradual scaling down of cash reserves and statutory liquidity

requirements (SLR) has afforded flexibility to banks to manage their asset

portfolios in time. The implementation of prudential norms relating to income

recognition, asset classification and provisioning capital adequacy

requirements characterized the first phase of banking reforms.

The second generation of banking sector reforms was guided by the

report of the Committee on Banking Sector Reforms (again presided over by

M. Narasimham) 1998. The reform measures focused on strengthening the

foundations of the banking system, streamlining procedures, upgrading

technology and human resources development and further structural

changes.

The norms of BASEL I and BASEL II committee:

The Basel I framework was confined to the prescription of only minimum

capital requirements for banks, the Basel II framework expands this approach

20

not only to capture certain additional risks in the minimum capital ratio but

also includes two additional areas, viz. Supervisory Review Process and

Market Discipline through increased disclosure requirements for banks. Thus,

Basel II framework rests on the following three mutually- reinforcing pillars:

Pillar 1: Minimum Capital Requirements — prescribes a risk-sensitive

calculation of capital requirements that, for the first time, explicitly includes

operational risk along with market and credit risk.

Pillar 2: Supervisory Review Process (SRP) — envisages the establishment

of suitable risk management systems in banks and its review by the

supervisory authority.

Pillar 3: Market Discipline — seeks to achieve increased transparency

through expanded disclosure requirements for banks.

The process of implementing Basel II norms in India is being carried out in

phases. Phase I has been carried out for foreign banks operating in India and

Indian banks having operational presence outside India with effect from March

31,2008.

In phase II, all other scheduled commercial banks (except Local Area Banks

and RRBs) will have to adhere to Basel II guidelines by March 31, 2009. With

the deadline of March 31, 2009 for full implementation of Basel II norms fast

approaching, banks are looking to maintain a cushion in their respective

capital reserves. The minimum capital to risk-weighted asset ratio (CRAR) in

India is placed at 9%, one percentage point above the Basel II requirement.

All the banks have their Capital to Risk Weighted Assets Ratio (CRAR) above

the stipulated requirement of Basel guidelines (8%) and RBI guidelines (9%).

As per Basel II norms, Indian banks should maintain tier I capital of at least

6%.

The Government of India has emphasized that public sector banks should

maintain CRAR of 12%. For this, it announced measures to re-capitalize most

of the public sector banks, as these banks cannot dilute stake further, as the

Government is required to maintain a stake of minimum 51% in these banks.

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1.11 NEED FOR THE STUDY

A sea change has taken place in the banking environment since the

initiation of reform process in 1992-93. The period of almost two decades

witnessed remarkable changes in perceptions, policies and practices of

banks. In the light of sweeping changes that have taken place in banking

policies and practices during the last nineteen years of reform period, it is

thought appropriate to evaluate the impact of reform measures on the

efficiency, profitability and overall performance of banks vis-a-vis bank groups

in the public and private sector since 1992-93 and also to make a comparative

analysis of performance of bank groups in both quantitative and qualitative

aspects.

Though recently a large number of studies evaluating the performance

of commercial banks in the reform period have come up, yet certain important

aspects remain untouched. These studies by and large confined to economic

aspects of their performance i.e., profits alone and socio-economic

dimensions of their working are altogether ignored. Moreover, in most of these

studies, analysis is passed upon very limited number of indicators, limited

number of years and for limited banks and bank groups. Not even a single

study seems to cover sufficiently large time span after the initiation of reforms

by taking the required number of indicators and incorporating all the public

and private sector banks and bank groups. Therefore against this

background, it is thought desirable to take up a comprehensive study

evaluating and comparing the performance of different aspects of the

domestic commercial banks in India.

Banks should discard old practices/ethos that act as constraints and

indicate modern methods of management/operation to stand up to the

challenges. This ‘re-engineering process’ aims at reviewing the current business

practices and elimination of non value-added services in pursuit of total

customer satisfaction. In fact, many international management consultants have

developed strategies for banks which adopt the ‘re-engineering strategies’. The

re-engineering takes the focus on customer one step further and combines risk

analysis, market research, business analysis and cost-cutting strategies as

components of the process. Good banking needs healthy competition and not

22

war among banks. The underlying force for healthy competition should come

from effective marketing strategies. In fact, marketing has become an

inseparable portion of successful banking.

Banks in future have to take recourse to effective marketing strategies

on account of;

(1) Compulsion in the area of profitability of banking business;

(2) Resource crunch and poor recovery;

(3) Efforts to globalize our economy and integrate it with the rest of the

world;

(4) Need for effective product development;

(5) Emergence of new range of banking services; and

(6) Ensuring optimum use of vast banking infrastructure.

Given the above scenario one can conclude that practicing the

‘marketing concept’ is the only way left to the banks for their survival. Hence,

marketing of banking services has a crucial role to play and greater efforts are

to be made to make the banks market oriented.

Accepting deposits and granting loans and advances are the primary

functions of a banker. Schemes designed to accept various types of deposits

and sanction advances for different purposes are the products for the banker.

Merchant banking services, mutual funds, credit cards, factoring and

investment counseling services are some of the innovative products of the

banking industry. Banks are desirous of devising new schemes/products

without violating RBI norms. For the successful marketing of such

schemes/products a few tips are given below-

1. Knowing its own strengths and weaknesses is equally an important

element in bank marketing. Wide net-work of branches, regional

concentration, strong metropolitan base and possession of good

counter staff with acumen and enthusiasm are the strengths of a bank.

On the other hand, poor customer services, absence of national

network of branches and stiff resistance of personnel to changes are

some of the weaknesses of a bank. Banks have to design schemes to

23

popularize their products in the market by availing the strengths of the

organisation and by circumventing the weakness.

2. Effective bank marketing requires a well co-ordinate effort at all levels

of the organisation. Ideas to launch new products may emanate from

the planning and development department. But this department has to

design pragmatic schemes. It is high time Indian banks created an

exclusive department for marketing as in western countries.

3. Banking is basically a person to person business. In an environment

where major components of marketing mix like ‘place’, ‘product’ and

‘price’ are regulated by the RBI, the quality of service alone determines

the effectiveness of marketing. Bank personnel involved in launching a

new product have to educate the field staff about the special features

of the proposed product. An attempt in this direction will help the

people at the branch level to render quality services to improve the

quantum of business in the new product lines.

4. Timing is yet another important factor in marketing a new

product/service. Every product has a life cycle and the bank has to

enter the market at the right time. Introduction of the instrument ‘stock-

invest’ is timely in the sense the primary market of corporate securities

is buoyant in India.

5. Though the banks corporate office is responsible for the anticipation

and identification of customers’ requirements and design

schemes/products to suit their different needs, it is only at the branch

level that schemes/products are being marketed. Hence, the success

of the scheme/product mostly depends on the marketing strategy

adopted by branch personnel. To start with, the branch has to give

wide publicity to the new schemes in the service area. This may be

done through hoardings, wall paintings, posters and exhibition of slides

in cinema theaters. Effective publicity should ever be followed by direct

marketing for better results. The branch has to prepare a list of

potential customers and the manager has to address a personal letter

to everyone of them highlighting the salient features of the proposed

24

scheme/product. This has to be reinforced through personal contact

either by the branch manager or by the branch staff possessing

influence in the society. In short, the branch manager has to articulate

the marketing strategies and communicate them effectively to his team

of staff for percolation to prospective customers.

6. Promotional campaigns have a stellar role to play in the successful

launching and marketing of banking products. Media support is a must

to make promotional campaigns more effective. But the public sector

banks in India have limited freedom in this regard since they have

largely to confine their publicity campaigns through the joint publicity

committee. As the banks are facing stiff competition and they are

periodically launching investor friendly products/schemes, they should

be permitted to use the popular audiovisual medium-TV, to create

awareness among the general public about the implications of the

proposed schemes/products.

7. Effective marketing requires enough care in designing the product.

Market segmentation facilities the banker to locatemarket opportunities

and market opportunities ,in turn assist to design marketable products.

8. As mentioned above the financial system in India has built, over time, a

vast network of financial institutions and markets. A strong and

efficient financial system is crucial to the attainment of our objectives

of creating a market-driven, productive and competitive economy and

to support higher investment levels and accentuate growth. The

creation of such a system has been the objective that has inspired the

process of financial sector reform since 1992 as part of the broader

programme of structural economic reforms.

As part of this process, reform of the banking sector is now under way.

The banking system is, by far, the most dominant segment of the financial

sector accounting for about two third of the assets of the organized financial

sector and it is appropriate that reform in this sector has been receiving major

emphasis. The reform measures taken in this area have followed the

recommendations of the Committee on the Financial System (CFS), which

25

submitted its report in November 1991. The Report had made a number of

recommendations aimed at improving the productivity, efficiency and profitability

of the banking system on the one hand, and providing it greater operational

flexibility and functional autonomy in decision-making, on the other. It covered

policy aspects, accounting practices, institutional and structural issues and

matters relating to organizational development.

Following the recommendations of the Committee on Financial System

which reported in 1991 and the second Report of the Narasimham Committee in

1998, a considerable ground has been covered in putting in place a financial

system which can meet the requirements of a more competitive and open

economy. By and large, financial reforms in India have proceeded in four major

directions.

First, setting the policy conditions right and removing the operational

constraints of the financial system.

What the reform process has tried to achieve is to lower the share of pre-

empted resources in the total resources of the banking system through gradual

liberalization of the cash reserve ratio and the statutory liquidity ratio.

The second directional change has been in the area of creating a more

competitive environment in financial sector through reform measures such as

relaxation of entry and exit norms, reduction in public ownership in banking

industry and letting banks access capital market for meeting their fund

requirement. The objective is to bring out the best result in terms of pricing and

quality of banking services over a period of time.

The third important direction of reform has been the strengthening of

market institutions and allowing greater freedom to financial intermediaries.

These reforms have taken the form of gradual liberalization of interest rates,

development of money, capital and debt and giving operational flexibility to

banks in the management of their assets and liabilities subject, of course, to

prudential guidelines

The fourth important element of reform concerns the “safety” aspects of

the financial system. This is the core of the challenges facing the financial

system at present. When the reform process was started in 1992, there was a

26

massive problem of cleaning the balance sheets of banks which had

deteriorated over the years. Successive reform initiatives in this area gave been

aimed at prescribing certain prudential standards for the financial system and

addressing certain structural weaknesses which could minimize their recurrence

in future. Measures such as income recognition norms, asset classification,

meeting minimum capital adequacy standards through re-capitalization and

devising a supervisory framework are steps in the direction of ensuring the

safety of the financial system.

The Report of the Narasimham Committee (April 1998) provides a

framework for the current phase of reforms-the second generation of reforms-

which could be conveniently looked at in terms of three broad inter-related

issues:

(i) Actions that need to be taken to strengthen the foundations of the

banking system;

(ii) Related to this, streamlining procedures, upgrading technology and

human resource development Structural changes in the system.

The reforms including the important aspects of banking policy, institutional,

supervisory and legislative dimensions, which have been studied in this study.

Considering the financial reforms banking organizations have changes

their policies, procedures, systems and also operations, to cope with the new

banking policies and to serve the customers in better way and also make

sustainable development.

In this chapter the introduction and evolution of banking sector and its

development has been explained. .The present study is concerned with

Impact of Banking sector Reforms in the post liberalization period. Now in the

coming chapter, I will explain the details of the research methodology.