T R A N S F O R M A T I O N: THREE DECADES OF INDIA’S FINANCIAL AND BANKING SECTOR REFORMS (1991–2021)

TRANSFORMATION

THREE DECADES OF INDIA’S FINANCIAL AND BANKING SECTOR REFORMS

(1991–2021)

A GREAT TURNAROUND OF 1990S AND

EMERGING CHALLENGES

DASARATHI MISHRA

AN EXPERIENCED CENTRAL BANKER AND BANKING REGULATOR

Copyright © 2022 by Dasarathi Mishra.

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CONTENTS

Foreword

Preface

1   India’s Financial Sector Reforms: A Great Turn Around In The Banking Sector

2   Banking Sector Reforms In India - Towards Competitive Efficiency

3   Entry of New Banks In The Private Sector

4   Differentiated Banking In India – Turning A New Leaf

5   Foreign Banks’ Presence In India And Indian Banks’ Foray Overseas

6   Banking Regulation In India A Robust Framework

7   Ownership And Governance of Banks

8   Banking Supervision – From Rule Based To Risk Based

9   External Sector Reforms – Navigating Important Milestones

10   India’s NPA Management – A Creditable Achievement

11   Credit Information System In India – Ushering In A New Credit Culture

12   Consolidation of The Indian Banking Sector

13   Technology In Banks–A Transformative Role

14   Payment And Settlement System – A Game Changer

15   Fintech Revolution

16   Reforms In The NBFC Space

17   Micro Finance Institutions - Serving The Bottom Of The Pyramid

18   Consumer Protection For Small Depositors

19   Financial Inclusion – A Movement In India

20   Financial Literacy – Harbinger Of Change

21   Transformation of India’s Infrastructure

22   Capital Account Convertibility – A Journey

23   Gold Policy – Pragmatic And Progressive

24   India’s External Debt – Sustainable

25   Crypto Eco System – Challenges Galore

26   Impact Of Covid-19 On The Indian Economy And Policy Response

27   India’s Economic Journey Beyond 2021

Acknowledgements

To

Amit, Asima, Anshuman, Mihika and Sakuntala

FOREWORD

T he financial sector reforms, started in 1991, envisaged promoting a competitive, diversified and efficient financial sector in the country with the objective of improving allocative efficiency of available resources, strengthening financial health of the banks and financial institutions. The reform process resulted in visible improvement in profitability and efficiency of banks. The new standards focused attention on banks soundness and stability by introducing wide ranging reforms from infusing competition, introducing more stringent prudential norms to compliance with international regulatory standards. On the recommendation of the Narasimham Committee, licences were issued to new private banks which heralded a new generation of banks that were fully automated from commencement and had a demonstration effect on the public sector banks to enhance use of technology.

Because of the reform process and the sound management of capital account, India remained much less vulnerable than most of the East Asian economies during the South-East Asian crisis of 1997-98 and Global Financial Crisis of 2008-09.

To widen financial inclusion, RBI issued differentiated banking license viz., Small Finance Banks (SFBs) and Payments Banks (PBs) in 2015. Small financial banks, Payment banks were allowed to function in niche areas. They are playing a significant role in furthering financial inclusion.

Banking regulation must balance the focus on systemic aspects with promoting efficient and competitive financial systems and healthy institutions to support growth and economic development. In recognition of the fact that the costs of systemic crisis can be excessive, significant work has started post crisis at the international level to lay down minimum standards for assessing soundness of individual financial institutions as well as focusing on stability of the financial system through higher standards for the systemically important financial institutions and through macro prudential regulations.

NBFCs are an important segment of the financial sector as they support economic activity and complement the credit intermediation function of banks both by widening and deepening access to financial services. They have played a crucial role in providing access to the unbanked and enhanced competition in the financial sector. Their cost structure is lower, decision making is quicker, they are more customer oriented which results in more efficient financial services. On the liabilities side, NBFCs do not provide operating account facilities like savings and current deposits, cash credits, overdrafts etc. However, on the liabilities side they borrow from markets, banks and from other entities in the financial sector as well as external sources to the extent permitted. Due to divergent regulatory requirements, there was scope for regulatory arbitrage which allowed some NBFCs to grow the balance sheet and assume systemic importance. RBI has been making significant modifications in the regulatory framework for NBFC with a view to address systemic risks as also bring in proportionality of regulation based on scale.

Recent governance failures in financial services companies have brought to fore the importance of quality of governance on efficiency in allocation of resources, protection of depositors’ interest and maintaining financial soundness and systemic stability. It is erroneous to assume that regulatory oversight is a substitute for corporate governance. The lesson that public policy makers have learnt from the global financial crisis is that banks are risk repositories in the system – any notion of their risks being dissipated into or outside the system is inherently flawed. There is therefore need for limits, prudential safeguards, and adequate capital to support the risks both on and off-balance sheet. Bank boards and management need to lay down internal policies on limits depending on the business model and the risk appetite of the bank. There exists complementarily between regulation and corporate governance in banking. The impact of corporate governance on financial soundness does not end with commercial banks.

It is imperative to extend the principles of good corporate governance practices to cooperatives, NBFCs and other financial institutions. India has been in the forefront in many of the technological developments in both wholesale and retail payments systems. This has led to greater productivity, efficiency and speed in payments and settlement mechanism in the financial system.

Unified Payments Interface (UPI) is a game changer and unique. The system powers multiple bank accounts into a single mobile application (of any participating bank), merging several banking features, seamless fund routing and merchant payments into one hood. It also caters to the Peer to Peer collect request which can be scheduled and paid as per requirement and convenience. This has been possible due to Reserve Bank of India’s initiatives and products to push digital payments, and banks and fintech incentivizing and encouraging customers to shift from paper-based to digital payment modes.

Globally, fintech has accelerated transformation in the financial sector. India is amongst the fastest growing fintech markets in the world. A recent survey indicates that 87 per cent of the digitally active population has adopted fintech, placing it as a leader in the world. Several factors have contributed to the spectacular growth of fintech in India. These are: funding by venture capital, and institutional investors, enhanced telecom, internet and smart phone penetration, favourable demographics, and augmented digital infrastructure. Good to see that the Reserve Bank’s calibrated regulatory approach has kept pace with the rapid developments in the fintech space.

The development of an efficient credit information system is considered critical for the development of a sound financial system. Setting up of Credit information companies piloted by RBI has been a landmark development. CIBIL- the first credit bureau in India was incorporated in 2001 and was launched its operations in April 2004. Following enactment of the Credit Information Companies (Regulation) Act (CICRA) in 2005, Rules and Regulations made in 2006, three other Credit Information Companies (CICs) were set up.

The pandemic continues to have an overwhelming influence on global and domestic macroeconomic conditions. In this milieu, the Reserve Bank has taken many pre-emptive and proactive steps to safeguard the economy from the ravages of the pandemic.

The book is comprehensive in coverage and has captured very well the three decades of Indian banking sector reforms 1991-2021. D Mishra with long experience in banking, NBFC regulation, and expertise in areas such as credit information, foreign exchange, gold policy, merger and amalgamation of banks has explained these topics in a lucid and simple manner. This book is a great reference book and very useful to researchers, practitioners and students interested in banking and finance.

I congratulate the author for producing an authentic and informative work on such an important subject.

Shyamala Gopinath

Former Deputy Governor, Reserve Bank of India

23 March 2022

PREFACE

T he work on the book TRANSFORMATION started more than five years ago. Initially, it was planned to cover twenty five years of financial and banking sector reforms in India (1991–2016). Since then, a lot of developments have taken place in the Indian banking sector. Special mention may be made in the areas of banking regulation, supervision, differentiated banking, credit information companies, merger and amalgamations, the Insolvency and Bankruptcy Code, and Fintech, It was, thus, necessitated to extend the coverage of the book till 2021.

Governments and central banks have responded on a war footing to face the financial challenges at the onset of and during the Covid-19 pandemic. Per the Reserve Bank of India, the central bank remains committed to mitigate the impact of Covid-19 on the economy. The policy responses of the government and RBI have been unparalleled. During these critical years, inflation, liquidity, and non-performing asset (NPA) management are on the right track and right measure, which are laudable. By steering the economy well through a well- coordinated approach by the government and the reserve bank, macroeconomic stability has been maintained. The banks and the corporate sector have emerged stronger. This book also covers crypto assets–a new challenge–and central bank digital currency, which are an in thing.

Going back down the line, I must mention that my article ‘Banking Sector Reforms towards Competitive Efficiency’ was published in the Hindu Business Line, in July 1995. As a faculty member of Reserve Bank Staff College, Chennai, the apex training institution of the reserve bank, I was dealing with banking and related areas and closely following up the reforms in the financial sector. My first article in Edit Page encouraged me to get into writing on banking and finance.

Thereafter, I had contributed select articles on banking and finance, which were published in the Journal of Indian Institute of Banking and Finance and Journal of the Indian Banks’ Association. In the last decade, I wrote articles for Orissa POST, an English daily from Odisha, an eastern state of India.

The reserve bank is a great central banker and banking regulator. I joined the portals of the Reserve Bank of India in late seventies and served the great institution till 2011. During the early days of my career, I had exposure to the functioning of banks as I was associated with statutory inspection of commercial banks. It was a great learning experience as I had exposure to the banking practices, ground rules, credit management, forex management, risk management by the banks, trade credit, etc.

I had the opportunity to conduct a good number of financial education camps in small towns, schools and universities in Odisha targeting students, youth and women, starting from July 2014. Few financial literacy programmes were conducted covering SHG women, senior citizens. The experience is shared in chapter on ‘Financial Literacy- Harbinger of Change’.

In April 2019, I had the opportunity to attend the spring meeting of IMF and the Civil Society Organisation Forum (CSOF) meetings of World Bank headquarters in Washington, DC. There were many lessons to be learnt from the sessions, particularly on financial inclusion and digital banking. I was highly impressed with the way digitalisation through M-Pesa has brought transformation in Kenya as depicted by the governor of the Central Bank of Kenya. This, I mentioned in ‘Financial Inclusion– A Movement in India’.

With a spate of developments in the financial sector after the book was published in 2022, it needed an updation and revision. I have decided to drop the chapter on ‘Demonetisation of High Denomination Notes’ (20) and added one chapter ‘India’s Economic Journey Beyond 2021’ (27). On getting feedbacks from friends, well-wishers, I have changed the sequence of chapters to have a smooth and seamless flow of reading.

Dasarathi Mishra

Bhubaneswar

24 October 2023

1

INDIA’S FINANCIAL SECTOR REFORMS

A Great Turn Around In The Banking Sector

As the reforms were introduced, profitability and

efficiency increased, and non-performing asset ratio

progressively came down. Care was taken to ensure

that the social content of lending was not reduced.

The Indian banking system has emerged considerably

stronger because of the changes introduced.

—C. Rangarajan, former governor, Reserve Bank of India

T he year 1991 was the watershed year for the reform landscape in India. The new government, which took office on 21 June 1991, faced difficult situations. Foreign exchange reserves had depleted which can roughly support two weeks of imports–and fear of default in the external sector was looming large. The government of India, without wasting time, announced structural reforms in the industrial, trade, and public sector policy. Concomitantly, it announced reforms in the financial sector, particularly the banking sector.

The financial system is very important for a country and should be strong enough to support trade, industry, and services bringing in inclusive growth. As India liberalised its economy in 1991, it was felt that banks needed reform. The banking sector, handling 80 percent of the flow of money in the economy, should usher in an efficient, vibrant, and competitive economy by adequately supporting the country’s financial needs.

In this backdrop, the government of India appointed a high-level committee, viz. the Committee on Financial System, on 14 August 1991 with Maidavolu Narasimham, former governor of the Reserve Bank of India, as the chairman to study and suggest reforms in the financial sector. Narasimham, the thirteenth governor of the Reserve Bank of India (RBI) from 2 May 1977 to 30 November 1977 was a noted economist and had deep understanding of the Indian financial system. The other members included A Ghosh, Deputy Governor, RBI, M N Goiporia, Chairman, State Bank of India, Y H Malegam, and noted Chartered Accountant. K J Reddy, Additional Secretary (Banking), Government of India was the Member – Secretary. The committee is popularly known as the Narasimham Committee I.

The memorandum for appointing the committee stated, ‘The last two decades have seen a phenomenal expansion in the geographical coverage and financial spread of our financial system...In recent years, however, certain rigidities and weaknesses have developed in the system, and these must be addressed to enable the financial system to play its role in ushering in a more efficient and competitive economy.’

The objective of the Narasimham Committee I, was to study all aspects relating to the structure, organisation, functions, and procedures of the financial systems and to recommend improvements in their efficiency and productivity. The committee submitted its report to the finance minister in November 1991, which was tabled in the Parliament on 17 December 1991. It made far-reaching recommendations which gave a clear direction of India’s financial sector reform process.

The need for financial sector reforms arose from several reasons. The committee observed that despite impressive quantitative achievements in resource mobilisation, extending credit by banks, several distortions had surfaced. The pace of branch expansion had been spectacular after the nationalisation of 14 banks in 1969 and 6 banks in 1980, with increase of the number of branches from 8,187 in 1969 to 59,752 at the end of March 1990. The growth of rural branches was even faster, increasing from 1,443 in 1969 to 34,791 in 1990. Low operational efficiency contributed to low profitability, leading to erosion in capital. In the process, many banks and financial institutions had turned financially weak and were not able to meet the challenges of a competitive environment. The staggering growth of the branches of banks had placed an enormous organisational and management strain on the banking system.

The committee observed that financial rigidities and aberrations had crept in due to policy-induced inflexibilities, excessive degree of central direction in credit, investment allocation, and political interferences in sanction of credit. The committee’s recommendations touched on transforming Indian banking from a rigidly regulated to a market-oriented system. The reform essentially focused on three important issues: deregulation, introduction of prudential accounting standards, and facilitating the entry of new banks to infuse competition. An article written by the author on banking sector reforms published in the Hindu Business Line assessed the situation: ‘Indian banks are looking up to-day towards operational efficiency, improved productivity and profitability–thanks to the banking sector reforms initiated by the Government of India and the Reserve Bank of India’(D. Mishra,1995).

The seeds of reform sown by the Narasimham Committee were nurtured by the central bank. Within a short span of three years, the process had not only taken a firm root but also yielded significant results. The reform has been a continuous journey; the pace and sequence were calibrated by the reserve bank. The banking sector reforms continue to strengthen the banking system and promote competitive efficiency. Overall, the central government and reserve bank’s policy initiatives from 1992 onwards were directed at building strength and ensuring safety and stability of the financial system of the country.

Pre-1992 Scenario

An important aspect of the banking system in India was the predominance of the public sector. The public sector banks were holding more than 90 percent of the total banking business in terms of deposits and advances. With impressive branch expansion, the average population served per bank branch declined from 64,000 (1969) to 14,000 (1990). There was wider access of banking services. Further, total deposits as a percentage of GDP increased from 12.7 percent to 32.4 percent during the period.

The Indian financial system, particularly the banking system, was functioning in an environment of administered interest rates and asset allocation limitations. Due to socio-economic considerations, the banking system was over-regulated. Entry of new banks was under control. Functional freedom, profitability, and operational efficiency of banks were at a low ebb. The banking and financial system needed a structural reform as a part of the macroeconomic stabilisation programme. It may be seen that the reform objective of our country was largely to promote a competitive, diversified, and efficient financial system.

Post- 1992, the Indian financial system was in the process of rapid transformation. The following paragraphs give a synoptic picture of the reform process.

Prudential regulation- Asset Classification

The Narasimham Committee emphasised that a proper system of asset classification, income recognition, and provisioning was fundamental to preserve the strength and stability of the banking system. Based on the committee’s recommendation, the Reserve Bank of India, in February 1992, issued new guidelines on income recognition, asset classification, and provisioning requirements. The priority was the task of cleansing banks’ balance sheets. Emphasis was laid on transparency and disclosure, keeping in view the accepted international accounting standards. Prior to 1992, banks in India were booking income on an accrual basis even for accounts which are not likely to be realized.

Effective from April 1992, the banks were directed to book income on advances based on the record of recovery. In the new dispensation, banks were required to classify assets into four broad groups: standard, substandard, doubtful, and loss. Per regulatory guidelines, an asset is to be treated as a non-performing asset when interest is overdue for six months and above. It may be added that the term ‘non-performing asset’ (NPA) was unknown to the Indian banking system till 1992.

The new standards put the banking sector’s attention to credit risk and recovery management. The paramount need became to arrest and reduce NPAs. In fact, the gross NPA to total advances, which peaked at 24.0 per cent in 1993–94, was brought down to1 9.8 percent in 1994–95 and further to1 8.0 percent in 1995-96. The downward movement of NPAs needed to be continued. But it should be seen that while the ratio of NPA to total loan assets had come down; in absolute terms, the level of NPAs remains large. A robust system of credit appraisal and monitoring needed to be put in place by the banks.

Capital Adequacy Norms

Prudential regulations also include capital adequacy norms (CAN). The capital adequacy standards of the Basel Accord were adopted to bring India’s regulatory framework akin to international standards. A capital-to-risk weighted assets system was introduced in conformity with international standards. All the banks in India had to attain capital-to-risk asset ratio (CRAR) of 8 per cent norm by 31 March 1996. Indian banks having overseas operations were given a time line of 31March1995.

The government of India took measures to capitalise public sector banks in a phased manner. With the infusion of ₹ 57 billion by the government of India towards capital funds in 1993–94, all the public sector banks achieved the 4 per cent CRAR as of 1 January1994. The Banking Companies (Acquisition and Transfer of Undertakings) Acts of 1970 and 1980 were amended to enable the strong public sector banks to access the capital market. The programme of recapitalisation of banks was linked to the compliance of the performance criteria prescribed by the Reserve Bank through a memorandum of understanding. The performance indicators covered key areas, viz. performance parameters, management, capital, and customer service. To achieve these goals, the banks needed to restructure their business plans to be viable within a medium term of two to three years. These commitments were reviewed by banks quarterly at the board level and by RBI half-yearly. The World Bank also provided a restructuring loan of US $1,157 million to help the six public sector banks to augment the Tier II capital.

Progressive Reduction of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

CRR and SLR are both statutory compliances by the banks in India. Scheduled banks are required to maintain cash with RBI for a minimum of 3 percent of its net demand and time liabilities (NDTL) per sec 42 of the Reserve Bank of India Act of 1934. Further, in terms of Sec 24 of the Banking Regulation Act,1949, the banks are required to maintain a certain percentage of assets in government and approved securities daily. Before 1991, the banks needed to maintain the CRR and SLR at high levels because of rising fiscal and monetised deficits in the Indian economy. CRR was a direct instrument of monetary control.

A major plank of the financial sector reforms was phased reduction of reserve requirements, both CRR and SLR. A phased reduction of CRR and SLR was announced, in April 1992 to 10 per cent and 25 per cent of NDTL of the respective bank over a medium term. The SLR which had touched the pre-reform peak of 38.5 per cent in 1991–92 was progressively brought down to 28.2 per cent in March 1996. The CRR which reached a pinnacle of 25 per cent (inclusive of additional amount of CRR) in 1991–92 was brought down to 15 per cent in the same period. The level of pre-emption at 63.5 per cent in 1991 was progressively brought down to a level of 40 per cent in 1994. Further, CRR was brought down to 10 per cent in January 1997 and SLR to 25 per cent in October 1997. These measures augmented the lendable resources of the banking system. SLR reduction also set a new tone to government securities market.’ (Rangarajan)

Along with phased reduction of reserve requirements, the reserve bank pursued a policy of market-related interest rate on government securities. This had thrown new vistas in the investment management of the banks. The asset pattern of the banks was bound to undergo a change and would be influenced by the risk-reward configuration of individual banks.

Deregulation of Lending Rates

The Narasimham Committee observed that the lending rate on loans was overly regulated. The government also professed the philosophy of subsidised lending to certain sectors, viz. agriculture, export, etc. The committee felt that there was no need to have interest subsidy. The process handicapped banks in expanding credit.

The deregulation of interest rates constituted an integral part of the financial sector reforms. Dr C. Rangarajan, in his address ‘Financial Development and Economic Growth’ (1997), had mentioned that ‘administrative control of interest rate had been the most dominant feature of financial repression in India for log.’ The Committee had addressed the thorny issue and recommended the deregulation of interest rates in the banking system. Thus, the interest rate regime had been largely deregulated with a view to achieving better price discovery and efficient resource allocation. Banks were given freedom to decide their deposit and lending rate structure and manage their assets and liabilities with a degree of flexibility.

In September 1990, RBI had taken steps to simplify the administered interest rate by reducing the number of slabs to six. In 1992-93 the number of slabs was reduced to four. In April 1993, the slabs were further reduced to three. In October 1994, the reform process prompted the reserve bank to deregulate lending rates by abolishing the minimum lending rate (MLR) system for advances above Rs.2 lakh. It was a progressive step taken by the central bank as it gave banks a major degree of freedom to decide the interest rates. Lending rate structure of banks was thus rationalised. Each bank was free to fix its prime lending rate (PLR) and apply the rate uniformly in all its branches, depending on the credit standing and risk assessment of the borrower. The deregulation of lending rates stimulates healthy competition among banks and spur competitive efficiency. The transition from an administered interest rate regime to a deregulated one was smooth, and banks adjusted to the situation remarkably well.

Credit Delivery

Several measures were initiated to boost the credit delivery system of the banks. Norms for the working capital finance of banks were deregulated, and banks were free to decide the level of inventory holding and receivables. RBI, in January 1993, relaxed the norms for computing the maximum permissible bank finance (MPBF) for working capital purpose.

The cut-off limit of consortium lending was revised upwards to ₹500 million. At their discretion, banks were allowed to organise loan syndication for highly rated corporate borrowers enjoying a working capital limit of ₹500 million. Banks were allowed to undertake para-banking activities like equipment leasing, hire purchase financing, and factoring services. Other steps in the direction of easing credit delivery were introduction of agricultural cash credit system, enhancement of the limit of housing loans, imparting flexibility in margin in respect of loans against deposits, etc.

Debt Recovery Tribunal (DRT)

The loan recovery rate (LRR) in respect of banks in India had been low, and this affected their profitability. In this context, the Recovery of Debts due to Banks and Financial Institutions Act,1993, was passed in the Parliament on 10 August 1993 to facilitate expeditious adjudication of recovery of loans due to banks and financial institutions. The debt recovery tribunals were set up to deal with adjudication process and to improve recovery climate. The Committee recommended the creation of Asset Reconstruction Funds to which bad and doubtful debts of banks and financial institutions were transferred with appropriate haircut.

Strong Supervisory System

A strong supervisory system is an essential prerequisite for the success of the reform process. John Crow, former governor of Bank of Canada, once said, ‘Deregulation does not mean de-supervision.’ The supervisory focus is on the safety and soundness of the banking system. In India, the banks are subjected to an inspection under section 35 of the Banking Regulation Act,1949. On the recommendations of the Narasimham Committee, the Board for Financial Supervision (BFS) was setup in November 1994 comprising select members of the RBI board with the governor as chairman and a deputy governor as vice chairman and in charge of the executive functions. The Board includes professionals to exercise ‘undivided attention to supervision’. The BFS, which generally meets once a month, provides direction continually on regulatory practices including governance issues and supervisory practices. It also provides direction on supervisory action in specific cases (Reddy, 2005).

A separate department, viz. Department of Supervision (DoS), was carved out in December 1993 to undertake consolidated supervision of the financial sector covering commercial banks, financial institutions, and NBFCs and report the findings to the board. Regulation and supervision were separated to avoid conflict of interest. Recognising the fast-changing risk profile of the banks, BFS introduced the Off-Site Surveillance and Monitoring System (OSMOS) in February 1995, which serves as a complementary to the system of on-site supervision The banks were advised to constitute Audit Committee of the Board (ACB) to ensure efficacious and timely follow-up of banks’ internal inspection/audit reports.

Entry of New Private Banks

As a part of reforms, with an objective to inculcate competitive efficiency in the banking system, entry of private sector banks was permitted in the Indian banking space. In January 1993, RBI issued guidelines for setting up new banks in the private sector with a minimum paid-up capital of ₹1 billion with promoter’s contribution of 25 percent. This was a historic step, heralding a new policy approach. UTI Bank Ltd has the distinction to set up the first new generation of private sector banks.

Within a span of two years, nine new banks were permitted by RBI under Sec.22 of the Banking Regulation Act, 1949. Emphasis was laid that these banks should be professionally managed and technologically advanced to make them financially viable right from its inception. The new banks were subjected to RBI regulation, prudential norms, and capital adequacy of 8