Nationalization of Banks in India - Term Paper Example

of the of the of the Nationalization of Banks in India Banks play a central role in the economic development of the nation. They finance industries, in order to enable them to operate their business and increase production. Banks provide financial assistance for innovations, new businesses and agriculture. They are committed to the economic growth of the nation. Historically, banking institutions have played an important role in the economic development of nations. Moreover, several nations had acknowledged that the banking system was essential for realizing their national economic objectives. These objectives include economic growth and distributive justice to all citizens. In order to regulate potentiality of banking institutions, many nations have nationalized the banks in their country. In India, this nationalization has made it possible to establish bank branches throughout the nation and expansion of banking services to several areas of development. Moreover, this nationalization of banks had been instrumental in mobilizing deposits from citizens. Consequently, there had been a significant growth in deposits and advances. As such, most of the banks have expanded their branches and mobilized deposits (Bisht, Mishra and Belwal). The present banking system in India did not develop overnight. It was the result of the expansion – reorganization process and the consolidation of resources. This process had developed gradually over a period of time. There were three important phases in the development of the extant banking system, namely, the pre – nationalization phase, the post – nationalization phase and the post – liberalization phase. All these phases include the development of the market through innovative measures and diversified expansion into financial services. The expansion process has not stopped with this. Increased Internet use had added a fourth dimension to the banking system. The Internet has completely changed the concepts and traditional look of the banking system. The traditional banking system has been transformed due to electronic cash deposits and withdrawals. The electronic delivery channels have provided far more choices to customers and large industries (Bisht, Mishra and Belwal). In the past, the banking system was solely devoted to its economic objectives. However, this perception changed, subsequent to the nationalization of banks. The nationalized banks have a social responsibility and they have to fulfill social objectives (Bisht, Mishra and Belwal). The nationalization of banks commenced in the year 1969. In the first phase, fourteen major banks were nationalized. The objective of this nationalization was to reform the banking structure and to thereby create an egalitarian society. Another aim behind nationalization was to further the economic growth of the nation. The government introduced a new planned economic development concept. The main objective of this concept was to ensure that the weaker and neglected sections of society were provided with bank credit. In 1980, another six major banks were nationalized to meet the national objectives and economic goals. In the post – nationalization phase, there was a massive branch expansion by the nationalized banks in the country. However, the regional and sectoral imbalances in banking services, and access to these services persisted (Bisht, Mishra and Belwal). In the year 1955, the government acquired the Imperial Bank of India and renamed it as the State Bank of India or the SBI. The government enacted the State Bank of India Act of 1955 for this purpose. Subsequently in 1959 it passed the State Bank of India (Subsidiary Banks) Act. Under the provisions of this new act the government transformed seven banks in the princely states into the associate banks of the SBI. The Reserve Bank of India implemented several regulatory measures during the nationalization of the large commercial banks by the government. These initiatives engendered changes to the sectoral composition of credit. In addition, the RBI stipulated lending targets to the priority sector, and implemented facilities for refinancing and established credit guarantee initiatives. The RBI instructed the newly nationalized banks to establish their branches in rural areas and semi – urban areas. This expansion of banking system provided widespread banking access to a large number of citizens in India (Kumbhakar and Sarkar). The Reserve Bank of India or the RBI is the central bank of India. It has implemented several liberalization measures in India. These measures encourage the private sector banks to increase their market share and customer deposits. In the past there were regulatory barriers for the private banking sector. The liberalization measures have influenced the growth of productivity in the banking sector. The Indian banking system depicts a mixed participation by the public and private sector. These two sectors coexist in the banking system. Another characteristic of this system is the combination of domestic and foreign banking (Kumbhakar and Sarkar). The RBI specified the ceiling on deposit interest rates for savings deposits and term deposits with banks. It had also specified the differential lending rates on loans that were correlated to the income of the borrowers and the type of loan. Moreover, the RBI established the Lead Bank scheme, which is useful in preparing and implementing credit plans for micro financing. The initiatives of the RBI are essential for the growth of the banking system in India. They are of much greater importance for the public sector banks. The latter hold more than ninety percent of the total deposits and loans. The remaining ten percent is equally shared by the private sector banks and foreign banks (Kumbhakar and Sarkar). The nationalized banks made the blunder of concentrating primarily on quantitative achievements. This rendered them unprofitable and as per the international banking standards these nationalized banks had capital inadequacy. Many of these banks had non – performing assets, and customers were provided with banking services that were much below reasonable standards. At the same time, the operational costs of the banks had skyrocketed and several of the banks had excess staff, with large number of promotions. The net result was poor manpower utilization (Kumbhakar and Sarkar). The government constituted the Narasimhan Committee to address these lacunae in the banking sector. This Committee, after an exhaustive study recommended the abolishment of the branch licensing policy; and opined that the individual banks should be permitted to open new branches or to close down existing branches. Nationalized banks have introduced several welfare schemes, so as to develop the backward areas in the country. To this end a number of innovative schemes were introduced, which could easily be availed of by the backward and poor people. Despite these developments in the banking sector, the bank managers failed to undertake an active role to uplift the poor in backward areas. Most of the managers concentrated on profits and the security of bank loans. They were unable to discard their traditional and orthodox perception; and imposed rigid policies for availing loans. In addition, they were quite intransigent in their insistence upon collateral security for loans. Ultimately, this led to the concentration of bank loans in the developed and industrially advanced states of the country. Consequently, the unorganized sectors could not obtain credit from banks. The worst affected in the unorganized sector, were agriculture, and small and cottage industries. Small scale industries and business suffered grievously from these lopsided policies of the banks. This scenario benefitted the rich farmers who were given loans by the banks. In turn, these wealthy farmers lent these borrowed amounts to small and marginal farmers. The latter suffered the most due to this biased form of bank lending. Finally, the bank managements were mismanaged and they lacked the vision to anticipate the economic developments of the future. This contributed to a decline in profitability and earnings among the public sector banks. In addition to these factors, the Reserve Bank of India implemented certain liquidity and credit policies; which restricted bank lending to certain specific sectors (Bisht, Mishra and Belwal). These factors contributed to the increase in agricultural loan over dues and the closing down of several industrial units. A majority of industries became sick and could no longer operate. Furthermore, the operational costs mounted and to balance this sharp rise banks had to reduce their establishment costs. At the same time, there was poor manpower utilization planning, which resulted in the decline of productivity. There were poorly designed employee welfare packages; and there were no training facilities for employees to learn and implement new and creative plans. Subsequently, the performance of the nationalized banks reached an unacceptable level. The Khusro Committee of 1989 had specifically pointed out these drawbacks in the banking sector and stressed the importance of employee training programs to improve productivity and skills (Bisht, Mishra and Belwal). In the post – nationalization period, banks faced several upswings and downswings in their profitability. The Narasimhan Committee recommended several reforms to banking sector policies and the adoption of appropriate prudential norms with regard to capital adequacy, income recognition policies, and transparency in reporting financial matters. As a result of these recommendations, banks are compelled to improve their operational efficiency in all matters. Moreover, they are required to adopt new and innovative policies for debt recovery and recycling of funds. They have to reduce the increase of nonperforming assets. These recommendations are crucial for banks in terms of their efficiency in banking operations and their profitability (Bisht, Mishra and Belwal). In India public sector banks play a dominant role in the banking sector. In the year 1969, the then Prime Minister of India, Indira Gandhi nationalized some banks, in order to make available banking services to every citizen, particularly the poor. This nationalization process had expanded the infrastructure of banks throughout the nation; and now the nationalized banks provide their services in rural and remote areas. They also provide finance to the poor farmers at very low interest rates (Nationalised Banks in India). To address these drawbacks in the banking sector, the RBI adopted the recommendations of the First Narasimhan Committee. Some of its recommendations were entry deregulation; de-licensing of branches; unregulated interest rates; and permitting public sector banks to raise capital from the market by diluting their holding to 51%. Under these reforms the Cash Reserve Ratio of the RBI would be reduced in a gradual phase, which would increase the profitability of the banks. It was also recommended that there should be a gradual reduction in the Statutory Liquidity Ratio, to maximize the profits. The 8% Capital Adequacy Ratio is the standard set by the Bank of International Settlements. This norm would strengthen the banking system. Moreover, the RBI is to impose stringent income recognition and standards of provisioning criteria. Thus, these reforms would strengthen the banking sector in India and create a competitive environment, which would lead to a healthy, profitable and productive banking system (Kumbhakar and Sarkar). As such, the various reforms to the banking sector by the RBI are, first, implementation of structural changes for liberalization. In this process, it dismantled the complex system of regulatory controls over interest rates. The RBI removed the stipulation that its prior approval had to be obtained for sanctioning large loans. Further, it did away with the statutory requirement of investment by banks in government securities. Second, the RBI designed several measures to promote and enhance the financial soundness of the banks. To this end, it introduced capital adequacy norms and prudential standards. The RBI strengthened supervision over the banking system. Third, it encouraged competition in the banking system by liberalizing licensing for opening private and foreign banks in India. The RBI’s reforms generated significant positive results, and reduced the burden of non – performing assets. This was the major reform, which enabled a majority of the banks to meet the standards of the new capital adequacy regime (Ahluwalia). The growth of the economy reached 6.7% in the first five years of implementation of reforms. However, the growth rate came down, in the subsequent five year period, to 5.4%. It is important to note, that the growth rate of other developing countries had also slowed down during that period. This situation helped India to stand out among the other developing nations, in respect of growth rate. The target fixed for the growth rate was 7.5% but the recorded rate was only 5.4%. This constitutes a sizeable difference, and the effectiveness of the RBI reforms was doubted. The reform packages implemented several reforms to the banking sector, and these reforms had considerable influence on the capital markets in India (Ahluwalia). In the post – reform phase, Indian economic growth had several positive outcomes. The economy recorded a growth of 6% during the period 1992-1993 to 2001-2002. This growth rate placed India among the quickest growing nations. In the 1980s this growth rate was 5.7 percent. However, that growth rate was on account of external debt and was unsustainable. An economic crisis occurred in the East Asian nations, but its effect on the Indian economy was negligible. Thus, the 1990s economic growth was a result of the reforms initiated by the RBI and it was remarkable in Indian banking history. Another outstanding feature of these reforms was the decline of poverty in the country; which was faster in the 1990s than in the 1980s (Ahluwalia). The international financial crisis has raised questions regarding liquidity and confidence in the extant system. The RBI has to address the adverse effect of the outflow of funds from FII by setting aside securities relating to market stabilization. Such strategy would entail a partial depletion of the dollar reserves, which is inevitable in the present situation. This would prevent the abrupt reduction in liquidity, and prevent the sudden increase in interest rates (How the global financial crisis affects India). Nevertheless, the down sliding rupee would be beneficial to exporters. In addition, the stock markets, real estate and employment sectors would regain a semblance of sanity. Importers will not feel the pinch due to the dollar’s decline, because of the reducing oil and commodity prices (How the global financial crisis affects India). Resilience is an important characteristic of the Indian financial system; which is strong and resistant to external financial pressures. This was witnessed during the time when the nations in the East Asian region underwent severe economic crisis. Thus, the Indian financial system is resistant to shocks. The exchange rate regime in India is flexible and there are vast foreign exchange reserves. The significant feature is that the capital account has not been rendered fully convertible and there is limited foreign exchange exposure to banks and customers (History of Banking in India). Works Cited Ahluwalia, Montek S. "Economic Reforms in India since 1991: Has Gradualism Worked?" The Journal of Economic Perspectives (2002): Vol. 16, No. 3 , pages 67, 81,82 Published by: American Economic Association . Bisht, N S, R C Mishra and Rakesh Belwal. "Liberalisation and its effect on Indian banking." Finance India. Delhi (Mar 2002. p. 147): Vol. 16, Iss. 1; (6 pages). History of Banking in India. 29 October 2008 . How the global financial crisis affects India. 19 September 2008. 29 October 2008 . Kumbhakar, Subal C. and Subrata Sarkar. "Deregulation, Ownership, and Productivity Growth in the Banking Industry: Evidence from India." Journal of Money, Credit and Banking (Jun., 2003, pp. 406-408): Vol. 35, No. 3. Published by: Ohio State University Press. Nationalised Banks in India. 29 October 2008 . Read More