BANKING LAW

PROJECT
TOPIC:

ROLE OF BANKS IN INDIAN

ECONOMY

MADE BY: NIHARIKA SINGH

ENROLLEMENT NUMBER: A11911115077
COURSE: B.A.LL.B(H) (2015-2020)
SECTION: ‘D’
 ACKNOWLEDGMENT

This project is the outcome of the study by the author. Any material written by another person
that has been used in the paper has been thoroughly acknowledged. As my research has
concluded, there are a number of people I would like to thank for the successful attempt.

I thank the esteemed director of this institution, Mr. Aditiya Tomar for inculcating the concept
of preparing a project and allowing the researcher to present his/ her point of views in liberal
manner and encouraging the researcher by providing all the much needed support

I would also like to express my exceptional gratitude and acknowledgment to Mr. Indranil
Banerjee who undertook the role of a supervisor and guide for the successful preparation of
this project and for supporting throughout the time of research and writing.

I would also like to extend my thanks and gratitude for the contribution of all those who helped
me in this work as individuals or otherwise. On a personal level I would like to extend my
appreciation to my family and friends who supported me to conclude this research paper.
 INTRODUCTION

Banks over the years, have become a significant aspect of an economy. With the ongoing
financial depression, the position of banks have become all the more important in the course
of working of the money market and hence the economy of a nation. The banking sector
forming a portion of the financial sector primarily works as a financial intermediary
generating money supply. From the different macro-economic models , banks have been
found to be a part of the supply side of the economy . However, over time banks have
transformed from merely money generating organizations to a multi-tasking entity. In this
paper, we shall deal with the role of banks in the context of the world economy as well as
the Indian economy . The first section will illustrate the functions of a bank along with its
classification. In the second section, we shall discuss the role of a banks as a major
component of the service sector rendering to the economy as a whole. In the third section,
we would like to empirically validate our hypothesis with a comprehensive data analysis.
 Role of Banks in Indian Economy
In India , as in many developing countries , the commercial banking sector has
been the dominant element in the country’s financial system . The sector has
performed the key functions of providing liquidity and payment services to the
real sector and has accounted for the Bulk of the financial intermediation
process . Besides institutionalizing savings , the banking sector has contributed
to the process of economic development by serving as a major source of credit
to households , government , business and to weaker sectors of the economy
like village and small scale industries and agriculture. Over the years, over 30-
40% of gross household savings , have been in the form of bank deposits and
around 60% of the assets of all financial institutions accounted for by
commercial banks.
An important landmark in the development of banking sector in recent years
has been the initiation if reforms following the recommendations of the first
Narasimham Committee on Financial System. In reviewing the strengths and
weaknesses of these banks , the Committee suggested several measures to
transform the Indian banking sector from a highly regulated to a more market
oriented system and to enable it to compete effectively in an increasingly
globalised environment . Many of the recommendations of the Committee
especially those pertaining to Interest rate , an institution of prudential
regulation and transparent accounting norms were in line with banking policy
reforms implemented by a host of developing countries since 1970‟s .

Role of Central Bank ( RBI )

The main objectives for the establishment of the Central Bank were as follows :
To manage the monetary and credit system of the country.
To stabilizes internal and external value of rupee
For balanced and systematic development of banking in the country For
the development of organized in the money market in the country .
For proper arrangement of agriculture finance.
For proper arrangement of Industrial Finance .
To establish monetary relations with other countries of the world &
international financial institutions.
For proper management of public debts .
For centralization of cash reserves of commercial banks .
To maintain balance between the demand and supply of currency .
Evolution of Indian Banking
Prior to 1969 , all banks , except State Bank of India and its seven associate
banks were privately owned /. However there was a perception among policy
makers that under private ownership , too many rural and semi urban-areas
remained un-served by banks , whereas the banking industry has to be
developed to “touch the lives of millions”. Further as India became an
increasing planned economy , policy makers felt that „It would be difficult to
undertake credit planning unless the link control of industry and banks in the
same (private) banks is snapped by the nationalization of banks‟ (Hazari Report
, 1967) . These considerations led to the Nationalization Act of 1969 which
caused 14 largest privately owned domestic banks to be nationalized. In 1980
under the same Act , the Government of India acquired ownership of 6 more
private banks , bringing the total number of nationalized banks to 20 .
Notwithstanding the positive role played by the banking sector since
nationalization in institutionalizing savings and becoming a source of credit to
the small borrower , the cumulative effect of excessive focus on quantitative
achievement and social obligations took a toll on profitability and efficiency .
Rates of return became low by international standards , the capital base was
eroded, NPS‟s were on the rise, and customer service was below expectation .
These conditions led to gradual liberalization of banking sector operations since
the mid 1980‟s and culminated in the initiation of fundamental banking sector
reforms of 1992 with the acceptance of key recommendations of the
Narasimham Committee .

Narasimham Committee Banking Reforms

Restructuring of the banking system : The committee recommended 4-tier
structure of the banking system consisting of : (a) : Three of Four Large
(international) banks . (b) : Eight to ten national banks with a network of
branches throughout the country . (c) : Local works with operations confined to
a specific region. (d) : Rural Banks with operations confined to rural areas and
business confined to agricultural and allied activities .
Enhancement of Capital Base of Bank : The committee recommended that the
banks should be allowed to raise fresh capital from the public . Mutual Funds ,
profitable public sector units and employees can also subscribe to these issues .
Deregulation of Interest Rates : The committee recommended deregulation of
interest rate on loan so that they reflect the actual market conditions . The
interest rate on government borrowings may also be gradually deregulated to
bring it in line with market rates . However interest rate on bank deposits may
continue to be regulated .
The first step was taken in October 1994 , when rates were deregulated for
advances more than 2 lakh . In April 1998, under new regulations interest on
credit limits up to Rs 25,000 was prescribed at 12% and for credit limit between
Rs 25,000 and Rs 2 lakh , the rate was not to exceed 13.5% per annum .
Abolition of Licensing : The committee proposed no further nationalization of
banks . It proposed abolition of branch licensing. It said that the banks should be
allowed to decide for themselves. The foreign banks, private banks should be
allowed to open branches in the country
Cut in SLR , CRR : The committee recommended bringing down the SLR of
banks in a phased manner period of five years . It also recommended reducing
of CRR from its present high level .
Trends in Cash Reserve Ratio (CRR) and statutory liquidity ratio (SLR) 1991-
92 to 1997-98
Year CRR (As % of NDTL*) Base SLR (as % of
NDTL*)
1991-2 15 38.5
1992-3 15 37.75
1993-4 14 34.75
1994-5 15 33.75
1995-6 14 31.5
April 1996 13 31.5
July 1996 12 31.5
October 1996 11.5 31.5
January 1997 10 31.5
October 1997 9.75 25
January 1998 10.5 25
April 1998 10 25
Note: *Net demand and time liabilities
Source : RBI , Annual Report, Various issues and RBI Credit Policy October
97, April 98
The committee favoured of putting on end to dual control over banks by RBI
and Banking division. It suggested that RBI should be the primary agency for
regulations . Supervisory functions over banks and financial institutions should
be given to a new quasi autonomous body under RBI .
The committee favoured scrapping of prior approval of Government or
Securities Exchange Board of India for any issue in the market . The issuing
company should be free to decide on the nature of the instrument , its terms and
lending.
Foreign banks should be subject to same requirements as applicable to Indian
banks . They should be permitted to open offices in India as branches or as
subsidiaries .
Computerization of Bank Operations needs to be stepped up .
The committee also proposed that its directed credited programme should be
phased out . The priority sector should be redefined to comprise small and
marginal farmers , the tiny sector of the industry , village and cottage industries
, small business and other weak sections .
A special tribunal should be set up to speed up the process of recovery of
overdue loans .
An asset reconstruction fund should be set up to speed up the process of
recovery of overdue loans.
 Performance of Indian Banking Sector Post Reforms

We now look into the different aspects of bank performance which have been
targeted by the reforms. These are :
1. Deposit mobilization
2. Portfolio Choice
3. Competition
4. Profitability
5. Efficiency
6. Capital Adequacy
7. NPA‟s
Deposit Mobilization : Estimates of trends in real deposit growth post reforms
reveal that the rate of growth has fluctuated, slackening between 1994-5 and
1995-6 but picking up during 1996-7 .
Growth rates of key banking Variables (1981)
Item 1980-81 to 1990-91 to 1993-94 to 1994-95 to 1995-96 to
1989-90 1995-96 1994-1995 1995-96 1996-97
Aggregate 9.8 6.8 10.7 4.1 6.3
Deposits
Time 10.2 6.5 8.1 5.8 7.2
deposits
Bank 8.7 4.2 -1.6 9.3 -1.9
Credit
Investments 10.5 10.3 22.9 4.3 9.6
in Govt
Securities
Note : Compound annual growth rates. All estimates are in real terms . Given in
% forms . Sources : RBI annual report 1996-97 and RBI Bulletin Different
issues
In a nutshell , the present banking scenario with respect to deposits and
advances can be observed from the following table :
 Year % Increase in % Increase in % Growth in
Deposits Advances GDP

1999- 19.23 31.5 9.59

00

2000- 17.2 30.93 7.53

01

2001- 14.26 23.6 7.8

02

2002- 13.02 15.12 10.94

03

2003- 16.47 16.93 13.6

04

2004- 39.96 30.99 13.88

05

2005- 9.11 32.3 15.15

06

2006- 23.88 30.93 14.47

07
Source : RBI Trend and progress of banking in India various issues
Bank credit consists of food and non food credit and bank investments comprise
of investment in Government securities, bonds, debentures , shares issued by
public sector undertakings and private corporate sector and commercial paper .
The rate of growth on non food credit between 1995-96 and 1996-07 was a
negative 0.7 compared to a growth rate off 11.6% between 1994-95 and 1995-
96 . A comparison of growth Rate on investment in government securities in
real terms over the pre-reform and post-reform years does not reveal substantial
differences .
Competition :
With the entry of new private banks , the market shares of public sector
banks have declined by close to 4% points from around 90% in 1991-92 to
around 85% in 1995-96 . This kind of competition has led to adoption of newer
banking practices like ATM , Online transactions and others to fit in the global
competitive market .
Profitability :
Estimates for 1996-97 show public sector banks turning a net profit of
30.95 billion wiping out the loss of 3.71 billion in 1995-96 .
Efficiency :
An increase in competitive pressures is expected to improve efficiency
levels. However in this regard , there has been marginal improvement except the
state bank group and old domestic private banks .
Capital Adequacy :
In 1996-97 , out of the 27 public sector banks, 25 have attained the BIS
norm of an 8% risk waited capital to asset ratio .
Non performing Assets :
In 1993-94 , the average percentage of NPA‟s to total advances for 27
public sector banks was 21.89 which declined to 9.8% of total advances in
1996-97 .

The Challenges Ahead

Let me now turn to the major challenges facing the banking system in the
country, particularly in the wake of the global financial crisis.
The First Challenge: Maintaining the Credit Flow

There was a noticeable decline in the credit demand in the month

of November
2008 but it is not yet clear if it was a one off episode or it reflects a trend. If it is
indicative of slowing economic activity, it would be a major challenge for the
banks to ensure healthy flow of credit to the productive sectors of the economy.
As you know, economic growth, even in normal times, requires efficient
financial intermediation. An economic downturn, therefore, requires even more
efficient financial intermediation – and this is a major challenge that the
banking community has to address.
The Second Challenge: How to Reform Financial Sector Regulation?
Several issues have come to the fore. I will mention just a few.
How can complex derivative products, which transmitted risks across the
system, be made more transparent? What are the financial stability implications
of structured products like credit derivatives? Are exchange traded derivatives
better than over-the-counter (OTC) derivatives? How do we eliminate the
drawbacks of the 'originate-to- distribute' model? Is universal banking, the
model that the United States has now turned to, appropriate? Can we apply the
same regulatory regime for both wholesale and retail banks?
The Third Challenge: Effective Implementation of Basel II Framework

As you are aware, a part of the Indian banking system has already
migrated to the Basel II Framework effective March 31, 2008 and the remaining
commercial banks are slated to do so by March 31, 2009. However, having
regard to the state of preparedness of the system, we have, for the present,
adopted only the simpler approaches available under the Framework. The RBI
is yet to announced the timeframe for adoption of the Advanced Approaches in
the Indian banking system but the migration to these Approaches is the eventual
goal – for which the banking system will need to start its preparations in all
earnestness.
 Conclusion
Going forward, developments in the real economy, financial markets and global
commodity prices point to a period of moderation in growth with declining
inflation. What is heartening though is that the fundamentals of our economy
continue to be strong. Once calm and confidence are restored in the global
markets, economic activity in India will recover sharply. But a period of
painful adjustment is inevitable. It is our collective challenge – for you, the
bankers, and for us at the RBI – to respond to this extraordinary situation
effectively and return India to its path of growth and poverty reduction.
 References
Trend and Progress of Banking in India ( Different issues from 1990 – 2007)
Annual Report RBI ( Different issues )
Economic Survey of India 2008 Handbook of Indian statistics www.IMF.org
www.RBI.org.in www.wikipedia.org www.Google.com