Financial Sector Reforms was introduced after the recommendations from Narasimhanm Committee I in the year 1991. The 1991 economic reform process redefined the role of government in the economy; in the future, the economy will rely on greater private participation for its development. Such a shift in perspective on development necessitated a complete overhaul of the economy’s investment structure. The private sector would now demand large amounts of investible capital from the financial system. As a result, there was a pressing need to restructure India’s entire financial system.
The banking system in the country had grown tremendously in terms of geographical coverage and financial spread in the three decades following nationalization. Certain flaws in the system were discovered in the late 1980s, and it was felt that they needed to be addressed in order for the financial system to play its role in ushering in a more efficient and competitive economy.
Narasimhan Committee I: Committee on the financial system (CFS)
The Narasimhan Committee I was appointed by Dr. Manmohan Singh (then Finance Minister) on August 14, 1991. The second such committee was appointed in December 1997 by P. Chidambaram (then Finance Minister). The First Committee had worked to suggest Financial reforms in the country while the second one was for the banking sector reform. As a result, on August 14, 1991, a high-level Committee on the Financial System (CFS) was established to examine all aspects of the financial system’s structure, organization, function, and procedures; based on its recommendations, a comprehensive banking reform was implemented in fiscal 1992-93.
The Committee on the Financial System based its recommendations on some fundamental assumptions in the banking industry. And, in light of this assumption, the committee’s recommendations became logical; there is no disagreement. “The resources of the banks come from the general public and are held by the banks in trust that they will be deployed for the maximum benefit of the depositors,” according to the assumption. This assumption was made automatically:
- That the government had no business jeopardizing the nationalized banks’ solvency, health, and efficiency under the guise of using banks’ resources for economic planning, social banking, poverty alleviation, and so on.
- Furthermore, the government had no right to seize bank funds at low-interest rates and use them to fund its consumption expenditure (i.e., revenue and fiscal deficits), thereby defrauding depositors.
The recommendations of the CFS (Narasimham Committee I) were aimed at:
- ensuring a degree of operational flexibility;
- internal autonomy for public sector banks (PSBs) in their decision-making process; and
- a greater degree of professionalism in banking operations.
Recommendation of CFS
The CFS recommendation could be summed up under five sub-titles:
On Directed Investment
The RBI has been advised not to use the CRR as a primary tool for monetary and credit control, instead of relying more on Open Market Operations (OMOs). Regarding the CRR, two proposals were recommended. CRR should be progressively reduced from the present high level of 15 percent to 3 to 5 percent.
RBI should pay interest on the CRR of banks above the basic minimum at a rate of interest equal to the level of banks, one year deposit. In the next five years, it was recommended that the SLR be reduced to the bare minimum (i.e., 25%) from its current high of 38.5 percent (it was cut down to 25 percent in October 1997). The government was also advised to gradually transition to a market-based borrowing program so that banks can profit from their SLR investments.
These suggestions aimed to increase the amount of money available to banks, convert idle cash to use, and reduce the interest rates that banks charge on their loans.
On Directed Credit Programme
Under this subtitle, the suggestions revolved around the compulsion of priority sector lending (PSL) by the banks. The program of directed credit should be phased out gradually. Agriculture and small-scale industries (SSIs), according to the committee, had reached maturity and did not require any special assistance; two decades of interest subsidy was sufficient. As a result, concessional interest rates may be unnecessary.
Directed credit should not be a regular program; rather, it should be a one-time boost to specific weak areas, and it should be temporary rather than permanent.
The PSL concept should be redefined to only include the most vulnerable members of the rural community, such as marginal farmers, rural artisans, village and cottage industries, the tiny sector, and so on. The “redefined PSL” should have a 10 percent fixed of the aggregate bank credit. The composition of the PSL should be reviewed after every 3 years.
On the Structure of Interest Rates
The major recommendations on the structure of interest rates are:
- Interest rates to be broadly determined by market forces;
- All controls of interest rates on deposits and lending to be withdrawn;
- Concessional rates of interest for PSLs of small sizes to be phased out and subsidies on the IRDP loans to be withdrawn;
- Bank rate to be the anchor rate and all other interest rates to be closely linked to it; and
- The RBI is the sole authority to simplify the structure of interest rates.
On Structural Reorganisation of the Bank
For the structural reorganization of banks, some major suggestions were given. Mergers and acquisitions will result in a significant reduction in the number of PSBs, allowing for greater efficiency in banking operations.
The RBI and the Banking Division (of the Ministry of Finance) should be separated immediately, and the RBI should be made the primary regulator of the banking system. PSBs must be made free and self-sufficient. The RBI will review all guidelines and directives issued to the banking system in light of the banks’ independence and autonomy.
Finally, it was suggested that the Chief Executive Officer of the Bank (CMD) be appointed based on professionalism and integrity rather than political considerations. It was suggested that an independent panel of experts recommend and finalize the best candidates for this position.
Asset Reconstruction Companies/Fund
The committee proposed the establishment of asset reconstruction companies/funds to combat the threat of higher non-performing assets (NPAs) among banks and financial institutions (taking a clue from the US experience).
The PSBs’ sorry state was directly blamed by the committee on the Government of India and the Ministry of Finance. The Gol, officials, bank employees, and trade unions all used and abused these banks, according to the report. The recommendations were revolutionary in many ways, and bank unions and leftist political parties opposed them. There were some other major suggestions of the committee which made it possible to get the following things done by the government:
- opening of new private sector banks permitted in 1993;
- prudential norms relating to income recognition, asset classification, and provisioning by banks on the basis of objective criteria laid down by the RBI;
- introduction of capital adequacy norms (i.e., CAR provisions) with international standards started;
- simplification in the banking regulation (i.e., via board for financial supervision in 1994); etc.
Previous Year Questions for UPSC Prelims
Ques 1: According to which of the following organizations, globalization is “a shift from a world of distinct national economies to a global economy in which production is internationalized and financial capital flows freely and instantly between countries”?
d. European Union
Answer: Option B
Explanation: The developed economies of the world campaigned for the creation of the WTO after an OECD conference in the 1980s, which is better known as the beginning of the Uruguay Round of GATT negotiations that culminated in Marrakesh (1994) with the creation of the WTO.
The OECD also officially defined globalization in 1995, referring to it as “a change from a world of different national economies to a global economy in which production is internationalized and financial capital flows freely and instantly across countries.”
Ques 2: Consider the following statements regarding the Structural Reform Measures adopted by India during the Economic reforms of 1991:
I. Structural Reform Measures includes all the policy reforms which have been initiated by the government to boost the aggregate supply of goods and services in the economy.
II. It naturally entails unshackling the economy so that it may search for its own potential of enhanced productivity and production.
III. Under this measure, the purchasing capacity of the people is to be increased, and the economy needs increased income which comes from increased levels of activities.
Which of the following statement(s) is/are correct?
a. Only I
b. I and II
c. II and III
d. All of the above
Answer: Option D
Explanation: Included under Structural Reform Measures are all government-initiated reforms designed to increase the economy’s total supply of products and services. It means liberating the economy so that it can pursue its own potential for increased productivity and output. In order to improve the purchasing power of the populace, the economy must generate more money through greater activity levels.
Quick Questions on Financial Sector Reforms for UPSC Preparation
Initiated in the early 1990s, the primary purpose of India’s financial sector reforms was to establish an efficient, competitive, and stable financial sector that could then contribute more to growth stimulation.
There were many reforms suggested by Narasimhan Committee I. However, major reforms suggested were (1) Liberalisation, (2) Privatisation, (3) Globalisation of the Economy, (4) New Public Sector Policy, (5) Modernisation, (6) Financial Reforms, and (7) Fiscal Reforms.
LPG was introduced in the 1991 as part of the Chandra Shekhar Singh government’s reforms. The primary goal of this reform was to free the Indian economy from economic stagnation.
Credit has been directed. Reducing directed credit requirements is a regular element of banking reforms, and India was no exception. The high levels of the SLR, which commandeered bank resources to finance the government deficit at low interest rates, constituted a significant directed credit need.