Financial Sector Reforms: The 1991 economic reform process had 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.
Committee on the financial system (CFS)
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 CFS 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.
Every PSB should pursue a radical shift in work technology and culture in order to become more competitive internally and to keep up with the wide range of international innovations.
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.