ORIGIN OF INDIAN BANKING

The period of last six decades has viewed many macro-economic development of India. The monitory, external and banking policies have undergone several changes. The structural changes in the Indian financial system specially in banking system has influence the evaluation of Indian Banking in different ways. After the independence and implementation of banking reforms, we can see the changes in the functioning of commercial banks. In order to understand the changing role of commercial banks and the problems and challenges, it would be appropriate to review the major development in the Indian banking sector.

Evaluation of Indian banking may be traced through four distinct phases

(1) Evolutionary phase (Prior to 1947)

(2) Foundation phase (1947-1969)

(3) Expansion phase (1969-1990)

(4) Consolidation and Liberalization phase (1990 to till)

The present chapter analyses the above phases and structure of the banking sector in India. The main objective of this chapter is to setup the ground and logic for the next chapter.

Table of Contents

EVOLUTIONARY PHASE (PRIOR TO 1947)

According to the Central Banking Enquiry Committee (1931), money lending activity in India could be traced back to the Vedic period, i.e., 2000 to 1400 BC. The existence of professional banking in India could be traced to the 500 BC. Kautilya’s Arthashastra, dating back to 400 BC contained references to creditors, lenders and lending rates. Banking was fairly varied to the credit needs for the trade, commerce, agriculture as well as individuals in the economy, Mr. W.E. Preston, member, Royal Commission on India Currency and finance set up in 1926, observed “….. it may be accepted that a system of banking that was extremely suited to India’s then requirements was in force in that country many countries before the science of banking become an accomplished fact in England.” They had their own inland bills of exchange or Hundis which were the major instruments of transactions. The dishonoring of bundies was a rare at that time as most banking worked on mutual trust, confidence and without securities.

The first western bank of a joint stock verity was Bank of Bombay, establishing 1720 in Bombay. This was followed by bank of Hindustan in Calcutta, which was established in 1770 by an agency house. This agency house and banks were close down in 1932. The first, Presidency Bank was the Bank of Bengal established in Calcutta on June 2, 1806 with a capital of 50 Lakh. The Government subscribed to 20 percent of its share capital and shared the privilege of appointing directors with voting rights. The bank had the task to discounting the treasury bills to provide accumulation to the Government. The bank was given powers to issue notes in 1823. The Bank of Bombay was the second presidency bank set up in 1840 with a capital of 52 Lakh, and the Bank of Madras the third Presidency bank established in July 1843 with a capital of 30 Lakh. The presidency banks were governed by Royal charters. The presidency banks issued currency notes until the passing of the paper currency Act, 1861, when this right to issue currency notes by the presidency banks were taken over and that function was given to the Government. The presidency bank act, which came into existence in 1876, brought the three presidency banks under a common statute and imposed some restrictions on their business. It prohibited them from dealing with risky business of foreign bills and borrowing abroad for lending more than 6 months.

The presidency banks were amalgamated into a single bank, the Imperial Bank of India, in 1921. The Imperial Bank of India was further reconstituted with the merger of a number of banks belonging to old princely states such as Jaipur, Mysore, Patiala and Jodhpur. The Imperial Bank of India also functioned as a central bank prior to the establishment of the Reserve Bank in 1935. Thus, during this phase, the Imperial Bank of India performed three set of functions via commercial banking, central banking and the banker to the government.

The first Indian owned bank was the Allahabad Bank set up in Allahabad in 1865, the second, Punjab National Bank was set up in 1895 in Lahore, and the third, Bank of India was set up in 1906 in Mumbai. All these banks were founded under private ownership. The Swadeshi Movement of 1906 provided a great momentum to joint stock banks of Indian ownership and many more Indian commercial banks such as Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were established between 1906 and 1913. By the end of December 1913, the total number of reporting commercial banks in the country reached 56 comprising 3 Presidency banks, 18 Class “A” banks (with capital of greater than 5 lakh), 23 Class “B” banks (with capital of 1 lakh to 5 lakh) and 12 exchange banks. Exchange banks were foreign owned banks that engaged mainly in foreign exchange business in terms of foreign bills of exchange and foreign remittances for travel and trade. Class A and B were joint stock banks. The banking sector during this period, however, was dominated by the Presidency banks as was reflected in paid-up capital and deposits.

By 1930, the number of commercial banks increased to 107 with the Imperial Bank of India still dominating the Indian banking sector. Besides, at end-March 1929, 158 cooperative banks also existed. The number of co-operative banks rose sharply (more than doubled) between 1922- 23 to 1928-29. Although greater than commercial banks in number but the size of deposits of co- operative banks was much smaller.

WORLD WAR I AND ITS IMPACT ON INDIAN BANKING SECTOR

The World War I (1913-1918) has affected badly the Indian economy and created many problems like high Inflation, low productive of agriculture sector. During the war period, a large number of banks failed. Some banks that failed were also doing trading function with banking function. Mast of the banks that failed during war period had low capital base. Several exchange banks also failed during this period mainly due to global reasons. The great depression (1928-1934) also affected Indian banking industry as the number of banks failing raised sharply due to high NPAs. The capital of bank that failed, on an average, was lower than the average size of the capital of reporting banks in categories A and B.

Reserve Bank of India was setup in 1935, as bank failure and neglecting of agriculture sector were the main reasons for the establishment of Reserve Bank of India. Yet, even after 12 years of the Reserve Bank establishment, bank failure did not stop. The major concern was the existence of non-scheduled banks as they remained outside the preview of the Reserve Bank. Banking was more focused on urban areas and the credit requirements of agriculture and rural sectors were neglected. These issues were solved when the country attained independence.

FOUNDATION PHASE (1947-1969)

When the country became independent in 1947, India banking was entirely in the private sector. In addition to the Imperial Banks, there were five big banks, each holding public deposits aggregating ₹100 Cr. and more, Central Bank of India Ltd., Punjab National Bank Ltd, Bank of India Ltd, Bank of Baroda Ltd. and United Commercial Bank Ltd. At the time of independence, the banking structure was domestic scheduled commercial banks. Non- scheduled banks, though large in number but constituted a small share of the banking sector.

The banking system at the time of independence was largely urban- oriented and remained beyond the reach of the rural population. A large percentage of the rural population had to depend on the money lenders as their main source of credit banks. Rural access was grossly inadequate, as agriculture was not considered as an economic proposition by banks in these days. Thus, the rural economy, in general, and agriculture sector in particular, which is the crucial segment of the Indian economy was not supported by the banking system in any form.

Establishment of State Bank of India

At the time of Independence, the Imperial Bank of India and all other commercial banks were urban oriented. Therefore, it is the need of the hour, to provide the banking facility to the rural area. It was suggested that the Imperial Bank of India should extent its branches to Taluka or Tehsil to provide the banking services for the neglected area. The Imperial Bank of India was given a target of opening 114 offices within a period of five years commencing from 1st July, 1951. But Imperial Bank of India could open only 63 branches till June 20, 1955. Imperial Bank of India was taken over by the Government under the State Bank of India, Act, 1955, effective from July 1, 1955. Under the State Bank of India (Subsidiary Banks) Act, 1959, eight state owned/sponsored banks were taken over by State Bank of India as its subsidiaries, now called Associate Banks. With amalgamation of two of them (State Bank of Bikaner and Jaipur), the number of these associate banks has come down to seven. At present, state bank group consists of six banks.

EXPANSION PHASE (1969-1990)

Although the banking system had made some progress in terms of deposit growth in the 1950s and the 1960s, its spread was mainly concentrated in the urban areas. It was felt that if bank funds had to be channelled for rapid economic growth with social justice, then most of the banks should be nationalized. Accordingly, the Government nationalized 14 banks with deposits of over 150 Cr. by the Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, 1969. These banks were the Central Bank of India, Bank of Maharashtra, Dena Bank, Punjab National Bank, Syndicate Bank, Canara Bank, Indian Overseas Bank, Indian Bank, Bank of Baroda, Union Bank, Allahabad bank, United Bank of India, UCO Bank and Bank of India.

The main objectives behind the nationalization of the banks were as follows:

  • Reduction in the regional imbalance of economic activities.
  • To make the banking system reaches in hand of rural and semi-urban people.
  • The aim was to bring a large area of economic activity within the organized banking system.

Although banks penetrated in rural areas, but amount of credit extended to the weaker section of society was not satisfactory. In 1974 the Narsimhan Committee went into these problems and recommended the establishment of regional Rural Banks (RRB) under the “Regional Rural Banks Act, 1975”. Banking in collaboration with central and State Governments, set up Regional Rural Banks in selected regions where the co- operative system was weak and where commercial banks were not very active. On April 15, 1980, six more private sector banks were nationalized, making the number of public sector banks 27.

CONSOLIDATION AND LIBERALIZATION PHASE (1990 TO TILL)

By the time the decade of 1990s started, a number of problems were facing Indian economy. The situation had become extremely uncontrollable. Fiscal deficit was constantly growing, balance of payment situation had become extremely critical. There was pressure from the external sector for putting the domestic economy in order. The need for initiating radical structural reforms was being greatly emphasized. Under structural reforms, the emphasis was on relaxing restrictions which severely impeded the functioning of the market mechanism and led to inefficiency and sub optimal resource allocation. It was a period when policy measures were directed towards liberalization, privatization and globalization of the economy in selective phased manner. Financial sector reforms constituted an important component of the structural reforms. The basic objectives of these reforms was to promote a diversified, efficient and competitive financial sector for achieving improved efficiency of available savings, greater investment profitability and accelerated growth of the real sector of the economy.

A three-pronged strategy was adopted under these reforms.

1. Improving the overall monetary policy framework

2. Strengthening the financial institutions

3. Integrating the domestic financial system with the global economy in a phased manner.

One of the most important policy initiative of this phase was the acceptance and implementation of many recommendations of far reaching implications for the financial sector, made by the Narsimhan Committee Simultaneously, for strengthening the securities market, Securities and Exchange Board of India was made a statutory body and given sufficient power to deal with various fraudulent practices and scams effectively. A few years later, Insurance Regulatory and Development Authority was set up to regulate and promote the insurance business on competitive lines. In order to improve the financial strength and the profitability of the public sector banks and tone up the overall Indian financial system by examining all aspects relating to structure, organisation, function and procedures, the Government of India set up two high level committees with M. Narshimhan, a former Governor of RBI, as their Chairman. The first Committee submitted its report in 1991 and the second committee, which was set up a few years later, submitted Report in 1998.

These reports made certain recommendations for introducing radical measures. The major thrust of the recommendations was to make banks competitive and stron strong and conducive to the stability of the financial system. The Government was advised to make a policy declaration that there would be no more nationalization of banks. Foreign banks would be allowed to open offices in India either as branches or as subsidiaries. In order to promote competitive culture in banking, it was suggested that there should be no difference in the treatment between public sector banks and private sector banks. It was emphasized that banks should be encouraged to give up their conservative and traditional system of banking and take to new progressive function such as merchant banking and underwriting, retail banking, mutual funds etc. The committee recommended that foreign banks and Indian banks should be permitted to set up joint ventures in these and other newer forms of financial services.

The Government of India accepted all major recommendations of Narsimhan Reports and started implementing them straightway, despite stiff opposition from banks unions and political parties in the country. It is primarily because of the financial sector reforms initiated during the last two decades or so that the Indian financial system is acquiring fast the shades of a vibrant, dynamic, globalized, complex system today, creating new opportunities and challenges. But it still continues to be largely dominated by the presence of a giant public sector particularly in banking and insurance even though the private sector has been growing at a much faster rate in the recent years, out-playing the public sector in the matter of efficiency and performance.

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