Banking Sector set for Drastic Change

- Chandrakant Naidu


The legislation liberalising banking regulations and potentially increasing foreign investment has aroused the nation's curiosity. After the epoch-making nationalization policy that changed the course of India's banking history the sector is expecting another overhaul.

It would be relevant to take a look at the "course corrections" Indian banking industry has seen through its 250-odd years' run so far.

Bank of Hindustan and General Bank of India were among the first to be established in 1770 and 1786 when the British were entrenched in India. This was a phase of slow growth and periodic failures. In a major setback in 1787 the General Bank of India was voluntarily liquidated following losses caused by currency confusion. The failure of several banks affected public trust in banking itself.

Lack of trust

Through periods of war and uncertainty in Europe the depositors in India, as elsewhere, lost money and interest in keeping deposits. With no stiff regulation in place banking remained the exclusive need and privilege of Europeans till the early 20th century. For capital most banks depended on deposits. Rivalry forced them to lure depositors with interest rates they could ill afford. Indian Companies Act, passed in 1913, was the first significant legislation to regulate banking.  It was not effective as many banks were left out of its purview.

Under the East India Company's charter: Bank of Calcutta, Bank of Bombay and Bank of Madras (three presidencies), were set up and subsequently merged into Imperial Bank of India in1921 giving the colonial India the first taste of quasi central banking. We now know the Imperial Bank of India as the State Bank of India since 1955. Given its origin in the Bank of Calcutta that was established in 1806, the State Bank of India is the country's oldest bank.   

Foreign banks

Calcutta, where the British Raj was anchored, attracted other foreign banks too. The French arrived in Calcutta in 1860 to set up Comptoire d'Escante de Paris and soon went on to start branches in Bombay, Madras and Pondicherry. The HSBC also began its operations in Bengal in 1869. But, the Union Bank floated by the Indian merchants in Calcutta in 1839 failed in nine years.

The global scenario affected India even then. The Civil War in the 1860s that cut American cotton supply to British textile industry sprang a cotton trade boom in India and spurred economic and banking activity. But, a large share of profit flowed out of the country.

The Swadeshi movement then inspired businessmen and political leaders to set up banks for the Indian community. Bank of India, Corporation Bank, Indian Bank, Bank of Baroda, Canara Bank and Central Bank of India, established during this phase, continue to prosper over a century.

Till 1935 most banks were run by industrial houses or individuals who ploughed the deposits into their own business. In 1935 the Reserve Bank of India (RBI) was formed to maintain monetary stability in the country. It was also tasked with regulating the issuance of banknotes, maintaining reserves to secure monetary stability and operating the credit and currency system of the country.

By the 1960s banking industry was a major facilitator for economic development. Given India's professed policy of socialism, more was needed to be done for poverty alleviation as the banks had failed to achieve social and developmental goals. Rural areas and small-scale borrowers remained neglected despite the Banking Regulation Act enacted in 1949 and the nationalization of the State Bank of India in 1955.

The industry's share in the credit disbursed by commercial banks jumped up from 34 to 68 per cent between 1951 and 1968 while agriculture received less than 2 per cent. The banks couldn't free the farmers from the clutches of private money lenders.

Historic Turnaround

Cornered by intense political pressure, the government, in a swift and sudden move, nationalized 14 largest commercial banks from the midnight of July 19, 1969.  They held 85 percent of the country's bank deposits. In 1980 six more commercial banks were nationalized covering more than 90 percent of the country's banking business. Nationalized banks were made to provide 18 percent of their credit to the agricultural sector. The catalytic effect on agricultural development was spectacular.

Post-nationalization, the branches of the public sector banks rose 800 percent from 7,219 to 57,000, with deposits and advances vaulting by 11,000 percent and 9,000 percent to Rs 5,035.96 billion and Rs 2,765.3 billion respectively. Consequently, profits went up to Rs 30 billion in 1993 from Rs 90 million in 1969.

However, the nation's economy suffered the side effects other political and social lapses. A balance of payments crisis in 1991 pushed the country to near bankruptcy. As a price for the IMF bailout gold was transferred to London as collateral, the Rupee devalued and economic reforms had to be accepted.

The western nations have always perceived the nationalization and regulation of the banking sector as oppressive. Indian policy makers finally bowed to pressure to deregulate interest rates. ease credit rules under the priority sector lending arrangements and lowered entry barriers for domestic and foreign players.

The western analysts do concede that even under "repressive" government control the banking indicators witnessed spectacular upswing in India. There is no guarantee that the market-based banking system would be any better than the state-directed one.

Even under liberalized regime India's banking system came under strain due to rising non-performing assets and debt restructuring especially from heavily indebted industrial groups. This hastened the expansion of FDI in retail banking. The argument against the new proposal is that allowing banks to participate in commodities futures will increase speculative activity and expose the funds of depositors to markets risks. 

The state must intervene to ensure that conditions are created for scrupulous adherence to ethics.