[Dec 2007, Volume 4 Quarterly Issue] Pdf File size - The IIPM Think ...

Anurag Sharma
Research Fellow,
Faculty of Business and Economics,
Monash University, Melbourne
Indian Banking Reforms and Policy
Reversal: A Vicious Cycle
"In sovereignty there are no gradations. There
may be limited royalty, there may be limited
consulship; but there can be no limited government.
There must, in every society, be some
power or other, from which there is no appeal,
which admits no restrictions, which pervades the
whole mass of the community, regulates and
adjusts all subordination, enacts laws or repeals
them, erects or annuls judicatures, extends or
contracts privileges, exempt itself from question
or control, and bounded only by physical
necessity.
By this power, wherever it subsists, all legislation
and jurisdiction is animated and maintained.
From this all legal rights are emanations, which,
whether equitably or not, may be legally recalled.
It is not infallible, for it may do wrong; but it is
irresistible, for it can be resisted only by rebellion,
by an act which makes it questionable, what shall
be thenceforward the supreme power."
-Samuel Johnson
1. Introduction
In the first decade following India’s independence
in 1947, the banking sector
was characterized by low reserve requirements
and no control on interest
rates (Demetriades and Luintel, 1996).
Acting pursuant to its policy of directed
and concessional lending to priority
sectors (agriculture, exports, small
scale industry) the government assumed
control of the financial sector in the
1960’s by nationalizing the major banks.
Liquidity requirements were raised and
interest rates on lending and deposits
controlled and these became a major
source of inefficiencies in the banking
sector, through out the 1970’s and
1980’s. Concessional lending to priority
sectors with weak regulatory and supervision
framework led to a high incidence
of Non Performing Assets (NPA)
in the banking sector. In 1992-93 NPA
amounted to 24 percent of the total assets
of public sector banks. The government
began a gradual process of financial
sector reforms in the mid 1980’s.
Even though the pace of reform increased
following the 1991 financial
crisis, they remain incomplete. Demetriades
and Luintel (1996) examine the
effect of various types of banking controls
on financial deepening in India
and conclude these controls (with the
exception of the lending rate ceiling)
are having a negative impact on financial
deepening and thus adversely affecting
economic growth.
The Indian economy has experienced
more than a decade of economic reform
following the 1991 financial crisis. The
present paper focuses on a critical analysis
of the reforms process with emphasis
on the banking sector, to highlight
those inefficiencies which can contribute
to “policy reversal” by the government.
Policy reversal can be described
as a situation in which government policies
of sound fiscal management or
financial restructuring adversely affect
the banking sector (due to underlying
inefficiencies) so that the government
is forced to revive the banking sector by
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