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

REIMAGINING INDIA
rural areas to provide credit to small
farmers and entrepreneurs. There are
currently 196 RRB’s accounting for
four percent of the total assets of scheduled
commercial banks. India also has
specialized financial institutions under
the following categories: big industry,
investment and credit guarantee, exim
trade, capital market, agriculture and
housing development. Their geographic
reach is classified as all India, statelevel
and other institutions. All-India
financial institutions include (a) development
banks (i.e., Industrial Development
Bank of India, Industrial Credit
and Investment Corporation of India,
Small Industrial Development Bank,
Industrial Investment Bank of India,
and Industrial Finance Corporation of
India); (b) specialized financial institutions
(such as, Export Import Bank of
India, Technology Development and
Information Company of India); (c) investment
institutions (i.e., Unit Trust of
India (UTI), Life Insurance Corporation
of India, General Insurance Corporation
and subsidiaries); and (d) refinance
institutions (i.e., National Bank
for Agriculture and Rural Development
(NABARD) and National Housing
Bank). The role of these financial institutions
is to promote economic development
in various sectors of the economy.
State level institutions include
state financial corporations and state
industrial development corporations.
Other institutions consist of the Export
Credit and Guarantee Corporation of
India and Deposit Insurance
and Credit Guarantee Corporation.(S
hirai,2002).
2.1 Pre-reform Period
The banking system in India prior to
1991 was highly regulated and inefficient.
The most significant of these distortions
were:
• The existence of high levels of Cash
Reserve Ratio (CRR) and Statuary
Liquidity Ratio (SLR): CRR is a requirement
on banks to hold a certain
amount of deposits in the form of deposits
to RBI. It is calculated as a
percentage of reserve liabilities
which are defined as a difference between
all liabilities exempted from
the SLR requirement and net time
and demand deposits. The CRR rose
from around 15 percent in 1960-70 to
its upper legal limit of 15 percent in
Banking reforms started in the second half of the 1980’s
but was only seriously implemented after the 1991 financial
crisis. The role of foreign and private sector banks
remained negligible due to restricted entry regulations and
strict branch licensing policies
1991. The high value of CRR led to
low profitability for banks and higher
spreads. The RBI uses CRR as a
tool for monetary intervention in the
economy; e.g. the RBI increased
CRR in August 1993 in order to sterilize
capital inflows (Shirai, 2002).
SLR is a liquidity requirement 1 for
banks to hold a certain amount of
deposits in the form of government
and eligible securities. The upper legal
limit of SLR is 40 percent. SLR
increased from 25 percent in 1970 to
38.5 percent in 1991. Hence for some
time periods overall reserve requirements
exceeded 50 percent.
• Prior to 1991, Indian interest rates
were administered by government.
These included lending and deposits
rates including rates on saving deposits.
The administration of rates
was politically motivated and adversely
affected bank balance sheets.
Joshi and Little (1996) report the average
return on assets in the second
half of the 1980’s was just
0.15 percent.
• Directed and Concessional Lending:
The state pursued a policy of allocation
of financial resources to the socalled
“priority sectors”. These included
agriculture, small scale
industries, small business and selfemployed
persons. Thus policy set
quantitative loan targets 2 on banks
and was a major reason behind the
NPA of public sector banks. At the
beginning of 1992-93 NPA amounted
to 24 percent of total credit. 3
• Lack of competition in the banking
sector: The role of foreign and private
sector banks remained negligible
due to restricted entry
regulations and strict branch
licensing policies.
These government policies were the
main cause of deteriorating bank performances
and diminished banks’ incentive
to operate efficiently. There was
lack of a proper regulation and supervision
mechanism, which allowed banks
to take high risks. This situation was
worsened by the presence of implicit
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