Banking Sector Reform in India

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Introduction

It is widely believed1 that the reforms of 1991, both in the industrial sector and the financial sector, released a variety of forces that propelled India into a new growth trajectory.2 In this paper, we are going to assess the role that the banks played in making this growth happen and the impact that these reforms had on banks. We start with a brief history of banking regulation in India. We then move on to outline some of the principal reforms that were implemented in the 1990s and their impact on the banking sector. Although this section does present some data in support of its arguments, it is by no means a rigorous analysis of the issues at hand. It seeks instead to present ideas and hypotheses based principally on the insights gained by the authors through observing these developments as participants in the system. We suggest that this period created certain problems for the banking system, the sources of which remain largely unresolved. We propose that unless the unique set of circumstances3 that existed during the past decade manifest themselves in this decade, there is a possibility that the future could see the Indian banking system facing difficulties. We conclude by suggesting some reform strategies that could equip the financial sector to better address the challenges that lie ahead.

In the center of India’s flag sits a spinning wheel, a symbol used by Gandhi to protest English textile imports under colonial rule and to demonstrate the nobility of a society of small-scale agriculture and industry. For much of its independence, India’s economy was governed by the principle of the spinning wheel – with disastrous economic and social effects. Just as the United States, in industrializing, had to overcome the belief in the nobility of agriculture that shaped its founding fathers, India is still struggling to move beyond Gandhi-era economics and raise its standard of living.

India’s recent progress toward economic growth stems from reforms undertaken after the 1991 fiscal crisis, which lifted India from decades of slow growth under socialist rule and offered an opportunity to improve living conditions in the immense, poor country. And the recent growth has been impressive – among the highest growth rates in the world. A great portion of the world’s poor live in India, and will depend on its future growth to overcome poverty. But the recent progress is not enough. Certainly, great steps have been taken toward reform on trade, industrial policy, and the financial system; substantial progress has been made in reducing poverty; and India has a growing and thriving middle class. However, much remains to be done: the government intrudes where it need not, in everything from coal mining to discos, and fails to manage the basic services that it should, like decent roads, a stable power distribution infrastructure, and quality primary education. For the United States, developing its relationship with India is quickly gaining in importance. India is emerging as an important trading partner and as a political counterbalance to Chinese power in Asia – but its power depends on its ability to continue growing. Because its strength benefits the Unites States both politically and economically, continuing reforms have huge strategic importance for the United States.

DEVELOPMENT OF THE INDIAN BANKING SECTOR

Development from Independence until 1991

At the time of Independence in 1947, the banking system in India was fairly well developed with over 600 commercial banks operating in the country. However, soon after Independence, the view that the banks from the colonial heritage were biased in favor of working-capital loans for trade and large firms and against extending credit to small-scale enterprises, agriculture and commoners, gained prominence. To ensure better coverage of the banking needs of larger parts of the economy and the rural constituencies, the Government of India (GOI) created the State...
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