Banking Reforms in India

Banking structure is regulated for the promotion of financial stability and economic development. Though post-independence era witnessed increasing public sector ownership of banks and a combination of joint-stock companies, subsidiaries, cooperatives and corporations, it does not guarantee optimal banking structure that the financial reforms sought to achieve since 1991. This chapter focuses on changing the dimension of banking structure on various quantitative measures: (a) density-ratio, (b) relative size of banking system, (c) size distribution of banks within the banking system and (d) geographical concentration. Each of these indicators recorded a positive gain, in some more than double, approaching towards optimality in banking structure for better performance than otherwise would have been possible.

Banking reforms as recommended by Narasimham Committee were carried out to restructure and consolidate in banking system. This included deregulation of entry barriers, interest rates and reduction in policy variables—Statutory Liquidity Ratio and Cash Reserve Ratio. Prudential regulations comprising capital norms, transparency and disclosures, classification of assets and recovery mechanism were introduced. The objectives of these banking reforms were to improve efficiency, competitive environment and operational flexibility enough to withstand the challenges of globalization.

The RBI policy of mergers and acquisitions (M&As) in post-reform period became a strategy for banks’ further restructuring. A major perspective of the RBI banking policy is to encourage competition, consolidate and restructure the system for financial stability. Mergers and acquisitions have emerged as one of the common methods of consolidation, restructuring and strengthening of banks. There are several theoretical justifications to analyse the mergers and acquisition activities, namely change in management, change in control, substantial acquisition, consolidation of the firms, and merger or buyout of subsidiaries for size and efficiency. Thus the objective here is to examine whether the performance of banks has increased after mergers. The null hypothesis that there is no significant improvement after merger is accepted in the majority of the merged cases with few exceptions. Therefore, the strategy of mergers and acquisitions to consolidate the banks for efficiency reason is doubtful. The future banking policy must take note of this empirical reality and long-drawn experience of past 2 decades.

It is an overview of Indian banking market structure and analysis of competition for a quarter century since 1991 in view of persistent public sector dominance governing market for more than a half-century. For this purpose, concentration and degree of competition are examined by the structural and non-structural methods to find out the underlying market structure of the banks. The k-firm concentration ratios and Herfindhal-Hirschman Index (HHI) are estimated to find out concentration and implied degree of competition in the banking sector. Further, competitive behaviour of the banks is also tested by using the non-structural Panzar-Rosse (P-R) Model. The study covers almost a quarter century of post-reform period from 1991–1992 to 2014–2015. The results of the k-firm concentration ratios and HHI values indicated the presence of oligopolistic condition in Indian banking for these years. Further, the H-statistic values of 0.56 lend support to the above conclusion.

It is important to analyse the cost efficiency and productivity of public sector banks for the period from 1991–1992 to 2014–2015. It studied cost structure, economies and diseconomies and total factor productivity change. All the banks were operating at a scale reaping economies of scale in most of the years. Both the bank groups did not show diseconomies with respect to total cost even though there are diseconomies in other individual cost items. The minimum efficient size (MES) was attained by all the public sector banks at much small size in each of the years selected. Majority of the public sector banks found to have positive growth in total factor productivity, and half of them recorded productivity change by 1.26–1.50 score values and 2 banks even recorded a change of more than 1.50 during 1991–1992 to 2014–2015. Hence, cost efficiency gains were supported by record of total factor productivity change by public sector banks.

Since 1991, public sector banks began to emphasize profitability objective in order to strengthen their net worth and financial health as necessitated under financial reforms, and therefore, the analysis is in terms of three profitability ratios—return on assets (ROA), return on equity (ROE) and profit margin (PM) for the period from 1991–1992 to 2014–2015. Positive trend in growth rates of these indicators suggested the favourable impact of banking reforms over the period. ROA of the public sector banks improved by 0.06% points, ROA annually by 1.05% points and PM by 0.69% points per year. Among determinants of banks’ profitability, significant factors were credit quality and management of funds.

Recent rising trend of non-performing assets (NPAs) has become a major concern for banks and RBI both because of its inherent risk of weakening financial system. Effective management of NPAs is essential for preserving the economic value of banks and economic stability. Along with sliding domestic growth during 2009–2012, the banking sector also witnessed a slowdown in its overall performance associated with rising NPAs. Whether or not slowdown in economic growth was associated with higher level of NPAs of banks? Were NPAs result of asymmetric information problem of banks? Empirical analysis showed that there was a statistically significant negative correlation between NPAs and real GDP growth rate for each bank group. This supports the hypothesis that higher NPAs of banks were due to slowdown in real domestic economic growth. However, there may be macroeconomic shocks or asymmetric information problem of the banks that affects the level of NPAs in some cases.

Over the last few decades, technology has enabled banking sector to go beyond its traditional role and services provided. Role of technology, its spread and intensity is witnessed in the electronic mode of banking sector. It examined technology use in Indian banking industry and its impact on overall performance of its functioning in recent decades. Correlation between technology and productivity ratios produced statistically significant values. For the ratio of interest cost to total assets, statistically significant results were obtained but coefficients do not have theoretically expected signs. The study might be a useful general understanding of the effects of technological-based digital banking in India.

Optimal banking structure defined by relative size, accessibility and outreach, and allocation of credit is evaluated from empirical data for changes consistent with dynamic needs of Indian economy during reform era. Despite significant movements on the above parameters, ideal accomplishments were far from satisfactory, and thus further reforms were needed. Reserve Bank of India imposed deregulation and prudential norms for reforming banks that have made substantial impact on banks’ balance sheet and other performance variables. Consolidation and restructuring initiatives muted by policy constraints and consequences were marginal variations in the level of concentration and competition in Indian banking. Market-oriented banking reforms contributed to performance of banks. Notable achievements were lower average cost combined with growth of total factor productivity, superior profitability and intensive advanced technology adoption. But current high non-performing assets ratio is a drag on banks’ profitability as it was the case in 1990s despite  a drastic fall in the ratio in intervening years followed by its upward trend in post-global crisis.