2.1 Evolution of Banks in India

The financial sector of a country plays a pivotal role in the development of the economy, and banks are the indispensable part of the financial sector. Banks perform the role of intermediary between the savers and investors. Banks collect the surplus money of the savers and invest the funds to the firms and the entrepreneurs.

A well-developed banking sector can carry out this role of intermediary efficiently and successfully. It has been historically seen that the countries with efficient financial sector, particularly the banking sector, have developed quickly. Flow of credit from the banks has played an important role in the development of different sectors of a country. It has been observed that the sector which has an easy and quick access to the bank credit develops faster as compared to the sector which does not have such an easy access to credit.

Although the concept of banks is very age-old, the prototype of modern banking can be traced to the fifteenth century, in Banca Monte dei Paschi di Siena in Italy (1472). Gradually banks spread across entire Europe and later on to the colonies of the European nations.

In India, the establishment of the British rule necessitated the development of the modern banking system. Since then, Indian banks have passed through several phases and regimes. It has embraced myriad changes, grown in stature and attained international standard in terms of products and services offered. So, before embarking on any serious study on the performance of the formal banking structure, it makes sense to discuss historical transformation of the banking system in the country.

2.1.1 The Early Phase

Anthropologists claim that the credit system emanated in the human society with the arrival of trade and commerce. In India, the ancient Chalcolithic sites have been found in many places of the sub-continent. However, in the North-Western frontier, the border of Pakistan and Afghanistan, settlements practically became condensed into a large artisan village at Mehrgarh. Evidence proved that Mehrgarh had a thriving community that required credit.

In the upcoming civilizations of Indus with sprawling towns and cities, there are ample evidence of a strong trading community. These traders settled abroad setting up colonies at Sumer. They were so powerful that they had language interpreters thriving in the courts of the Akkad rulers. It is evident that they should have strong trading-lending system. Without the existence of such a system, the trade of Indus would not have flourished.

Even after the fall of the Indus civilization, their descendants resided with the Indo-Aryan nomadic tribes. In Rig Veda, these descendants were called Panis. There was strong resentment and probably jealousy about their wealth. The Rig Veda again asks Indra to give them the wealth of Panis.

India was not alien to the ideas of banking before the emergence of occidental ideas. There were ample evidence of the prevalence of the usurious practice and interest rate in the early Vedic age. Though there was no distinct reference to coined money, there was mention of the dubious word Nishka in the Rig Veda. In some cases, Nishka was regarded as money, whereas in some other cases, it is dubbed as golden ornaments.Footnote 1

Similar types of instruments were also in vogue in the ancient and the medieval eras. According to the Arthashastra of Kautilya, an instrument called adesha which is tantamount to modern-day bill of exchange or hundi was in vogue during the Mauryan period.

The merchant community flourished from the early Christian era to at least the fifth-sixth century AD. These communities maintained a close network among their members. In many cases, they ran a banking system whereby credit was given to the members. The importance of the merchant deals and their credit activities were noted in the contemporary literature. Buddhists sanghas also played an important role of credit authorities. In the later era, starting from the seventh century, temples began to give loans to ordinary people, trades, craftsmen and others. Basu (1984) mentioned about holy loaning in Karnataka. These loans were given by temples in a specific period. It has to be repaid. Basu (1984) mentioned that the amount to be refunded to remain same independent of the time of loaning.

Ain-e-Akbari along with various other documents and writings of European travelers provide ample evidence that in the medieval period, indigenous bankers performed three important functions—money lending, hundi-backed lending operation and providing financial assistance to the kings and nobles.

During the tumultuous days of civil wars, indigenous bankers, variously called as Seths, Shroffs, Mahajans, Sahukars, Chettias, etc., served as the sole shelter in monetary matters. Early bankers were predominantly traders and used to execute trading as well as banking operations simultaneously. These bankers used to wield huge influence in the society.

2.1.2 Development of Banks in the Pre-independence Era

The seeds of the modern banking system were sowed by the East India Company in the beginning of the nineteenth century with the establishment of the three banks—Bank of Bengal in 1809, Bank of Bombay in 1840 and Bank of Madras in 1843. These banks, also known as the ‘Presidency Banks’, operated as independent entities.

Due to their common interests, in 1921, all these presidency banks were amalgamated to form the Imperial Bank of IndiaFootnote 2 which was run by European Shareholders.Footnote 3 The establishment of the Indian banks received a boost from the Swadeshi movement in 1905. However, it was not a smooth ride for the Indian banks. The three Presidency Banks enjoyed certain advantages as it could use the government balances and business. Contrarily, the Indian banks had to rely on a class of business which was outside the ambit of properly managed banks (Ghosh, 1979). Moreover, the amount of investments made by the Indian banks and the quantity of funds available for industry was paltry.

Adding more worries, Indian banks began to invest heavily in speculative activities and in many cases suffered losses. The banking crisis of 1913-14 further aggravated the situation. In the four years following 1913, 87 banks with over 50% of the total paid-up capital in the banking sector failed (Ghosh, 1979). These series of events necessitated the realization of National Banking Establishment, which ultimately resulted into the establishment of Reserve Bank of India in 1935.

Prior to the establishment of RBI in 1935, there was no central bank for India. Imperial bank was predominantly a commercial bank and it was a banker’s bank only secondarily. In other words, it was a half-way house (Bagchi, 1972). In fact, till 1935, the power to issue notes was bestowed upon the Government of India. But, the Government of India never used its power to issue notes in a conscious manner so as to influence the market rate of interest like. Notably, influencing the rate of interest is a standard practice of the modern central banks.

The Reserve Bank of India Act, 1934 bestowed various powers to the RBI such as the power to issue the currency notes, custodian of the commercial banks’ reserves and the discretion of granting them accommodation. The primary functions of the RBI could be classified as (a) to act as a banker to the government, (b) to issue notes, (c) to act as a banker to other banks and (d) to maintain the exchange rate.

However, in the earlier years, the RBI lacked in supervisory and regulatory powers. It was not in a position to conduct auditing and inspection operations in order to identify and control unhealthy banking practices. Moreover, it could not suggest measures like issuing or revoking licenses. Instead, the operations of the commercial banks were controlled by the Company Law.

The promulgation of the Banking Regulation Act in 1949 was a very important step in the evolution of banking system in India. RBI was armed with far-reaching supervisory and regulatory powers, courtesy this Act. The two main aims of the Banking Regulation Act in 1949 were to regulation and development of the banking system and giving topmost priority to the interests of the depositors.

In fact, the phase up to 1947 was difficult time for the Indian banking sector. Most of the banks of this era were small, localized and they lacked in capital resources. During this period, which witnessed the two world wars and the Great Depression, several banks failed. In its early days, the Reserve Bank of India, with its limited powers, could not do much to regulate the small banks. Pre-independence organized banking was mainly concentrated in the urban areas, while the agriculture and the rural sector were not under banking radar.

2.2 Background and Rationale of Bank Nationalization

India has a long tradition of indigenous banking system since the days of the Raj or perhaps even before that. These bankers used to lend money, acted as money changers and financed the internal trade of India by means of hundis or internal bills of exchanges. The indigenous bankers were usually a family concern. They did not have link with the other financial institution in the country.

However, as early as in 1931, the Central Banking Inquiry Committee felt the necessity of fusing indigenous banking system with the organized banks. In 1935, the RBI started many attempts to control the indigenous bankers. In 1954, the Shroff Committee recommended the RBI that it should take steps to link hundis with the organized banks. The Banking Commission of 1972 accepted the importance of indigenous banks but suggested that they should be incorporated within the organized sector.

Upon independence, the country inherited a war-ravaged economy plagued by the scars of partition, acute shortage of food grains and severe unemployment problem. The banking system, at that time, was grossly unorganized and oriented toward the cause of the shareholders. It was indeed an upheaval task to re-orchestrate and broadening the objectives of the banks for the betterment of the economy (Sarma, 1998). Soon after independence, the view that the banks with its the colonial leanings were biased in favor of the trade and large firms and against extending credit to small-scale enterprises, agriculture and commoners gained coinage. In order to ensure better coverage of banking needs of larger parts of economy and the rural areas, the Government of India nationalized the Imperial bank and transformed it into the State Bank of India with effect from 1955.

There was some discernible progress in the banking sector in the 1950s and 1960s. Despite that, it was felt that the SBI was not able to sufficiently fulfill the credit needs of small-scale industries and the agricultural sector. There was a general perception that banks should play a more prominent in India’s growth strategy by mobilizing resources for sectors that were deemed very much vital for economic expansion. This obviously resulted into the announcement of the policy of social control over banks. It attempted to make changes in the management and distribution of credit by commercial banks.

The postwar development strategy was in many ways a socialist one and Indian Government felt that banks in private hands did not lend enough to those who needed it most. In July 1969, the government nationalized all 14 banks whose national-wise deposits were greater than Rs. 500 million, resulting in the nationalization of 54% more of branches in India and bringing the total number of branches under government control to 84%. The main argument for nationalization of banks was that organized banking system did not play proper role in the development of the country. These banks were controlled by a few rich magnets. Nationalization is an attempt to broaden the base of these banks. The government thought that the banks should expand rapidly to become accessible to people. Also, the emphasis was on priority sector and development-oriented banking.

A second round of nationalization of six more commercial banks took place in 1980. The stated aim of this follow-up nationalization endeavor was to give the government increased control over credit delivery. With this, the government’s control of the banking business rose to 91%.

Nationalization led to a substantial expansion of the bank branches. Also, there was a huge upsurge in bank deposit. This increased from Rs. 820 crores in 1950–51 to Rs. 503,600 crores in 1996–97. Also there was an expansion of bank credit. Importance of the priority sector has been substantial.

The Narasimham Committee (1998) acknowledged certain spectacular achievements of banks since nationalization. It has been pointed out that the commercial banks have significant success in many facets. Expansion of branch, penetration in the rural area, prioritizing the bank lending, increasing deposit and involvement of the relatively unbanked states were some of the striking success of bank nationalization.

However, banks failed in maintaining high profitability and raising working efficiency. The reasons were many. Chief among them are the directed credit, political and administrative interference, subsidization of credit and mounting expenditure of banks. Also there were some problems relating to NPAs, competition, competency, overstaffing, inefficiency, etc. for the nationalized bank.

2.3 Indian Banks in the Modern Era

The year 1991 marked a crucial changing point in India’s economic policy since independence in 1947. Due to the severe balance of payment crisis, structural reform measures were initiated that brought about fundamental changes in the prevailing economic condition. After long period of deepened government influence in the business world, known as ‘the mixed Economy’ approach, the private sector began to play a more important role (Acharya, 2002).

Like the real sector, the reform measures impacted the banking sector as well. Prior to 1991, there were considerable amount of state control over the allocation of credit and the determination of the rate of interest. The blueprint for banking sector reforms in India was laid in the report of the Narasimham Committee in 1991. The committee recommended complementarity between banking sector reforms and changes in fiscal, trade and monetary policies, developing financial health and development of financial markets.

Three ways the government interfered in the banking sector were statutory preemptions, regulated interest rates and directed credit programs (Denizer, Desai & Gueorguiev, 1998). The economic and financial sector reforms aimed to transform the operating environment of banks and financial institutions in the country and to strengthen the Indian economy. The recommendations of the Narasimham Committee (1991, 1998) provided the blueprint for the reforms of the financial system in India. Important developments in the financial system over the period include more liberal entry of foreign banks, more freedom to the banks in choosing deposit and lending rates, lowering of the statutory preemptions, etc. (Bhide, Ghosh & Prasad, 2002).

The second decade of reforms saw widespread usage of technology and electronic banking in banking operations. Use of automated teller machines (ATMs), smart cards, remote banking services, mobile banking Internet banking, etc. has transformed the banking business.

All these reform measures made an attempt to boost up bank efficiency. In the present study, we wish to understand the performance of banks fifty years after nationalization. Nationalization aimed at stabilizing a fragile banking system. It also aimed to contextualizing the banks with respect to common populace. Both the aims have somewhat been successful. In the modern context, efficiency and productivity are of paramount importance. A bank should not only be closely integrated with the society also it should act in an effective way. The question of efficiency thus arises.

What is the condition of banks fifty years after nationalization? How far are have the banks been able to achieve the criteria of efficiency? Also tested is the market structure and the conditions under which the banks in India operate. What and how much the main ethos of bank nationalization has been transformed into the present scenario of banks’ performance. These questions are of crucial importance. The present study is a modest attempt in this field.