CHAPTER2

EVOLUTION OF THE BANKING SYSTEM IN INDIA

The objective of this chapter is to describe the evolution of the

banking system in India and to situate the dissertation in its wider context
and historical perspective. Our attempt is to outline the major developments
in the banking sector in India since independence focussing on the events
leading to the nationalization of banks and the effect of nationalization on
the banking system in India. This discussion, which begins with a historical
digression, is divided into four sections.
Section I gives a brief account of the evolution of banking in India
before Independence ( 194 7). 1 Section II covers developments in the Banking
Sector since independence in 194 7 till the nationalization of banks in 1969.
These two sections briefly cover major developments in the respective
periods in order to understand clearly the changes that occurred in the post-
nationalization era, which is the main focus of the chapter. Section III deals
with the performance of the banks after nationalization and attempts a critical
evaluation with special reference to achievement of the goals of
nationalization. This section deals specifically with the conditions that
prevailed in early 1992 when the financial scam was discovered. Section IV
concludes.
I
Historical Perspective (5th Century BC to 1947)
In this section an attempt is made to describe the evolution of banking
in India during the period beginning from 5 00 BC till independence in 194 7.
It is not proposed to analyse the entire historical developments during the

1
See Bagchi ( 1997) for the original writings of Cooke (1863 ), Brunyate ( 1900) and Scutt (1904) on the
evolution of banking in India.
period. The description is only synoptic with a view to describe the historical
background. This description is attempted in three parts. Part A covers the
period from 500 BC to 1600, Part B describes the developments during the
period 1600-1921 leading to the establishment of Reserve Bank of India
(RBI) and Part C describes the developments during the period 1921 to 194 7.
A. Early period (500 BC to 1600):
The knowledge of banking in India goes back centuries, long before
Western influence reached the shores. Though the system under which it was
carried on was very different from that which was practiced in Europe, there
is plenty of evidence to show that even prior to the advent of occidental
ideas, India was not a stranger to the concept of banking. Earlier records
show that a few centuries before Christ, India had a system of banking which
admirably suited her needs. Rules and rates of interest relating to deposits
and advances were laid down. 2 The fact that Manu Smriti devoted a special
section to the subject of deposits and pledges show that the transition from
money lending to banking had taken place before 5th Century BC. 3 Although
there is evidence regarding existence of money lending operations in India in
the ancient literature dating back to vedic times, the available literature does
not throw light on the growth of banking as a business pursuit until 500 BC
during the Buddhist period. The details of money lending and remittances of
money in cash or by credit installments are available from 5th Century BC
onwards. The historical evidences show that the "Banker" was an
indispensable pillar of Indian society. 4
Kautilya 's Arthashastra makes an attempt to formulate guidelines
regarding deposits and utilisation of the interest payments received on them.
The Arthashastra prescribed the maximum legal rate of interest on secured

2
Bedi eta! ( 1972).
3
Tandon (1989) p.48.
4
Mongia (1982) p.227.

7
loans at 15 per cent per annum and that on unsecured loans at 60 per cent per
annum without any discrimination as to caste; the rate could go up to 120 per
cent or 240 per cent according to the risk involved, in special circumstances.
Dharma Shastras, though in general agreement with the Arthashastra
introduced caste as an important factor in money lending, expectedly to the
advantage of the higher castes. 5 The literature in this area show that the
early bankers were traders and often combined trade with banking and the
bankers wielded great influence in society. 6 Every town, big or small, had a
'Sheth', also known as 'Shah', 'Shroff' in Gujarati or 'Chettiar' in Tamil
who performed a number of banking functions. He was respected by all
sections of people as an important citizen.
There is plenty of evidence to show, that even prior to the advent of
occidental ideas, India was not a stranger to the concept of "Bills of
Exchange" (Hundies). During the early period of development, the bankers'
assistance was convenient and fairly important as the transactions
necessitated intermediaries because of collection of land revenues in kind.
The early rulers collected the land revenues in kind. The records of the
Muslim period of Indian history, writings of European travellers, State
Gazetteers and the Ain-e-Akbari show that both under the early Muslim and
the Mughal period, indigenous bankers performed three important functions.
They were (i) lending money, (ii) lending for internal and foreign trade with
cash or bills and (iii) giving financial assistance to rulers. 7 During Mughal
rule, the issue of various kinds of metallic money in different parts of the
country gave indigenous bankers great opportunities for developing very
profitable business of money changing, and the most important among them
were appointed as mint officers, revenue collectors, bankers and money

5
Mongia (1882), p.48.
6
Bedi (1972).
7
Tandon (1989) pp.48-49.

8
 changers to Government in vanous parts of the emp1re. Many of them
wielded great influence in the country.
The military contingents in the tenth and eleventh centuries were
invariably accompanied by a banker or "gumastha" who disbursed salaries
and pay of officers and sepoys. The Imperial Gazetteer records that F eroz
Shah (13 56-81) borrowed large sums of money from a banker of Delhi for
payment to his army. The soldiers of Delhi were paid by cash orders,
"italaq ", in outlying places. These were discounted at Delhi by financiers
who made a regular business of it and earned a good income. No
information is available on the rates of interest charged by the early bankers
in these records. The occidental influence on Indian Banking started with
the advent of the English traders in India. The setting up of East India
Company in 1600 marks the beginning of a new era in the evolution of
banking system in India.
B. Developments during 1600-1921:
During the period 1600-1921, the major developments were the
development of modem banking in India, setting up of the three Presidency
Banks at Calcutta, Bombay and Madras, legislation for the setting up of
Imperial Bank of India in 1921 and the realisation of the need for the
National Banking Establishment, which culminated in the establishment of
the Reserve Bank ofindia in 1935. 8
1. Presidency Banks:
Modem Banking was initiated in the European community with the
primary objective of handling current funds. Banking in India, on modem
.
lines, was started around 1770 by Messrs. Alexander and Company, one of
the leading agency houses of Calcutta by setting up Bank of Hindustan,
which was the earliest European Bank in India. The Bank of Calcutta was

8
Tandon ( 1989) p.49.

9
set up in 1806 under the active support of the Government of Bengal, with
9
East India Company contributing Rs.1 0 lakh out of the capital of Rs.50 lakh.
This was the first Presidency Bank which subsequently was renamed as
Bank of Bengal in 1809. The Bank ofBombay was incorporated in 1840 and
the Bank of Madras in 1843, with their charters containing the structural and
regulatory framework designed on lines similar to that of the Bank of
Bengal. 10
The three Presidency Banks had the privilege of the issue of currency
notes on a restricted scale. These restrictions, however, were relaxed
in 1862, when the right to issue notes was taken over by the Government
itself, and the Presidency Banks were given the right of use of Government
balances and the management of treasury work at the Presidency towns and
at the branches. As the new duties were supposed to involve a less onerous
responsibility than the old, the statutory limitation on their business was
relaxed and the banks were given wider discretion in the conduct of their
business, but the Government retained its powers of control. The relaxation
was short-lived as one of the three chartered Banks - Bank of Bombay made
injudicious use of its funds. This led to reimposition of earlier restrictions
through the revision of three separate charters by the Presidency Banks Act
of 1876, as the common statute for the three banks. The common interests of
the three Presidency Banks found their natural culmination in their
11
amalgamation in the Imperial Bank of India in 1921.
n. Setting up of Imperial Bank of India:
Imperial Bank of India was proposed by J.M. Keynes who argued that
the new bank was to be obtained by the amalgamation of the capital and
reserves of three Presidency Banks. He also opined that the "Supreme

9
Brunyate ( 1900) p.2.
10
Ghosh ( 1979) p.l6.
11
Ghosh (1979) p.I7.

10
Control" of the bank must lie with the Central Board, consisting of Governor
of the bank, Director General and representative of Government and three or
more assessors (who will be nominees of Presidency head Offices or of other
head offices). The main function of the proposed imperial bank included:
management of note issue, public debt, effecting remittance for the Secretary
of State through London Office, acceptance of payments and making
disbursements on behalf of Government and to perform all functions as
performed by the Presidency Banks. The Royal Commission on Indian
finance and currency (Chamberlain Commission) was appointed in 1913 to
study and report on certain aspects of the working of the currency and
exchange-system. The question of setting up of a central bank was not
referred to this commission. The Chamberlain Commission, however, could
not accept or reject Keynes proposals and things got stuck.
It is pointed out that the Indian Banks came to be established primarily
in the wake of the Swadeshi movement in 1905, and the growth of the Indian
joint stock banks followed an altogether different pattern. With the
financing of foreign trade in the hands of foreign exchange banks, owned
outside India, especially in the United Kingdom, the best medium for bank
investment namely trade bills, was not available to others. It was difficult for
the Indian banks to get into this business. Further, the three Presidency
Banks enjoyed the advantages that accrued from the use of the Government
balances and Government business. In consequence, the Indian banks were
"forced to seek profits on a class of business which appeared to be outside
the sphere of operation of properly managed banks". 12
Indian banks depended on their own social roots for financing local
trade and industry. The larger of the banks usually confined their business to
the larger land holders, plantation community and others who possessed

12
Ghosh ( 1979).

11
tangible and marketable security. Smaller banks were generally loan offices,
and advanced money to the professional and agricultural classes. Of the
volume of investments by banks in India, the extent of funds made available
for industry was very limited. While the representatives of all established
firms, European and Indian, testified before the Indian Industrial
Commission to the fact that they had little difficulty in obtaining capital for
any well-considered proposal, the Commission had pointed out that the
banks had done little to attract small traders in towns where they had
branches, and that the lack of financial facilities had been one of the serious
difficulties in the way of expansion of Indian industries. Financing of
industry continued in the tradition of the old European agency houses which
functioned as investment bankers and provided funds for the establishment
and operation of indigo plantations, tea gardens, jute mills, iron and steel
works and other kinds of industries. 13
Indian banks started giving finance out of proportion to speculators in
stocks and shares in cotton seeds, wheat, and bullion, instead of financing the
legitimate requirements of trade and industry, and eventually suffered in
many cases. The banking crisis of 1913-14 appeared to be the first occasion
when the issue of Government's duties and responsibilities in such
circumstances was raised. In the four years following 1913, eighty-seven
banks with over half of the total paid-up capital in the banking sector
14
failed. The authorities were constrained to accept a certain measure of
responsibility by placing interest-free government balances at the disposal of
the Presidency Banks to enable them to help banks in temporary difficulties.
But such intervention was to be the exception and, unlike what was done in
the case of the Presidency Banks, no legislative safeguard was contemplated.

13
Ghosh (1979) p.l8.
14
Ghosh (1979).

12
The decision to amalgamate the Presidency Banks was announced in the
Indian Legislative Council in September 1919 by the Finance Member
H.F. Howard. The amalgamation came into effect in January 1921 and the
Imperial Bank of India was established primarily as a commercial bank. The
need for a National Banking Establishment was realised and this realisation
eventually led to the establishment ofReserve Bank of India in 1935.
C. Developments during 1921-1947:
1. Establishment of the Reserve Bank of India:
The Banking system during 1900 to 1934 was characterised by a
dyarchy in the matter of control for the currency and banking system - a
"cumbrous duplication of reserves and antiquated and dangerous division of
responsibilities for the control of credit and currency policy." 15
While the need for a unified and central authority in the matter of
regulation and supervision of the currency and banking system came to be
recognised from time to time, the decision to set up a Reserve Bank with
authority continued to be postponed on one account or another. The first
definite propos~! emerged in the wake of the recommendations of the Hilton
Young Commission (1926). In January, 1927 a Bill was introduced to
16
constitute a new "Reserve Bank". This was aborted as the Government was
unwilling to accept any amendment seeking induction of members of the
legislature into the Board of Directors of the bank since in its opinion the
proposed Reserve Bank of the country should be entirely free from any
control by or any influence emanating from the legislature. It was felt that a
Reserve Bank acting independently of the government and having direct
contacts with the London market and the Bank of England could provide a
built-in institutional safeguard.

15
Ghosh (1979).
16
Ghosh ( 1979).

13
 The discussion in London in the early 1930s, at the Round Table
Conference, clearly brought out that the establishment of Reserve Bank of
India was the "sine qua non" for the handing over of responsibility to a
finance member answerable to an Indian legislature. The Federal Structure
Committee of the first Round Table Conference proceeded on the basis that
the proposals for constitutional reforms were to be framed on the assumption
that the Reserve Bank was to be in operation by the time it was possible to
inaugurate the federation. The Government wanted not only to insulate it
from the political influences but also to ensure that the independent authority
could act with continuity. Significantly, the pre-conditions specified in the
White Paper for Indian constitutional reforms (1933) were those which were
vital for the preservation of remittance mechanism, namely, restoration of
normal export surplus and accumulation of adequate reserves.
The Reserve Bank of India Act was passed in 1934 and the Reserve
Bank of India came into existence in 1935. The establishment of the Reserve
Bank of India, however, did not envisage any radical transformation of the
existing money market or banking structure in the country. All that was
attempted was to draw the scattered and rather undisciplined elements of the
existing structure within the orbit of a new reserve system and to give it a
loose unity and coherence by opening up channels for closer contact between
them. The Reserve Bank of India was to be an institution superimposed on a
heterogeneous mass of commercial banks, exchange banks, cooperative
banks, indigenous banks and money lenders. Unlike the Bank of England,
which was "the gradual consequence of many singular events and of an
accumulation of legal privileges", it did not grow and mature through a
process of natural evolution. 17 This point has to be kept in view to
understand the functioning of RBI in the subsequent years.

17
Ghosh (1979) p.22.

14
u. Dual Control over banking companies:
The purpose of the RBI Act 1934 was to regulate the issue of bank
notes and keeping of reserves with a view to securing monetary stability in
British India and generally to operate the currency and credit system of the
country to its advantage. The Act specified classes of banks which will be
dealt with, namely, those which fulfilled the two criteria; (i) that a bank is a
company or a statutory corporation and (ii) the bank has paid up capital and
reserves of not less than Rs. five lakh. These banks were called scheduled
banks as their names were specified in a · schedule to the Act and were
required to maintain minimum deposits with the Reserve Bank of India and
were eligible for discounting facilities from the Reserve Bank.

The control and regulation of banking companies did not undergo any
change. The Indian Companies Act, 1913 continued to apply commonly to
banking as well as non-banking companies in respect of all important matters
of incorporation, organisation and management. The regulatory provision
under the Indian Companies Act, 1913 with the amendment in 193 6 based on
the recommendations of the Indian Central Banking Enquiry
Committee 1931 was applicable. The responsibility of identifying the
banking companies remained with the Registrar of Companies of different
States and was outside the purview of RBI. The Reserve Bank of India Act
did not cover the question of banking regulation. The returns required to
be submitted by the scheduled banks were not adequate for an effective
assessment of their operation. These were intended to satisfy the Reserve
Bank of India that the statutory requirement regarding maintenance of
minimum cash reserves were being complied with. Inclusion or retention in
the schedule was a matter of routine. The significant point to be noted is the
fact that the evolution of RBI was different from that of Bank of England. It
came into being primarily to serve the British interests and did not have

15
control over the banks. The banking companies were governed by the Indian
Companies Act.
Even in the case of scheduled banks, matters regarding certain
important aspects of management and supervision remained with the
Registrar of Companies under the Indian Companies Act. The duality in the
matter of control and regulation over banking companies placed the Reserve
Bank of India in a serious dilemma particularly during the South Indian
banking crisis of 1938. As a banker's bank, it was expected to deal with the
cnsts, or to forestall their emergence through financial and regulatory
measures. The relationship between the Reserve Bank and the scheduled
banks was based on provision of credit facilities through loans and discounts.
There being no demand for such assistance because of the prevalence of easy
money conditions, the Reserve Bank could not use the financial lever to
achieve any specific objective. "It did not - in fact, could not - till the
enactment of the Banking Regulations Act in 1949, play any meaningful
role as the banker's bank". 18 It was obvious that such a set up of Central
Bank cannot perform its functions as the banker's bank. This situation was
addressed to after the Independence and the Banking Regulation Act 1949
was enacted.
II
Post Independence and pre-nationalisation period (1947-69)
In this section, we shall examine how the structure of the Indian
Banking System which evolved from the colonial framework of commercial
banking adapted itself to the needs of independent India. This examination
will focus on the major developments in the banking system since 194 7
leading to the nationalisation of banks in 1969. The discussion is divided
into four parts: A. Government control over the Reserve Bank of India

18
Ghosh ( 1979).

16
(1948); B. Enactment of Banking Regulation Act (1949); C. Establishment
of State Bank of India (1955); and D. Nationalisation of Banks (1969)

A. Government control over the Reserve Bank of India (1948):

As we have stated earlier, the structure of the Indian Banking System
evolved in the pre-independence years with little purposive control and
direction by the Government. This position changed significantly after
independence. Control and regulation of the Indian economy by the
Government necessitated major changes in the banking structure. The first
measure after independence in this direction was the nationalisation of the
Reserve Bank of India (RBI) in September, 1948. This was achieved by
giving a legal recognition of the principle that the policies pursued by the
central banking institution of the country have to serve the social and
economic objective laid down by the government while preserving the
autonomous character of the RBI. With this objective in view, government
brought an amendment whereby government could give directions to the RBI
as it might consider necessary in public interest. By this the government's
policy to control the RBI for realising the economic objectives was made
clear. We would like to point out that even though the central government
had statutory powers to give directions to the RBI, the approach of the
government has always been not to give directions to the RBI but to work
out the policy in consultation with RBI. However it should be noted that the
Ministry of Finance always controlled the RBI and RBI always had to
'consult' the government before taking policy decisions. Even though the
statutory "de jure" directions were seldom issued, in actual practice
government kept its "de facto" control over the RBI through the process of
"consultation" before major policy decisions. The message to the RBI was
made clear that the RBI has to orient itself towards the economic goals of the
government and advice the government accordingly. We would consider this

17
as the first step towards the nationalisation of the banks which took place
in 1969.
B. Enactment of Banking Regulation Act (1949):
The enactment of Banking Regulation Act (B.R. Act) in 1949 was the
major step in the history of banking in India. This Act conferred on the RBI
a wide range of regulatory and supervisory powers relating to the
establishment of a bank and maintenance of a certain minimum operating
standards.
The RBI considered it a matter of urgency to bring forth legislation to
consolidate the rapid and uncontrolled growth of banking during the Second
World War. Inflation during the war had led to a proliferation of financial
companies and uncoordinated branch expansion. RBI had noticed a number
of unhealthy practices which had corrupted the system. Most of these
practices were against the interest of the depositors. For example, RBI had
received reports regarding a number of banks extending advances on
inadequate security. Banks had increased the number of branches without
following the norms. A few small banks had granted loans and advances out
of proportion to the total resources. After taking into account the prevailing
unhealthy practices the RBI proposed a comprehensive legislation for the
proper supervision and development of the banking system in India.
The B .R. Act came into existence in 1949. The Act defines banking as
"accepting for the purpose of lending or investment, deposits of money from
the public, repayable on demand or otherwise and withdrawable by cheque,
draft, order or otherwise". The twin objectives of the Act were regulation
and development of the banking system. To achieve this, there was
provision in the B.R. Act for inspection, empowering the Reserving Bank to
make a qualitative assessment on a bank's management and its policy and
methods of business from the point of view of depositor's interest.

18
Extensive powers of control and regulation came to be vested in the Central
Monetary Authority (RBI) and this provided the foundation for development
of a banking system during the subsequent decades.
The character and process of financial intermediation through the
banking system was materially conditioned by the way the regulatory powers
were exercised. The B.R. Act made RBI the statutory regulatory authority
of the Indian banking system. These powers covered the areas of requirement
of minimum paid up capital, management, lending, inspection, supervision
and winding up. Apart from inspection and supervision, the RBI exercised
control over the banking system, by virtue of its power to license the bank.
The way in which these powers were made use of to control and regulate the
system is described in various sections of the Banking Regulation Act, 1949
19
as amended from time to time.
1. Licensing of Banks:
For determining the eligibility for licensee under Section 22 of the

19
The major regulatory powers of the Reserve Bank in the B.R. Act 1949 are as follows:
Section 8 prohibited a banking company from dealing directly or indirectly in the buying or selling or
bartering of goods except in connection with its legitimate banking business.
Section 9 disallowed a banking company from holding any immovable property except for its own use.
Section I 0 held that a banking system cannot be managed by a managing agent.
Section II provided for a minimum paid-up capital and reserves, ranging from Rs.l to I 0 lakh, depending
upon location, etc.
Section 12 stated that the subscribed capital should not be less than one half of the authorised capital, and the
paid-up capital should not be less than one half of the subscribed capital. The capital should consist only of
ordinary shares.
Section 19 disallowed a banking company from holding shares in any company of an amount exceeding 30
per cent of the paid-up share capital of that company or 30 per cent of its own paid-up capital and reserves,
whichever was less. It also could not hold shares in any company in the management of which any Managing
Director or Manager of the banking company was interested.
Section 20 held that a banking company could not make a loan against its own shares; or unsecured loans to
any of its Directors or a firm/private company which the Director was interested as partner/managing
agent/guarantor.
Section 23 stated that new branches could not be opened and existing branches could not be shifted, except
within the same city, town or village, without prior permission from the Reserve Bank.
Section 35 gave powers to the Reserve Bank to inspect the book of a banking company.
Section 38 stated that the court could order the winding up of a banking company if it was unable to pay
debts, within two working days at places where a Reserve Bank office was established and five working days
at other places, or if the Reserve Bank applied to the court in this behalf.
Section 44 stated that no licensed banking company could be voluntarily wound up unless the Reserve Bank
certified that the company was not able to pay in full all debts to its creditors as they accrued.

19
banking Regulation Act, the Reserve Bank started a system of periodical
inspection in 1950, and evolved, for this purpose, certain criteria to judge the
efficacy of their working. These criteria were indicative of the strength of
reserves and the nature of security affecting the liquidity and quality of
advances. A scrutiny by the RBI of the nature of defects noticed during
inspection referred to inadequate reserves, over-extended advances,
relatively large unsecured advances against immovable property, large
proportion of bad and doubtful debts, ineffective control over branches, non-
observance of usual procedure and formalities in sanctioning advances, and
various types of procedural and organizational deficiencies. Broadly, these
undesirable features were classified in two categories: (a) defective nature of
advances and investments and (b) deficiencies in management and control.
Since the enactment of the B.R. Act, the RBI has been endeavoring to
improve the methods of operation of banks through periodical inspection and
issue of directions. Banks which could not improve their financial position
and methods of operation, in spite of repeated advice and guidance, were
closed down through refusal of license. A process of judicious amalgamation
was also recognized by the RBI as one of the methods of strengthening the
banking structure. However, assumption of statutory power for compulsory
amalgamation was not favoured during the mid-1950s. 20
ii. Amendment to Banking Regulation Act (1949):
With the objective of enabling the RBI to have effective control on the
management of banks, the B.R. Act (1949) was amended in 1950, 1953
and 1956.
The amendment in 1950 was to secure a speedy amalgamation of
banking companies and quick disposal of proceedings for their winding up.
The amendment in 1953 expedited the proceedings for the liquidation of

20
Travancore-Cochin Banking Enquiry Commission 1956.

20
banks ordered to be wound up. The amendment in 1956 mainly plugged the
loopholes in the earlier legislations in dealing with managerial irregularities
of banking companies. In particular, the existing powers of the RBI were
extended to cover the terms of appointment of Directors, Managing Directors
and Chief Executive Officers. The Act also aimed at the prevention of
misuse of voting rights through concentration of shares in the hands of a few
by withdrawing the exemption granted to banks incorporated prior to 15
January, 193 7 under Section 12. This clearly indicated the realisation that
concentration of shares in a few hands will give them control over the
banking operation and that will not be in national interest. We will be
discussing more about this subsequently while considering the circumstances
leading to the nationalisation of banks.
C. Establishment of State Bank of India:
An important development in the banking sector in the 1950s was the
conversion of the Imperial Bank of India into State Bank of India (SBI) in
July, 1955. The All-India Rural Credit Survey Committee recommended the
creation of a State partner and State sponsored bank by having control over
the Imperial Bank of India and integrating it with the former State Bank of
princely states. This recommendation was accepted and the SBI was
constituted as successor to the Imperial Bank of India. 21 The majority of the
shares of the Imperial Bank of India were acquired by the Reserve Bank of
India and this was the first step towards widening the scope of the banking
system in India. We would like to point out that the SBI, even though a
public sector bank, is not referred to as a nationalised bank. This was
because of the acquisition of the shares of the Imperial Bank of India by the
Reserve Bank of India. There was no nationalisation involved in this
process. Government also passed the legislation in 1959 enabl' e SBI to
-- - · · e~sit_y ""~.
X 33i~~:j~S4 'q'l_ '! t;;;··--~,•.'·~-
21TheStateBankofindiaActcameinto Sr In f:j( ~ ~' \\i
34
11111/I!IJWIII/III
TH8918
. '~}~~~
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take over 8 State associated banks (which were functioning in the princely
States) as subsidiaries of SBI. Of these eight subsidiary banks, the State
Bank ofBikaner and State Bank of Jaipur were merged into one. The other 6
banks were State Bank of Hyderabad, State Bank of Patiala, State Bank of
Mysore, State Bank of Saurashtra, State Bank of Indore and State Bank of
Travancore. The State Bank and its seven subsidiaries were intended to
accelerate the pace of extension of banking facilities all over the country.
This clearly indicated the perception of the government that their economic
and social objectives could be better realised through nationalisation of the
banks.
D. Economic reasons for Nationalisation of Banks (1969):
The purposive control on the banking system by the government began
in 1948 with the government assuming statutory powers to give directions to
the RBI. This policy gained momentum and finally culminated in the
nationalisation of banks in 1969. We would like to point out that the
nationalisation was basically a political decision to achieve the objective of
economic growth with· social justice. In this subsection we attempt an
analytical description of the underlying economic reasons which led to the
nationalisation of banks in 1969. There were two major factors. The first
one was the sectoral pattern of bank credit in 1960s. There was considerable
increase in the proportion of credit to industrial sector during the 1950s and
the 1960s. Industrial sector availed the bulk of bank credit and the corporates
virtually controlled the banking system. The second was the increasing
demand from agriculture and allied sectors during the 1950s and 1960s.
These two factors played a major part in paving the way for government
control over the banks.

i. Sectoral pattern of bank credit in 1960s:

The growth of the corporate sector and the State policy to

22
 .
I

accommodate the private sector through institutional diversification greatly

influenced the pattern of bank credit. Since 1950 there was an unprecedented
growth of the private corporate sector. Because of this, the 1960s witnessed a
marked change in the sectoral pattern of bank credit. The sectoral
distribution of bank credit during the period 1951 to 1965 is presented at
Table 2.1.
Table 2.1
Distribution of Scheduled Commercial Bank's Credit to Various Sectors
(Outstanding in rupees crore)
March 1951 March 1956 March 1961 March 1966 March 1968
Amt. %to Amt. %to Amt. %to Amt. %to Amt. %to
Sector Rs.Cr. Total Rs.Cr. Total Rs.Cr. Total Rs.Cr. Total Rs.Cr. Total
Industry 198.9 34 285.7 37.1 663.8 50.8 1471.0 62.7 2067.5 67.5
(of which State (29.0) (2.2) (76.0) (3.2) (114.0) (3.7)
owned and State
Managed concerns)

Commerce 210.6 36 281.0 36.5 373.2 28.6 502.3 21.4 587.7 19.2
(of which State (54.0) (2.3) (107.9) (3.6)
owned and State
Managed concerns)

Financial 74.0 12.7 71.9 9.3 67.1 5.1 77.6 3.3 84.2 2.7
Personal 39.7 6.8 51.1 6.6 87.9 6.7 107.8 4.6 113.4 3.7
Agriculture 12.4 2.1 15.6 2.0 40.5 3.1 56.5 2.4 67.1 2.2
Others 49.0 8.4 64.9 8.4 73.7 5.6 131.6 5.6 144.5 4.7
Total 584.6 100.0 770.2 100.0 1306.2 100.0 2346.2 100.0 3064.4 100.0
Source: RBI (1968-69).

From Table 2.1 it is seen that the ratio of advances to industry had
increased progressively since 1951. From 34% in 1951 it rose to 51% in
1961 and to 67o/o in 1968. There was a corresponding decline in the share of
commerce from as high as 36 per cent in 1951 to a low of 21.4 per cent
in 1966 and further decline to 19.2 per cent in 1968. The share of advances
to agriculture remained static at 2 per cent during 1951 and 1956, rose to 3.1
per cent in 1961 and fell again to 2.2 per cent in 1968. Further
disaggregation of credit to industry revealed that hardly 2.2 per cent of this
credit was actually disbursed to the public sector enterprises in 1961 which
rose marginally to 3. 7 per cent in 1968. During this period the bulk of the

23
bank credit was in favour of the industrial sector and in that too the
private sector. The credit flow to public sector was marginal. Thus the
distribution of bank credit was lopsided and the major beneficiary was the
private corporate sector.
Within the industrial sector to which the bulk of the bank credit had
gone, nearly four fifths was claimed by the private corporate sector and the
public sector was getting only 2 to 3 per cent. (Table 2.1 ). This conclusion
drawn from the data on bank credit to industry is also corroborated by the
data on the incremental credit share of industry during 1956 to 1966. The
relative proportion of credit to industry and commerce are presented in
Table 2.2.
Table 2.2
Credit to Industry and Commerce: Incremental share
(Amount in crore of rupees)
March 1956 April 1961 March 1966 March 1967
Over Over Over Over
March 1951 March 1956 April 1961 March 1966
(1) (2) (3) (4) (5)

1. Increase in total 185.6 536.0 1040.6 370.5

Advances
2. Increase in 86.8 378.1 807.2 277.0
Advances to
Industrial sector
3. (2) as% of (I) 46.8 70.5 77.6 74.8
4. Increase in 70.4 92.2 129.1 24.2
Advances to
commerce
5. (4) as% to (I) 37.9 17.2 12.4 6.5
Source: RBI Bulletin (1968).

From Table 2.2 it is clear that the increase in share of industries which
was 46.8% in 1956 increased to 70.5% in 1961, 77.6% in 1966 and declined
marginally to 74.8% in 1967. It is also seen that the increase in advances to
"commerce" decreased significantly from 37.9% in 1956 to only 6.5%
in 1967.

24
 An important structural feature of the Indian banking system was the
extremely low ratio of the paid-up capital and the bank deposits. The
mtmmum capital requirement for a bank was fixed under the Indian
Companies Act at Rs. 50,000 in 1936, and it continued to be so till 1962. The
Banking Regulation Act, 1949, kept the provision for the minimum
requirement of paid-up capital at the same level. The percentage of paid-up
capital and reserves to the total deposits of the banking system had been
going down over the years: from 9% in 1951 to 4% in 1960. While the low
capital base provided too thin a cushion for any possible erosion in deposits,
its implication from the point of view of concentration of power was no less
disconcerting. It was only in the early sixties that it came to be officially
recognized that concentration of power in the Indian banking system had
been greatly facilitated as a result of the low capital base and that the persons
controlling the capital base could, by having command over the deposit
resources, exercise enormous power.
RBI conducted two surveys regarding directorship of banking
compames and ownership pattern of shares of the banks. A survey of
directorships of twenty leading banking companies, conducted in 1963,
brought out that 188 persons, who had been serving on the Boards of
these 20 banks, had 1,452 directorships of other companies also. The total
number of companies (excluding non-profit making organisation), under
these directors, were 1,1 00. Another survey of six major banks conducted
in 1965 revealed that 65% of the shares were held by as few as 5000
individual holders and this gave an advantage to acquire and maintain
control over the bank by a small group. From these two studies, it could be
seen that the ownership pattern and the inter-locking between the banks and
companies in the corporate sector decided the flow of bank credit in favour
of the corporate sector.

25
 We would like to conclude this discussion by stating that the policies
and practices of commercial banks in the 1960s were in favour of the
industrial borrowers and the corporate sector was virtually controlling the
deposits and pattern of credit flow. The measures taken by RBI and the
guidelines issued under the B.R. Act did not succeed in altering the pattern
of credit flows. The close nexus between the banking system and the
industrial sector and the support given to large industrial houses by the
government owned financial institutions had a determining influence on the
commercial banks in the choice of their clients. This type of control of
corporate sector over the bank resources made the government realise the
need for taking steps to reorient the credit policy in line with the national
plans and priorities. Another factor which drew the attention of the
government was the demand for credit from the agriculture and allied
sectors.

11. Demand from Agriculture and Allied Sectors:

The RBI took the initiative and assumed responsibility for rural
finance by establishing the Agricultural Credit Department under the RBI
Act 1935. During the period 1947-51 a qualitative change took place in the
Reserve Bank's role in the sphere of rural credit. It began with a series of
procedural relaxation in the conditions for availability of credit facilities to
the cooperative sector. These were mostly ad-hoc in nature rather than the
outcome of a well-defined long-term plan. For example, at the instance of the
Bombay Provincial Cooperative Bank, the scheme to provide for the interest
rebate on accommodation granted against eligible paper was extended to
cover advances against government and trustee securities. The availability of
the second signature required for rediscounting of agricultural paper, being
difficult to obtain in States which do not have good central banks, the
Reserve Bank agreed to accept, at the pleadings of the Governments of

26
Central Provinces of Orissa and West Bengal, the guarantees of the
provincial governments in lieu of such second signatures. The criterion for
determining the borrowing limits in relation to owned funds was relaxed to
allow higher credit limits for deserving central banks at the instance of the
Madras Provincial Cooperative Bank. RBI set up All India Rural Credit
Survey Committee (AIRCSC) with the specific objective to streamline the
credit to agriculture sector. The recommendation of this Committee formed
an integral part of the second and subsequent Five Year Plans. However, the
AIRCSC failed in its objective of suggesting a suitable mechanism for
adequate and equitable distribution of credit for the farmers. 22 The Second
and Third Five Year Plan stressed the need for increasing agricultural
production by increasing the yield per unit of the land already under
cultivation. The need for credit for High Yielding Varieties Programmes
(HYVP) was accepted by the policy makers and had to be tackled. Demand
for agricultural credit, as it was increasingly emanating from large farmers,
could not be accommodated from the resources with the cooperative banking
sector and consequently the need for additional funds from the commercial
banking system became a necessity. The banking sector could ill-afford to
ignore the new sectoral demand, particularly when, in the wake of two
successive droughts, the need for assuring a steady flow of material and
financial inputs for increased agricultural production became an overriding
national objective. The prevailing situation gave an excellent opportunity for
the farmers in the countryside, to attempt to appropriate whatever share of
credit they could have from the resources of the commercial banking system.
Thus the focus turned on the commercial banking system.
iii. Nationalisation of banks:
With the view to bring about a wider diffusion of banking facilities

22
Ghosh ( 1979).

27
and to change the uneven distribution pattern of bank-lending, the scheme of
Social Control on banks was announced in Parliament in December, 1967.
This measure was taken following a resolution in Rajya Sabha committing
Government to extend social control over banks. Social control aimed at
ensuring that particular clients or groups of clients were not favoured in the
matter of distribution of bank credit and in the character of share holding of a
bank. The National Credit Council under Chairmanship of Prof. D.R. Gadgil
was set up in 1968 to assess the demand for bank credit from various sectors
of the economy and to determine the priorities for grant of loans and
advances.

The basic objective of the social control policy was to ensure, in the
immediate future, an equitable and purposeful distribution of credit, within
the resources available, keeping in view the relative priorities of
developmental needs. The policy stand of the government was stated by the
Minister Shri K.C. Pant in the Parliament "We want to work in a direction of
opening ever-widening opportunities for small and medium scale industries
and for cooperatives and agriculture. Indian banking system achieved
stability and maturity but it has to be geared to meet the new challenges and
it is, in this context, that I want to refer to Congress Working Committee's
Resolution: We have therefore undertaken an intensive examination of the
problem in all its aspects so as to decide upon the steps that may be
necessary to make the banks effective instruments in the furtherance of our
social and economic objectives". The major instrument conceived for this
purpose was the National Credit Council at the all-India level for the
assessment of the demand for bank credit from various sectors of the
economy.

The National Credit Council in its various meetings took note of the
legitimate resource needs of the large scale and medium scale industrial

28
sector and suggested targets for setting up one bank branch for population
of 10,000 in every town (March 1969). Though the council never went into
the details of the crucial issues related to credit planning and the need to
attain the various plan objectives, yet it conveyed the message that
ownership of the banks by the government was crucial for extension and
diversification of the banking system. This line of thinking soon led to the
nationalisation of banks.
The fourteen major banks having deposits of Rs.500 crore and above
were nationalised in July 1969. These banks were: 1. Central Bank of India,
2. Bank of India, 3. Punjab National Bank, 4. Bank of Baroda, 5. United
Commercial Bank, 6. Canara Bank, 7. United Bank of India, 8. Dena Bank,
9. Syndicate Bank, 10. Union Bank of India, 11. Allahabad bank, 12. Indian
Bank, 13. Bank of Maharashtra, 14. Indian Overseas Bank. In 1980, the
Government acquired six more banks each having deposits of Rs.200 crore
or more. These banks were: 1. Andhra Bank, 2. Punjab & Sind Bank, 3.
Corporation Bank, 4. Oriental Bank of Commerce, 5. Vijaya Bank and 6.
New Bank of India (merged with Punjab National Bank in 1993).
The nationalisation of banks enlarged the sphere of public sector
banking which prior to 1969, was confined only to the State Bank of India
and its seven associate banks. With the second spell of nationalisation of
banks in 1980, a major portion of the banking system (nearly 85% of the
total bank deposits) came under the control of the government.
III
Critical Assessment of functioning of Public Sector Banks (1969-1992)
The aim of this section is to describe the objectives of nationalisation
of banks and to critically examine the extent to which these objectives have
been realised. ,

29
A. Objectives of nationalisation:
The objectives of nationalisation were explained to the nation by the
Prime Minister in her broadcast on 19th July, 1969. These were: (i) removal
of control by a few; (ii) provision of adequate credit for agriculture, small
industry and exports; (iii) giving a professional bent to management; (iv)
encouragement of new classes of entrepreneurs, and (v) the provision of
adequate training as well as terms of service for bank staff.
One could conceivably argue that nationalisation was being looked
upon not as a radical departure from the social control phase, but as a
carrying forward of the process initiated through the package of social
control measures. The explanatory statement on bank nationalisation made in
Parliament two days later was also in the same refrain except for the
emphasis it sought to place on the role of the nationalised banks as a catalytic
agent for growth. "It will be", the statement emphasised, "one of the positive
objectives of the nationalised banks to actively foster the growth of the new
and progressive entrepreneurs and to create fresh opportunities for hitherto
neglected and backward areas in different parts of the country. We note a
greater precision in the statement of Objects and Reasons accompanying the
Banking Companies Acquisition and Transfer of Undertakings Act
(hereinafter referred to as the Nationalisation Act) seeking to replace the
Ordinance. This statement states "The banking system touches the lives of
millions and has to be inspired by larger social purpose and has to subserve
national priorities and objectives, such as rapid growth in agriculture, small
industries and exports, raising of employment levels, encouragement of new
entrepreneurs and the development of the backward areas. For this purpose,
it is necessary for Government to take direct responsibility for the extension
and diversification of banking services and for the working of a substantial
part of the banking system".

30
 The achievements and shortcomings of nationalisation are discussed
below:
B. Achievements:
The two major achievements of nationalisation of banks are (i) to
widen the branch network of banks in rural and semi-urban areas to ensure
higher mobilisation of deposits and accessibility of banking operations to all
citizens and (ii) the reorientation of credit flows for the benefit of the hitherto
neglected sectors such as agriculture, small scale industries and employment
generation programmes of the Government.
1. Spatial coverage and accessibility:
For achieving spatial coverage and accessibility, several steps were
taken and the licensing policy of the Reserve bank was tuned to enable banks
to open offices in rural and semi urban areas. With a view to understand the
expansion and coverage achieved we are presenting the statistical
information with relevant indicators for the period from June 1969 to
March 1992 in Table 2.3.
Whereas the number of Scheduled Commercial Banks almost
quadrupled from 73 in 1969 to 272 in 1992, the number of bank branches
increased almost eight times (from 8,262 in 1969 to 60,570 in 1992). There
was a massive increase in the number of bank branches in rural and semi
urban areas. Whereas the increase in the urban branches was from 1,584
in 1969 to 8,279 in 1992, the increase in rural branches during this period
was indeed phenomenal: rising from mere 1,833 in 1969 to 15,105 in 1980
and to a high of 35,269 in 1992.
Table 2.3 also shows that along with increase in the branch network
across rural, urban and semi-urban areas, the deposit base of the banks also
increased significantly. Whereas the overall deposits of SCB 's increased
from Rs.4,646 crore in 1969 to Rs.33,377 crore in 1980 and to an impressive

31
level of Rs.2,3 7,566 crore in 1992. The average deposits per branch office
increased from Rs.56 crore to Rs.1 03 crore and Rs.392 crore respectively
during these years. Alongside the increased efforts of the banking system in
mobilising the savings, the credit flow also increased impressively; per
capita credit registered an increase from merely Rs.68 in 1980 to Rs.1 ,516
in 1992. The ratio of deposits to GDP was around 15.5% in 1969 and this
increased to 35.8% in 1980. This further increased to about 50% in 1992.
The increase from 1969 to 1992 was phenomenal. In 1969, there was one
branch for a population of 64,000. In 1980 every 29,000 had a branch.
In 1992 there was a bank for every 14,000. Thus it could be seen that since
nationalisation in 1969 and 1980 the spatial coverage and accessibility of
banks showed a tremendous increase which was quite unique.
Table 2.3
Expansion of Banking System (1969-92)

Sl. No. Description oflndicator Position in

June 1969 June 1980 March 1992
1. No. of Commercial Banks 89 153 276
2. Scheduled Commercial Banks (SCB) 73 148 272
3. Of which RRBs 73 196
4. Non-scheduled Commercial Banks 16 5 4
5. No. of Bank Offices in India 8262 32419 60570
6. Ofwhich: Rural 1833 15105 35269
7. Semi Urban 3342 8122 11356
8. Urban 1584 5178 8279
9. Metropolitan 1503 4014 5666
10. Offices abroad 56 133 115
II. Population per office (in thousands) 64 21 14
12. Deposits ofSCBs in India (Rs. Crore) 4646 33377 237566
13. Deposits of SCBs per office (Rs. Lakh) 56 103 392
14. Credit of SCBs in India (Rs. Crore) 3599 22068 131520
15. Credit of SCBs per office (Rs. Lakh) 44 68 217
16. Per capita deposits ofSCBs (Rs.) 88 494 2738
17. Per capita credit of SCBs (Rs.) 68 327 1516
18. Ratio of Deposits ofSCBs to GOP 15.5 35.8 49.6
Note: SCB - Scheduled Commercial Bank GDP - Gross Domestic Product.
Source: RBI (1989, 1991-92, 1992-93).

n. Reorientation of Credit:
The second objective of nationalisation was reorientation of credit
flows for the benefit of the hitherto neglected sectors such as agriculture,

32
small-scale industries, small borrowers and the poverty alleviation
programmes of the Government. For achieving this, two major steps were
taken.
The first one was the introduction of a mandatory priority sector
lending scheme. The banks were required to lend a certain proportion of the
net bank credit for designated priority sectors which included agriculture,
small-scale industries and small business. This proportion was 33 per cent of
net bank credit (deposits after deducting SLR and CRR) till 1980 when it
was raised to 40 per cent, with the stipulation that it should be achieved
by 1985. Under the overall target, sub-targets were also laid down for credit
to specific sectors such as agriculture and for weaker sections of the society.
This step ensured that the nationalised banks complied with the mandatory
directions. Apart from fixing the percentage of deposits meant for lending to
priority sectors, government also stipulated that these !endings will be at the
administered rates of interest. This was a conscious step to make cheaper
credit available to this sector.
Secondly, with a view to meet more effectively the credit needs of the
weaker sections in the rural areas, Regional Rural Banks (RRBs) were set up
as separate institutions in the mid-1970s. In 1992 there were 192 RRBs. In
each RRB, the distribution of the share capital was as follows: 50 per cent
from the Central Government, 35 per cent from the sponsoring nationalised
bank and the remaining 15 per cent from the State Government concerned. In
effect, these were under the control of the Government of India and were
meant to ensure the flow of credit to the needy segment of the rural
population.

As a result of these steps, the profile of credit flows in the Indian

banking changed. A structural transformation did take place in the
disbursement of commercial bank credit. The effect of the policies on flow of

33
 credit to agriculture and rural sector (priority sector) can be seen clearly from
the data presented in Table 2.4 comparing the position in 1969, 1989
and 1992:
Table 2.4
Outstanding Credit of Public Sector Banks to priority sectors
(Rs. Crore)
June 1969 June 1989 June 1992
Priority Sector 441 34874 44995
(14.6) (44.6) (39.3)
I. Agriculture 162 14369 18464
(5.4) (18.4) (16.1)
II. SSI Sector 257 13248 17689
(8.5) (16.9) (15.5)
III. Other Priority 22 7257 8842
Sectors (0.7) (9.3) (7.7)
Net Bank Credit 3016 78178 114502
(100.0) (100.0) (100.0)
Note: Figures in brackets indicate ratio(%) to net credit.
Source: RBI (1985-86, 1990-91, 1993-94).
From the table 2.4, it is seen that the priority sector credit which was
only 14.6 per cent of net bank credit in 1969, increased to 44.6 per cent
in 1989 but declined somewhat to 39.3 per cent in 1992. The sub-sectoral
targets for agriculture, small scale industries, weaker sections and small
traders were also achieved. We would like to point out that this reorientation
of credit, while succeeding in realisation of achieving the targets set, had its
adverse impact on the economic viability of the banks. Study conducted by
RBI in 1994 revealed a number of defects in selection of projects and the
quantum of credit. A majority of projects were unviable and did not generate
adequate income to enable the repayment. 23
C. The effect of nationalisation on the Indian banking system:
The removal of control over the banks by a few, the expansion of the
branch network to cater to the needs of rural population and the reorientation
of credit to priority sectors can be regarded as three major achievements of

23
Report of Mehta Committee ( 1994 ).

34
nationalisation of banks. Of the five objectives, the first two were achieved
to a considerable extent. However, the remaining three could not be realised.
It was noticed that the exercise of ownership functions by the government on
the public sector banks was not conducive to the growth of a healthy, vibrant
and strong banking structure. We are discussing later in Chapter 7 the causes
of the financial scam of April 1992. In this subsection we attempt to
highlight the point that over a period of time after the nationalisation, the
profitability and efficiency of the public sector banks were adversely
affected.

1. Profitability:
A financially stable bank is one which makes profits and has a strong
balance sheet. This is true of public sector banks also. An adequate level of
profit implies that the bank's interest and other earnings are sufficient to
cover its financial and administrative expenses, that provisions exist for
various items such as bad debts, tax liabilities and depreciation of financial
assets and that it retains sufficient surplus to pay dividends to its
shareholders and to augment its reserves. From an economic point of view,
any bank's profitability is an important indicator of its borrowers' health and
of sound credit appraisal. A strong balance sheet means that the bank has
sufficient capital and reserves to protect its depositors and other creditors
from the risks it bears on the assets. A loss making bank is, ultimately, bound
to eat into its capital and reserves. When capital and reserves are exhausted,
losses begin to erode deposits. Adequacy of capital ensures that a bank can
bear occasional operating losses without threatening the safety of depositors'
funds.

We would like to point out that after the nationalisation of banks, the
emphasis was on expansion and priority sector credit. The quality of service
did not keep pace with modem standards and changing expectations. The

35
public sector banks were not computerised. This affected the speed and
accuracy of service and the basic integrity of banking process such as
internal controls, prompt recovery and inter-bank reconciliation of accounts.
The performance of Chief Executives was assessed not on the basis of
profitability. The general feeling was since these banks are owned by the
government any deficiency in the capital will be automatically made good by
the government by allocation of budget funds. This meant that if public
sector banks suffered loss and eroded its capital, the Ministry of Finance
should allocate funds to restore the capital. The assumption that the
government budget should underwrite the banks solvency is not conducive to
a sound economy since it is not sustainable. The resources of the government
should not be used to promote inefficiency.
Another important point to be noted 1s the way in which the
accounting of the interest income was calculated in the banking system. This
was not on the basis of the interest income actually received but on the basis
of the interest accrued which became due. Thus even if the interest due was
not actually received it was reckoned as income in the balance sheet. This
method of income recognition was against international standards and
lacked credibility and accuracy. When the financial results of public sector
banks are judged applying the criteria of profitability and capital adequacy
the performance of these banks had fallen well below international
standards. 24
The reasons for the erosion in profitability of public sector banks can
be analysed in two categories. The first one was due to factors external to the
bank and the second one related to organisational and management

24
The international standards were finalised by the Basle Committee in 1988. This committee established the
norm that commercial banks of developed countries engaged in international transactions should maintain
unimpaired capital at least equal to 8% of risk weighted assets. This norm has now been accepted by
developing countries also. In fact, the tendency of privately owned banks in many countries, after the
financial turbulence of the 1980s is to maintain even higher levels of capital.

36
shortcomings. We would like to point out that there was interaction between
the two, in that the external environment might have contributed to, if not
actively encouraged, poor management. These external and internal factors
are examined below:
a. External Factors:
There were three major policy decisions taken by the Government
which adversely affected the quantum of resources available with the banks
for commercial lending. The deposits of the banks were pre-empted by the
statutory requirements of RBI regarding Statutory Liquidity Ratio (SLR) and
Cash Reserve Ratio (CRR) and the government orders relating to priority
sector !endings at the rate of interest prescribed by the government. The
combined effect of these three factors resulted in impounding a major portion
of resources of the banks.
a. i. Pre-emption of bank resources through SLR and CRR:
All commercial banks in India are to comply with the statutory
requirements of SLR and CRR stipulated by the Reserve Bank of India. The
SLR requires bank to invest a portion of their net Demand Time Liabilities
(DTL ), which is the available resources of the bank for commercial lending,
in Central and State Government securities. The CRR requires the banks to
hold a portion of their deposits (net demand and time liabilities) in the form
of cash balances with the RBI. The restrictions of SLR and CRR are
applicable to all scheduled commercial banks. The statutory minimum for
SLR is 25 per cent and that of CRR is 3 per cent.
For our discussion the most important point is the way in which SLR
and CRR were increased after the nationalisation. Government adopted the
policy of meeting its borrowing needs by increasing SLR. In 1980, at the
time of second round of nationalisation, the SLR was 34% of DTL. This was
increased year after year to meet the needs of government. In 1991-92, SLR

37
was 38.5o/o of DTL of the scheduled commercial banks. CRR was increased
as a part of monetary policy of the RBI to restrict the money supply in the
economy. In 1980-81, CRR was 6% ofDTL. This was increased steadily and
in 1991-92 the CRR was 25% ofDTL (see Chapter 7, Section III). How did
this affect the lt~nding business of the banks? The investments in SLR
securities were unremunerative since the interest rates on these securities
were much below the prevailing market rates. While these lower interest
rates on SLR securities reduced the direct interest costs for the government
on its borrowings, these carried a considerable cost for the banks and hence
their profits were reduced. In the case of CRR, major portion of it did not
carry any interest since the RBI had frozen the interest on CRR at 1990 level.
In 1991-92, if a bank had a deposit ofRs.100, due to SLR (38.5%) and CRR
(25% ), Rs.63 .5 got impounded. After this pre-emption, the available lendable
resources were Rs.36.5 only and on this too the restrictions of priority sector
lending were applicable.

a. ii. Priority Sector Lending:

While the effect of pre-emption of funds due to increase in SLR and

CRR was applicable to all commercial banks, the mandatory priority sector
lending particularly affected the public sector banks where the credit flow to
this sector was strictly monitored. After deducting the SLR and CRR,
prescribed percentage of the deposits (DTL) had to be advanced to
designated priority sectors at rates of interest prescribed by the government
(see Table 7.1 ). It is relevant to point out that the performance of public
sector banks was assessed in terms of disbursements or lending to the
priority sector (and not recoveries). Such specification of quantitative targets
and administered interest rates lower than the market rate, finally resulted in
considerable erosion of profitability of the public sector banks. While the
social objective of expanding the credit coverage of the banking system to

38
 ...

priority sector was a laudable one, the economic cost associated with such
mandatory lendings was neither allowed to be recovered by the banks nor
was subsidised by the Government. The result was the public sector banks
had to suffer losses. For example in 1980-81, with CRR of 6 per cent and
SLR of 34 per cent of demand and time liabilities, 40 per cent of bank
resources were pre-empted and 40 per cent of the remaining resources (24
per cent) had to be reserved for the priority sector. Thus 64 per cent of the
deposits were pre-empted by the government leaving only 36 per cent for
commercial lending purposes. In 1991-92 with SLR and CRR at 63.5 per
cent, 40 per cent of the remaining 36.5 per cent (14.6 per cent) had to be
reserved for priority sector. This meant only 22% of the deposits was
available for commercial lending purposes. The effect of such pre-emption
was the compulsion on the part of the banks to increase their interest rate for
their commercial advances. These higher interest rates resulted in
encouraging "disintermediation" from the banking sector, due to the best
borrowers opting out of the banking system and relying on non-bank sources.

b. Internal factors:

As we stated earlier, after the nationalisation of banks in 1969

and 1980, there was a tremendous expansion in the number of branches
established by the public sector banks (see Table 2.3). This quantitative
expansion could not be matched by the development and professional
training of the managerial personnel. The result was a steady deterioration in
the quality of assets in the loan portfolio of the banks. The quantum of non-
performing assets (NPA) increased steadily. A non-performing asset (NP A)
is defined as a credit facility in respect of which interest has remained unpaid
for a period from the date it has become "past-due". A credit facility is
treated as 'past due' when interest has not been paid for thirty days from the
due date. As on March, 1993, the total non-performing assets of public sector

39
banks was estimated at Rs.3 7,000 crore forming 28% of the total loan
portfolio. 25 In 1992-93 the profits of public sector banks eroded considerably
after making provisions for non-performing assets and they reported a deficit
of Rs.3,400 crore. Out of the 28 banks in the public sector only 15 could
declare net profit. The remaining reported loss. 26 There were four major
factors which contributed to the poor quality of loan portfolio in public
sector banks.
Firstly, there was excessive focus on quantitative performance criteria:
such as growth of total lending, sectoral deployment of credit and the
geographical reach of the banks. These were regarded as indicators of
dynamism and strength in banking. There was inadequate concern and
examination of credit quality and the capacity of borrowers to repay the loans
granted to them. In such a climate, poor lending decisions were taken
without adequate scrutiny, security and monitoring.
Secondly, influential borrowers brought external pressure to bear on
banks to accept or live with defaults and this was tolerated because
prudential norms were absent. In the case of smaller borrowers, the culture of
repayment suffered because of periodic loan waiver schemes thrust on the
banks by populist government decisions (see Chapter 7, Section I).
Thirdly, accounting and prudential norms did not keep pace with
developments elsewhere in the world, which were moving towards greater
transparency and disclosure in bank balance sheets. In India, the then
existing income recognition norms allowed banks to book as income, interest
due but not received. Lack of explicit provisioning norms allowed banks to
make insufficient provision for non-performing assets. Both these methods
permitted banks to defer corrective action on their sick accounts.

25
The way in which the assets are classified and provisions made is given in Appendix IX.
26
MoF (1993).

40
 Fourthly, enforcement of bank claims in courts became extremely
time consuming with cases occasionally pending for over ten years. This
naturally encouraged an obstructive attitude on the part of defaulting
borrowers. Such delays were further compounded by the fact that banks
found it difficult to invoke recourse to pledged security or collateral,
particularly land, since the State Governments were not willing to give
permission under the Urban Land Ceiling Act and other state laws.
Thus the external and internal factors discussed above made public
sector banks extremely vulnerable and their revival very much depended on
the efficiency of their professional management and skills.
ii. Efficiency:
Efficiency of a financial enterprise and profitability are interlinked.
We have discussed the external and internal factors which were responsible
for preemption of nearly 7 5 per cent of deposits and a weak loan portfolio
with as much as 20 to 25 per cent of it in the form of non-performing assets.
In these circumstances, the performance of banks, in terms of profitability, is
bound ·to depend mainly upon its management, innovation and
modernisation. However, the way in which the ownership functions of the
government were exercised contributed to inefficiency in public sector banks
as described below.
a. Exercise of ownership functions of Government:
After nationalisation, Government became the owner of nearly 87 per
cent of the deposits in the banking system. One of the objectives of
nationalisation was to develop professionalism in management. The relevant
point for our discussion here is how the ownership responsibility of the
Government was exercised.

The Banking Regulation Act provides the RBI with statutory powers
of supervision and control over all the commercial banks including the

41
public sector banks. However, in the case of public sector banks, the
government became the appointing authority of the Chairman and Managing
Directors, Executive Directors and the Directors of Board of Directors. The
role of RBI was to recommend suitable names for consideration and approval
of the government. The appointing authority was also the disciplinary
authority. In other words the powers to appoint and take disciplinary action
against the top management of the public sector banks were with the
government while the control and supervision of banking operations was
vested with the RBI. Thus, there was dual control by the Government and
the RBI over public sector banks. In practice the appointments made by
Government were based on considerations other than professional skills. An
analysis of non-performing assets of public sector banks revealed that
advances were given without following prudential norms and obtaining
sufficient security. These were referred to as "behest lendings". Banks used
to write off loans without fixing the accountability for bad lending, on the
basis of assurance by the management that accountability will be fixed later.
Such assurances were never followed up and the responsibility was never
fixed. Instead, the management invariably held that the banker was not
responsible and therefore no further action was needed. This ethos of non-
accountability was widely prevalent in public sector banks and was in tune
with the general culture of non-accountability in public sector undertakings
and the government. In addition, the government also encouraged "Loan
Melas" where loans were disbursed as a mass operation without proper
scrutiny of applications and securities. There were also periodic
announcement of "loan waiver schemes" which had its adverse effect on the
recovery culture of loans given to small borrowers.

Thus the politicisation of appointments of top management, culture of

non accountability and encouragement of behest lendings, loan melas and

42
loan waivers were the major factors which made the public sector banks as
centres of inefficiency (see Chapter 7, Section 1). Another major factor which
had a strong bearing on the efficiency of public sector banks was the
approach and attitude ofthe strongly trade-unionised bank employees.
b. Organised Trade Unionism:
In the banking sector in India both the officers and employees are
organised and their collective bargaining power is quite high. In the case of
public sector banks, in 22 banks out of 27 banks, (20 nationalised banks,
State Bank of India and its six subsidiaries) the non supervisory employees
(bank staff) belong to one union 27 • The officers upto the level of General
Managers are also members of the association. The management can keep
industrial peace only by following the "policy of appeasement" which is
generally supported by the government. This means that the management
very often concedes the demands and adopts a conciliatory approach. This is
referred to as the approach of "give and take" and in practice, the
management 'gives' (yields) and the workers 'take'. The management in
public sector banks do not have freedom in recruitment, transfer and
promotion. Only 25 per cent of the officers cadre can be filled up by direct
recruitment and the remaining 75 per cent is meant for promotion from the
clerical cadre. The wages of employees have no relevance to productivity or
performance. The wage settlement at the industry level is valid for five years.
For example the employees of the UCO bank which is a weak bank reporting
loss continuously for several years, get the same wages as that of the
employees of Canara Bank which is a strong bank always reporting profit.
There is no linkage between productivity and remuneration.
The unions generally indulge in restrictive trade umon practices

27
The All India Bank Employees Association (AlBEA) controls majority employees in 22 public sector
Banks.

43
interfering in the day to day functions of management. When the
management decided to computerise the banking operations, the move was
opposed by the unions. Till 1993, computerisation in public sector banks
could not be initiated and this was possible only after the management
conceded to the demand of the unions for pension and additional increment
for accepting computers. The delay in introducing modernisation of banking
operations adversely affected the functional efficiency of public sector
banks. In sum, the overall behaviour of the organised trade unions in public
28
sector banks was not conducive to efficiency and better customer service.
IV
Conclusion
In this chapter we have attempted an analytical description of the
Indian banking system in independent India situating the discussion in a long
term historical perspective.
Banking in India had existed in one form or other right from the period
of ancient India as revealed by the historical evidence. However, the system
started developing only during the colonial period when the British East
India Company started trading in India. During the colonial era, the system
was subservient to the interests of the British Government but this situation
changed considerably after the independence. The passage of Banking
Regulation Act, 1949, was the most significant landmark in the evolution of
banking development in India. When the government adopted Five Year
Plans, the social and economic objectives of the Government considerably
influenced the role of the RBI. RBI took up a pro-active role and started
functioning more as a provider of resources to the agricultural sector, small
scale industries etc.

28
The bank employees used to go on strike for one or two days bringing the entire banking system to a
complete halt. The Government and the RBI remained as helpless spectators of the inconveniences caused to
customer.

44
 The social and economic policies accepted by the government
necessitated social control on banks and this paved the way for the political
decision to nationalise the major commercial banks in 1969 and 1980. Major
portion of the banking system (87 per cent of deposits and 93 per cent of
branches) were brought under the government control. There was significant
achievement in a few areas. At the same time there was also a few adverse
effects on the credibility of the banking system. The spatial coverage,
accessibility and reorientation of credit to priority sectors were the
achievements. But these achievements had an economic cost. The
profitability and efficiency of public sector banks were adversely affected. It
was obvious that public sector banks were lacking in professionalism,
modernisation, customer service and profitability. The conditions in the
banking system in India in the later half of 1980s and early 1990s can be
described as "over-regulated and under-governed" and this had its
consequential and collateral influence on the entire Indian Financial System.

45