BANKING IN INDIA: A study on the current condition of the Indian banking sector

Arundati Menon
Nov 5, 2023
14 min read

INTRODUCTION

Indian Banking Regulations Act, 1949, defines the activity of a bank as “ accepting for the purpose of lending or investing of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order, or otherwise.”

Certain services that are characteristic of banks to provide, and only if it provides all these services will it be called a bank. The first service is to collect deposits from the public. These deposits are then withdrawable by the depositor. The second service is to give out loans. This it does using the money it collects from its depositors. Third service is that of creation and destruction of money, which it does through its lending activities. This implies that while financial institutions like Non-Banking Financial Companies (NBFCs) lend it to others, it does not create money and cannot issue self drawn cheques. Hence, it is not a bank.

The existence of a variant of what we call a banking system today has existed for a long period of time, with mentions of some kind of usury in ancient Indian texts like the Vedas, Jatakas, and the Sutras. There was evidence and texts found showing banking systems and practices prevailing in large empires like the Mauryan and later the Mughal empire.

Banking took a more modern structured existence during Colonial rule in India. Banks like Union bank of Calcutta and Allahabad Bank were some of the banks that were established in the early years of the colonial era in India. In fact, Punjab National Bank (PNB), one of the largest banks in our country even today, was set up in 1894, in Lahore. Around the turn of the 20th century, India’s economy was going through a period of relative stability, and it is in this time that a number of smaller banks were established, most of whom served a particular ethnic or religious group, which is also a reflection of the division the British had brought to Indian society. After this, another wave of banks came about, this time because of the swadeshi movement. Few notable banks that were set up in this period are Catholic Syrian Bank, Bank of India, Bank of Baroda, and Canara Bank.

The Reserve Bank of India, now the central bank, and regulatory authority of the Indian banking system and monetary policy, was established in 1935 in accordance with the Reserve Bank Of India Act, 1934. Although first privately owned, it was nationalised in 1949, and is since owned by the government. The RBI is the apex institution in the banking and financial structure of the country. It controls the issue and supply of Indian currency, and it also controls the country’s monetary policy. It essentially prints money, and lends to other banks in the country. Using tools like bank rate changes and increasing and decreasing cash flow, it helps maintain stability in the economy.

In 1969, under the Prime Minister Indira Gandhi, the government issued the Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, 1969, with effect from 19th July 1969, nationalising the 14 largest commercial banks. The ordinance was later passed in parliament. A second round of nationalisation took place in 1980, when 6 more commercial banks were nationalised. The nationalisation of banks was undertaken by the government to increase control on credit delivery, and in order to ensure that credit was available to all industries, particularly to the agricultural sector which was in dire need of such support.

The next phase in banking was the liberalisation of the banking sector, with the onset of licenses being issued to a number of privately owned banks. These new banks were called the tech-savvy banks. This caused a much required ripple of competition in the banking sector in order to revitalise it. This liberalisation was also extended to introduce foreign banks, including banks like Citibanks and Standard Chartered Bank.

In the current banking system in India, there are seven types of banks. The first is the Central bank, RBI, and as mentioned earlier, it regulates the banking and financial structure of the country. Second come the Commercial Banks, like SBI and HDFC. They are the banks that collect deposits and supply credit to private individuals and businesses. Their activities and operation are aimed at creating profit. Third are Regional Rural Banks, like the Allahabad UP Gramin Bank, also known as the small man’s banks, that have been set up to meet the credit needs of the rural people. Fourth come the Exchange Banks, which was established with an aim of making foreign trade easier. It mainly purchases, sells, discounts, and accepts various bills that arise out of foreign trade, and provides credit to people engaged in the trade. Fifth are the Exim Banks, or ‘export-import’ banks which have been established to provide long term financial needs of international trading firms.

There are also the Cooperative Banks, like the Primary Agricultural Credit Society and Punjab Maharashtra Cooperative Bank, that were essentially established to make credit more readily available and accessible to farmers. As the name suggests, these banks run on a cooperative basis. Another such category of banks are the Land Development banks, that have been established to provide long term credit to farmers for various purposes, like buying machinery, cattle, etc. Finally, for other industrial activities, there are the Development Banks. They provide long term loans for private sector industries, and provide other development services, like provision of technical advice and market information. An example of such a bank is the Industrial Credit and Investment Corporation of India (ICICI).

Like most other industries, banking has also seen an increase in use of technology. The first of the technological advancements in the sector was the introduction of the ATM or the Automated Teller Machine, and with it the introduction of plastic money, otherwise known as credit and debit cards. An ATM machine is an electronic telecommunication device that enables customers of financial institutions to carry out financial transactions like making deposits, withdrawals, fund transfers, and account information inquiries without direct contact with bank officials. This device was seen to have revolutionised banking across the world as it has simplified and quickened financial transactions. It was first introduced in India by HSBC in their bank in Mumbai, in the year 1987. Since then, India has come a long way and has taken to the use of ATM. However, it is still far behind in terms of the reach of these machines. According to the International Monetary Fund’s data, India has the fewest ATMs per 1,00,00 people among the BRICS nations.

We have now reached the age of Online banking. Online banking or net banking allows the customers of a financial institution to perform financial transactions online. This form of banking is slowly gaining increased traction in India, although its use currently is primarily taking place in urban areas. One of the objectives set by the current govt is to make India a cashless society. In an attempt to take a step toward a cashless economy, The government in 2016 undertook Demonetisation, which was partly aimed at reducing use of cash in the economy and switching to digitised transactions. However, this aim was not achieved. 3 years after demonetisation, the RBI confirmed that use of cash had increased by 17%. Also, the ratio of currency in circulation to GDP has risen from 8.69% in march 2017 to 11.23% in march 2019. While digital transactions saw some growth as well, the attraction to cash has clearly seen an increase. There is a two pronged reason as to why such a measure to reach a cashless economy failed. One is India's sizeable informal sector, whose wages are paid in cash, and who receive and pay loans in cash. Second is that the high operational costs of ATMs has slowed down the pace at which new ones are established, which while it does create a space for the use of online banking methods, has caused the hoarding of cash in large pockets. This might be because of the popular belief, supported anecdotally and circumstantially, that India and other Southeast Asian countries prefer transacting in cash. This can be also because of the fact that although there is ample opportunity to adopt online banking, there is simply barely enough infrastructure to support it. Another aspect to note is that there has always been a apprehension to the capability of the internet in the Indian people, of the older generation especially, so for them it will be unthinkable to trust a computer to handle their banking transactions. That is why while we may be slowly moving towards online banking, it is primarily used by the younger generation, and the required infrastructure lies mainly in urban areas.

The UPI or Unified Payments Interface is a real-time payment system which enables inter-bank transactions. It has been developed by the National Payments Corporation of India (NPCI) and its function is regulated by the RBI. This is a part of the current government's initiative to facilitate the use of online banking. UPI users can carry out their transactions through their mobile phone. The use of UPI has definitely seen some level of acceptance. real-time payment system which enables inter-bank transactions. It has been developed by the National Payments Corporation of India (NPCI) and its function is regulated by the RBI. This is a part of the current government's initiative to facilitate the use of online banking. UPI users can carry out their transactions through their mobile phone.

The Indian banking system is an example of the capability in our country to serve the diverse needs of so many million, living in the different geographies and under different socio-economic conditions. That is to say, the Indian banking system is serving people in every nook and corner of the country, and this is not a small feat. According to IMF data for 2015, India had the highest number of bank branches in the world, with over 1.2 lakh branches. According to the RBI’s data in 2016, the distribution of these banks was - 38.8% in urban, 34.2% rural and 27% semi-urban. This has a larger implication on our economy. It provides credit to the lowest common denominator, and the richest people in the country, and both sections of the economy drive the economy forward using the credit they receive from this system. The Indian Banking System is also the largest source of credit in the country. Most economic activity that takes place in the country is connected to the numerous banks in the country. Banks have also tried to increase their efficiency through mobile banking and ATM services. All these factors make the banking system in our country an integral part of our economy, and a force that is instrumental in the furtherance of our growth as a country.

However, over the last few years, there have been many instances and events that indicate that there are a few issues with our banking system. The most recent event was the near-complete collapse of one of India’s largest private-sector banks, Yes Bank.

CASE STUDY: YES BANK CRISIS

The near failure of Yes Bank was an important event in early 2020. It was another indicator of the deteriorating state of the Banking sector in India. The reason why is due to the timeline, as well as the effect of this spectacle.

PICTURE CREDIT: ECONOMIC TIMES, MARCH 08, 2020

The signs began in 2018, when on September 19th, the then CEO, Rana Kapoor, was not given an extension of his term by the RBI, and stepped down from his position. Then in November of 2018, the Moody’s, the rating agency, changed its outlook on the bank from ‘stable’ to ‘negative’, citing issues of corporate governance within the bank. Cut to 26th April, 2019, when Yes Bank suffered its first quarterly loss, causing RBI to appoint ex-RBI Deputy Governor R Gandhi as an additional director to the Yes Bank board, on 14th May. Two months later, Yes Bank reported 91% drop in its profit in the first quarter. Between July of 2019, and February of 2020, Yes Bank witnessed an eventful few months, with the management scurrying about trying to get large investors to be excited enough to infuse it with much-needed cash. The deteriorating bad loan ratio was of no help in their efforts, when the ration went from 5% in July of 2019, to 7.39% in November of the same year. The efforts finally culminated in the shocking event when the RBI placed the bank under a moratorium for three months, and took over its board for 30 days.

Yes Bank was a large bank, so the effect of such an event was unsurprising. Many depositors suffered since they were unable to withdraw large amounts of cash they may have needed on an emergency basis. However, such events lay bare some of the shortcomings of the banking sector, and what this event lay bare are important shortcomings that need to be urgently addressed. The failure of Yes Bank as well as many others like it in the recent past can be attributed to a few causes, which can be categorised under systemic and contextual issues.

There are two systemic issues with the Indian banking system.

First, and at the centre of most of the bank crises, is the inept corporate governance that takes place in these banks. There are incorrect decisions taken in terms of asset quality, and their inability to absorb the credit blows that they inevitably head towards does not seem to bother them. For example, when the rating agency Macquarie went into the asset quality of Yes Bank’s assets, it rated 25% of the assets as ‘BB’ or ‘ junk’ rating, and 10-15% of the assets as ‘BBB’, which is the lowest investment grade. Their net worth, also, was nearly zero. Net worth is the calculation of the total value of a firm’s assets minus the total value of their liabilities. Moreover, Yes Bank’s NPA management, or rather the lack of it, has been on RBI’s radar since the Annual Financial Inspection (AFI) of the bank’s books as of March 31, 2017.

That brings us to an important factor- What was the RBI doing?

The RBI’s almost lackadaisical approach to the mounting NPAs of banks like Yes Bank, and the unwillingness to do anything in spite of knowing about the impending doom looming over these banks has been condemned by many, considering that their inaction has caused the lives of many to come to a halt. As the apex authority in the banking sector in the country the RBI is expected to hold the wrong accountable. Even in the context of what happened with Yes Bank, the RBI started to take action when the deposits simply were not able to sustain the wrongdoings of the upper management of the bank,, and that action was to send in one of its deputy governors, and although Rana Kapoor was later removed, no other significant change took place in the bank’s functioning that could solve the issue. This, when the RBI should have done a forensic analysis of the bank’s books. That is the problem. Where disruptive measures were the need of the hour, the RBI chose to keep an ailing system going. Not only had the RBI not responded in time, but the entire system’s response to such crises was ineffective. Bad corporate governance is ultimately, through banks like SBI, being bailed out by taxpayers, which is insulating private banking firms from being held responsible for their actions. This should not be the protocol that is set, because this will be a never ending process of taxpayers bailing out bank after bank.

The second factor that has contributed to the abysmal situation of the banking sector is the fraudulent reporting of Non-Performing Assets, or NPAs. Banks have mounting NPAs, which they try to manage in multiple ways, one of which is by lending to NBFCs. The other way to manage their NPAs is to under-report it. Yes Bank had serious reporting issues: the bank’s NPAs rose by 350% in the 9 months that Rana Kapoor was removed from his position in the company. It is then safe to say that this is definitely a systemic problem that needs to be resolved in terms of putting in place stringent rules regarding underreporting of NPAs and wilful defaulting.

The recent near-failure of Yes Bank, while being characterised with these systemic issues, had other contextual problems which led to such a situation. The problems can be rooted back to the stagflationary situation prevalent during the time. Stagflation is defined as a persistent rise in inflation combined with high unemployment and slowing economic growth. We are witnessing historically high unemployment rates, and reached the highest it’s been in 45 years in FY 2018 with 6.1% . We have also recorded really low nominal GDP growth rates, with the lowest growth seen in the 2nd quarter in FY 2020 of 4.5%. Our economy is also seeing inflation. The retail inflation, which is measured by the Consumer Price Index (CPI) climbed to a 68-month high after it rose 7.59 per cent in the month of January 2020 in the Ministry of Statistics and Programme Implementation (MoSPI) new data.Also, the rupee has weakened, currently at the highest it's been since 2003 at 75.62 rupees for every dollar, which clearly supports the fact that our economy is facing high inflation. Weakening currency is also seen as an indicator of an increase in budgetary deficit, balance of trade and payment deficits, and increasing debt burden. Plus, GST collections have been less than satisfactory. The collection has risen by 8.93% from the collections in 2018, but has contracted by 0.3% from November 2019 to December 2019. While low GST collections can be attributed to the less-than satisfactory roll-out of one of the world’s largest tax reform drives, it is also an indicator of the fact that industries are selling and producing less.

All of these factors prove that India is going through a period of stagflation, during which banks, like all other sectors of the economy, are bound to get affected. The economic conditions have, hence, impacted banking in India in the following ways.

First is the fact that depositors will have reduced amounts of money they are able to deposit because of the fact that real incomes are bound to reduce. This has led to a shortage of capital. Also, the lack of depositor confidence is seen in the snowballing effect in share prices of other banks. For example, after the Yes Bank crisis was revealed, the shares of IndusInd Bank also dropped by around 7%. Not only that, the earlier mentioned case of the dipping share prices of banks like Bank of Baroda and Punjab National Bank also shows the deteriorating confidence of people in our banks.

Second is the corporate aspect of it. Most businesses in a slowdown are mostly unwilling to take risks. This unwillingness is also extended to the banking sector, which is due to the fact that in recessionary times there is invariably a credit crunch. In such cases, firms who require the money urgently go to what are known as Non-Banking Financial Companies (NBFCs), or Shadow Banks. These shadow banks have taken loans from commercial banks. However, when a firm defaults on payment to a shadow bank, the Shadow Bank is unable to repay its dues to the commercial bank. This is the case with Yes Bank as well. Yes Bank had lent to shadow banks like IL&FS which had collapsed. Not only has Yes Bank lent to NBFCs, but has also been invested in by NBFCs, like Indiabulls. The bank now owes Indiabulls $89.5 million, which saw a 13% dip in its shares post the Yes Bank debacle.

Bank crises, like in the cases of PNB or Yes Bank, have had an effect on other bank and non bank sources of credit. This leads us to the next reason for bank failures- credit crunch. Data from IMF study shows that India has capital inadequacy, which translates to our banks not being able to absorb losses using its own capital. Yes bank, which had been deep in bad debt for months, had struggled to collect the adequate capital to stay above regulatory requirements. The lack of credit in the system can also be attributed to the current economic slowdown we are facing.

CONCLUSION

There are some very serious systemic issues that are at the core of the problems faced by the system, and these are born out of lack of accountability and effective corporate governance. No amount of investment in the furtherance of banking infrastructure will reap benefits if this aspect is not addressed. This means that there must be intervention by stricter and more efficient supervision by the RBI, as well as the promise of accountability from those who manage these banks. It is important that the people of India do not lose faith in their banks, as it can be catastrophic for the economy.

However, the picture is not all bleak. The banking system that services 1.3 billion people is no small accomplishment, and the infrastructural capability of the already existing system is tremendous. With better policy decisions and credit management by banks, as well as increased investment in boldening the banking infrastructure, the possibilities are endless.

There is an untapped reserve of exciting possibilities in the ‘Fintech’ or financial technology industry. It has the capability to revolutionise the conventional understanding and methodology of banking, and the effect this will have on rural economy if it were to percolate is really tremendous. The impact of an effective banking system on MSMEs and agriculture can be beneficial for our ebbing economic growth.

BIBLIOGRAPHY

BANKING IN INDIA: A study on the current condition of the Indian banking sector

Recent Posts

Comments