economic reforms

Economic Reforms of the Banking Sector In India

Indian banking sector has undergone major changes and reforms during economic reforms. Though it was a part of overall economic reforms, it has changed the very functioning of Indian banks. This reform have not only influenced the productivity and efficiency of many of the Indian Banks, but has left everlasting footprints on the working of the banking sector in India.

Let us get acquainted with some of the important reforms in the banking sector in India.

1. Reduced CRR and SLR : The Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are gradually reduced during the economic reforms period in India. By Law in India the CRR remains between 3-15% of the Net Demand and Time Liabilities. It is reduced from the earlier high level of 15% plus incremental CRR of 10% to current 4% level. Similarly, the SLR Is also reduced from early 38.5% to current minimum of 25% level. This has left more loanable funds with commercial banks, solving the liquidity problem.
2. Deregulation of Interest Rate : During the economics reforms period, interest rates of commercial banks were deregulated. Banks now enjoy freedom of fixing the lower and upper limit of interest on deposits. Interest rate slabs are reduced from Rs.20 Lakhs to just Rs. 2 Lakhs. Interest rates on the bank loans above Rs.2 lakhs are full decontrolled. These measures have resulted in more freedom to commercial banks in interest rate regime.
3. Fixing prudential Norms : In order to induce professionalism in its operations, the RBI fixed prudential norms for commercial banks. It includes recognition of income sources. Classification of assets, provisions for bad debts, maintaining international standards in accounting practices, etc. It helped banks in reducing and restructuring Non-performing assets (NPAs).
4. Introduction of CRAR : Capital to Risk Weighted Asset Ratio (CRAR) was introduced in 1992. It resulted in an improvement in the capital position of commercial banks, all most all the banks in India has reached the Capital Adequacy Ratio (CAR) above the statutory level of 9%.
5. Operational Autonomy : During the reforms period commercial banks enjoyed the operational freedom. If a bank satisfies the CAR then it gets freedom in opening new branches, upgrading the extension counters, closing down existing branches and they get liberal lending norms.
6. Banking Diversification : The Indian banking sector was well diversified, during the economic reforms period. Many of the banks have stared new services and new products. Some of them have established subsidiaries in merchant banking, mutual funds, insurance, venture capital, etc which has led to diversified sources of income of them.
7. New Generation Banks : During the reforms period many new generation banks have successfully emerged on the financial horizon. Banks such as ICICI Bank, HDFC Bank, UTI Bank have given a big challenge to the public sector banks leading to a greater degree of competition.
8. Improved Profitability and Efficiency : During the reform period, the productivity and efficiency of many commercial banks has improved. It has happened due to the reduced Non-performing loans, increased use of technology, more computerization and some other relevant measures adopted by the government.

These are some of the import reforms regarding the banking sector in India.

With these reforms, Indian banks especially the public sector banks have proved that they are no longer inefficient compared with their foreign counterparts as far as productivity is concerned.

Problems Identified By The Narasimham Committee

1. Directed Investment Programme : The committee objected to the system of maintaining high liquid assets by commercial banks in the form of cash, gold and unencumbered government securities. It is also known as the statutory liquidity Ratio (SLR). In those days, in India, the SLR was as high as 38.5 percent. According to the M. Narasimham's Committee it was one of the reasons for the poor profitability of banks. Similarly, the Cash Reserve Ratio- (CRR) was as high as 15 percent. Taken together, banks needed to maintain 53.5 percent of their resources idle with the RBI.
2. Directed Credit Programme : Since nationalization the government has encouraged the lending to agriculture and small-scale industries at a confessional rate of interest. It is known as the directed credit programme. The committee opined that these sectors have matured and thus do not need such financial support. This directed credit programme was successful from the government's point of view but it affected commercial banks in a bad manner. Basically it deteriorated the quality of loan, resulted in a shift from the security oriented loan to purpose oriented. Banks were given a huge target of priority sector lending, etc. ultimately leading to profit erosion of banks.
3. Interest Rate Structure : The committee found that the interest rate structure and rate of interest in India are highly regulated and controlled by the government. They also found that government used bank funds at a cheap rate under the SLR. At the same time the government advocated the philosophy of subsidized lending to certain sectors. The committee felt that there was no need for interest subsidy. It made banks handicapped in terms of building main strength and expanding credit supply.
4. Additional Suggestions : Committee also suggested that the determination of interest rate should be on grounds of market forces. It further suggested minimizing the slabs of interest.

Along with these major problem areas M. Narasimham's Committee also found various inconsistencies regarding the banking system in India. In order to remove them and make it more vibrant and efficient, it has given the following recommendations.

Narasimham Committee Report I - 1991

The Narsimham Committee was set up in order to study the problems of the Indian financial system and to suggest some recommendations for improvement in the efficiency and productivity of the financial institution.

The committee has given the following major recommendations:-

1. Reduction in the SLR and CRR : The committee recommended the reduction of the higher proportion of the Statutory Liquidity Ratio 'SLR' and the Cash Reserve Ratio 'CRR'. Both of these ratios were very high at that time. The SLR then was 38.5% and CRR was 15%. This high amount of SLR and CRR meant locking the bank resources for government uses. It was hindrance in the productivity of the bank thus the committee recommended their gradual reduction. SLR was recommended to reduce from 38.5% to 25% and CRR from 15% to 3 to 5%.
2. Phasing out Directed Credit Programme : In India, since nationalization, directed credit programmes were adopted by the government. The committee recommended phasing out of this programme. This programme compelled banks to earmark then financial resources for the needy and poor sectors at confessional rates of interest. It was reducing the profitability of banks and thus the committee recommended the stopping of this programme.
3. Interest Rate Determination : The committee felt that the interest rates in India are regulated and controlled by the authorities. The determination of the interest rate should be on the grounds of market forces such as the demand for and the supply of fund. Hence the committee recommended eliminating government controls on interest rate and phasing out the concessional interest rates for the priority sector.
4. Structural Reorganizations of the Banking sector : The committee recommended that the actual numbers of public sector banks need to be reduced. Three to four big banks including SBI should be developed as international banks. Eight to Ten Banks having nationwide presence should concentrate on the national and universal banking services. Local banks should concentrate on region specific banking. Regarding the RRBs (Regional Rural Banks), it recommended that they should focus on agriculture and rural financing. They recommended that the government should assure that henceforth there won't be any nationalization and private and foreign banks should be allowed liberal entry in India.
5. Establishment of the ARF Tribunal : The proportion of bad debts and Non-performing asset (NPA) of the public sector Banks and Development Financial Institute was very alarming in those days. The committee recommended the establishment of an Asset Reconstruction Fund (ARF). This fund will take over the proportion of the bad and doubtful debts from the banks and financial institutes. It would help banks to get rid of bad debts.
6. Removal of Dual control : Those days banks were under the dual control of the Reserve Bank of India (RBI) and the Banking Division of the Ministry of Finance (Government of India). The committee recommended the stepping of this system. It considered and recommended that the RBI should be the only main agency to regulate banking in India.
7. Banking Autonomy : The committee recommended that the public sector banks should be free and autonomous. In order to pursue competitiveness and efficiency, banks must enjoy autonomy so that they can reform the work culture and banking technology upgradation will thus be easy.

Some of these recommendations were later accepted by the Government of India and became banking reforms.

Narasimham Committee Report II - 1998

In 1998 the government appointed yet another committee under the chairmanship of Mr. Narsimham. It is better known as the Banking Sector Committee. It was told to review the banking reform progress and design a programme for further strengthening the financial system of India. The committee focused on various areas such as capital adequacy, bank mergers, bank legislation, etc.

It submitted its report to the Government in April 1998 with the following recommendations.

1. Strengthening Banks in India : The committee considered the stronger banking system in the context of the Current Account Convertibility 'CAC'. It thought that Indian banks must be capable of handling problems regarding domestic liquidity and exchange rate management in the light of CAC. Thus, it recommended the merger of strong banks which will have 'multiplier effect' on the industry.
2. Narrow Banking : Those days many public sector banks were facing a problem of the Non-performing assets (NPAs). Some of them had NPAs were as high as 20 percent of their assets. Thus for successful rehabilitation of these banks it recommended 'Narrow Banking Concept' where weak banks will be allowed to place their funds only in short term and risk free assets.
3. Capital Adequacy Ratio : In order to improve the inherent strength of the Indian banking system the committee recommended that the Government should raise the prescribed capital adequacy norms. This will further improve their absorption capacity also. Currently the capital adequacy ration for Indian banks is at 9 percent.
4. Bank ownership : As it had earlier mentioned the freedom for banks in its working and bank autonomy, it felt that the government control over the banks in the form of management and ownership and bank autonomy does not go hand in hand and thus it recommended a review of functions of boards and enabled them to adopt professional corporate strategy.
5. Review of banking laws : The committee considered that there was an urgent need for reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking Regulation Act, State Bank of India Act, Bank Nationalisation Act, etc. This upgradation will bring them in line with the present needs of the banking sector in India.

Apart from these major recommendations, the committee has also recommended faster computerization, technology upgradation, training of staff, depoliticizing of banks, professionalism in banking, reviewing bank recruitment, etc.

Evaluation of Narsimham Committee Reports

The Committee was first set up in 1991 under the chairmanship of Mr. M. Narasimham who was 13th governor of RBI. Only a few of its recommendations became banking reforms of India and others were not at all considered. Because of this a second committee was again set up in 1998.

As far as recommendations regarding bank restructuring, management freedom, strengthening the regulation are concerned, the RBI has to play a major role. If the major recommendations of this committee are accepted, it will prove to be fruitful in making Indian banks more profitable and efficient.

Evaluation of Foreign Investment Proposal

Before evaluation, let's revise the basics and meaning of Foreign Investment.

1. Investment is a thing, which is worth buying because it is profitable or useful in the near future.
2. Proposal is an offer and / or invitation to do some business or trade.
3. Statutory compliance are well-specified and documented obligations (duties and responsibilities) that are mandatory (compulsory by law) to be satisfied either by an individual or by an organisation that too in accordance (as per guidelines) with prevailing statutes (laws) and / or regulations of a governed jurisdiction (area, state, country, etc.).
4. Host country is a country in whose economy foreign funds are invested.
5. Foreign investment is that investment, which is made in any country other than the home or native country. In other words, investments which are made outside the jurisdiction of the home country are called foreign investments.

The currency used for foreign investment is the currency of the host country.

Before investing abroad, all the statutory compliance of the host country must be satisfied as they are mandatory by its inland laws.

The main ISSUES that must be considered and pre-evaluated before making any foreign investment proposal to a host country is clarified and briefly explained as follows:-

1. Economic Stability

The economic stability of the project is very important as it is directly related to the financial support of the project.

The economic stability of the host country is very essential as it has a direct relationship with the foreign exchange earnings represented in the form of foreign inward and outward remittance (transfer or payment of money).

The economic stability of a host country can be further classified w.r.t:-

1. Exchange Rate : The exchange rate of the host country is a very crucial factor for evaluating the foreign investment proposal. A highly fluctuating exchange rate of the host country is generally considered riskier because it may result in a huge financial loss to the project.
2. Inflation : The host country with a higher inflation rate shall not be considered for foreign investment proposal. Inflation reduces the purchasing power of the money. Sometimes, inflation may also cause erosion of funds invested. Furthermore, inflation not only affects the capital invested but will also result in a reduction in the profit margin, which overall effects the growth and expansion of the foreign company.

2. Political Stability

When an organisation is doing business in overseas countries, then the political stability in those host countries is of apex importance.

Any uncertain twist to the political scenario or environment of a host country may bring sudden unexpected changes in the administrative strategies and setup of that country. Such changes may or may not be favourable to satisfy the motives of foreign investment. Hence, a pre-systematic evaluation and / or research in the context of host country's political history and its current political stability is equally important.

Normally, following are some common incidents, which have been reported as a result or due to impact of political instability in the host country.

1. Issue of Circulars to discontinue the project that may lead to the seizure of property without paying an appropriate compensation.
2. The other way of interferences in the business operations can be levied by exchange control regulations. This may block the flow of project's funds.
3. Restrictions on employment of foreign managerial or technical personnel. This can hinder the quality and performance of the project.
4. Restrictions on import or export of goods and services.
5. Regulations requiring majority ownership vetting with the host country.

3. Taxation of Income

The host country levies taxes on income earned in their country by foreign organisations and / or companies.

The rates of taxes on income differ from one host country to another. In a majority of cases, the taxes levied on a domestic (indigenous or native) company of the host country is generally less than the taxes levied on a foreign company operating in that host country.

Foreign companies or organisations while deciding to expand themselves over new geographical areas or frontiers must consider and study some of the common policies adopted by various host countries.

Here, the important points to be considered are as follows:-

1. Understand the definition of TAXABLE INCOME as it differs from one host country to another.
2. Many host countries give priority to indirect taxes such as excise duty, custom duty, service tax, VAT or value-added tax, etc., over the income tax (direct tax). The increase in an indirect tax will result in an increase in cost of production.
3. Some host countries allow tax exemptions for foreign investments made in the certain categories of the projects.
4. Reference to Double Taxation Avoidance Agreement (DTAA) is a must. DTAA are taxation treaties entered into with different host countries.
5. Tax haven countries levy low taxes or sometimes zero corporate tax to attract foreign investments in mainland and boost their economy.

Conclusion on Foreign Investment

Foreign investments give better growth, profit and liquidity for the funds invested. Therefore, these investments need to be evaluated carefully. If the foreign investment proposal is evaluated properly in accordance with the parameters (issues) discussed above, then it will not only enhance the profitability of the project but will also eliminate the unexpected financial risk associated with the project.

Furthermore, these are just important minimal (here, common) parameters required to be considered in any type of foreign investment proposal.

What is Investment ? Meaning

In simple terms, Investment refers to purchase of financial assets. While Investment Goods are those goods, which are used for further production.

Investment implies the production of new capital goods, plants and equipments. John Keynes refers investment as real investment and not financial investment.

Different Types of Investment

Different types or kinds of investment are discussed in the following points.

1. Autonomous Investment

Investment which does not change with the changes in income level, is called as Autonomous or Government Investment.

Autonomous Investment remains constant irrespective of income level. Which means even if the income is low, the autonomous, Investment remains the same. It refers to the investment made on houses, roads, public buildings and other parts of Infrastructure. The Government normally makes such a type of investment.

2. Induced Investment

Investment which changes with the changes in the income level, is called as Induced Investment.

Induced Investment is positively related to the income level. That is, at high levels of income entrepreneurs are induced to invest more and vice-versa. At a high level of income, Consumption expenditure increases this leads to an increase in investment of capital goods, in order to produce more consumer goods.

3. Financial Investment

Investment made in buying financial instruments such as new shares, bonds, securities, etc. is considered as a Financial Investment.

However, the money used for purchasing existing financial instruments such as old bonds, old shares, etc., cannot be considered as financial investment. It is a mere transfer of a financial asset from one individual to another. In financial investment, money invested for buying of new shares and bonds as well as debentures have a positive impact on employment level, production and economic growth.

4. Real Investment

Investment made in new plant and equipment, construction of public utilities like schools, roads and railways, etc., is considered as Real Investment.

Real investment in new machine tools, plant and equipments purchased, factory buildings, etc. increases employment, production and economic growth of the nation. Thus real investment has a direct impact on employment generation, economic growth, etc.

5. Planned Investment

Investment made with a plan in several sectors of the economy with specific objectives is called as Planned or Intended Investment.

Planned Investment can also be called as Intended Investment because an investor while making investment make a concrete plan of his investment.

6. Unplanned Investment

Investment done without any planning is called as an Unplanned or Unintended Investment.

In unplanned type of investment, investors make investment randomly without making any concrete plans. Hence it can also be called as Unintended Investment. Under this type of investment, the investor may not consider the specific objectives while making an investment decision.

7. Gross Investment

Gross Investment means the total amount of money spent for creation of new capital assets like Plant and Machinery, Factory Building, etc.

It is the total expenditure made on new capital assets in a period.

8. Net Investment

Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of time, usually a year.

It must be noted that a part of the investment is meant for depreciation of the capital asset or for replacing a worn-out capital asset. Hence it must be deducted to arrive at net investment.