History of Banking System

History of Banking System

This article deals with ‘History of Banking System.’ This is part of our series on ‘Economics’ which is important pillar of GS-3 syllabus . For more articles , you can click here .

Financial Intermediaries

  • Institutions that channel funds between surplus and deficit agents are called financial intermediaries.
Financial Intermediaries
  • These include Banks, Insurance companies , pension funds, mutual funds etc. .
Financial Intermediaries

Banking System

Type of Banks

Type of Banks

Scheduled Commercial Banks

When RBI is satisfied that a bank has (Paid Up Capital + Reserves =) Minimum 5 Lakhs  & it is not conducting business in a manner harmful to its depositors, then such bank is listed in the 2nd Schedule of RBI Act, and it is known as a Scheduled Bank.

Scheduled Banks Non-Scheduled Banks
Are bound to maintain CRR with RBI and maintain SLR as mandated by the RBI . Not required to maintain SLR and CRR .
As a benefit , they are eligible to borrow  funds via Liquidity Adjustment Facility (Repo and Bank Rates) It depends on RBI’s discretion to allow them to borrow via this mechanism .
Can be subdivided into two parts 1) Scheduled Commercial Banks e.g. SBI, Axis , PNB, ICICI Bank etc. 2) Schedule Cooperative Banks like Haryana Rajya Sahakari Bank  etc. Hundreds of cooperative banks are non-Schedule Banks.

Topic : History of Banking System in India

History of Banking System in India before Independence

  • Present Banking System was introduced in the western world and was later introduced in India during the British Raj.
  • History of  Banking system in India goes to 19th century (then known as Agency Houses ).
  • During British Times, there were two type of Banks
British Banks East India Company established Banks in 3 Presidencies
1. Bengal : 1806
2. Bombay : 1840
3. Madras : 1843
1921 : These three merged to form  Imperial Bank of India . Later, it was nationalised and became SBI . It targeted British  Army officers , Civil Servants & Judges.  
Swadeshi Banks These were setup by the Indians , parallel to the British Banks.
First Indian Bank was Allahabad Bank(1856).
Other – Bank of Baroda (backed by Gaekwads of Baroda) , Punjab National Bank (role  was played by Lala Lajpat Rai in it’s formation) , Punjab & Sind Bank (by Bhai Vir Singh) .
These banks targeted big merchants particularly raw material exporters  

But neither helped in financial inclusion .

Birth of RBI

  • By the early 1930s,  there were large number of banks operating in India . They were registered under the Company Law and regulations on this sector were not present. But problem arose during The Great Depression(1929) which started in USA . Due to this, demand of Indian exports in the foreign market  decreased and Indian merchants started to default .  Consequently , large number of Indian banks collapsed.
  • To deal with such situation and bring banking sector under regulation,  British Indian government setup Reserve Bank of India in 1934 under the recommendations of Hilton Young Royal Commission.

History after Independence

Two important steps were taken by Government of India

  • Nationalisation of RBI
  • Banking Regulation Act,1949 : It empowered RBI to control & regulate Banking sector in India .

Nationalisation of Banks

Nationalisation of banks :  SBI Case (1st Round )

1955 Imperial Bank was nationalised & renamed SBI . (At the same time, Nationalisation of Insurance Companies also done)
1960 8 Banks were nationalised & made subsidiaries to State Bank of India
1963 Two subsidiary Banks were merged  (State Bank of Bikaner & State Bank of Jaipur) leading to the formation of  State Bank of Bikaner & Jaipur
2008 State Bank of Saurashtra merged  with Parent Bank .
2010 State Bank of Indore merged with Parent Bank .
Till recent times There were  5 subsidiaries of SBI
1. State Bank of Bikaner & Jaipur
2. State Bank of Hyderabad
3. State Bank of Mysore
4. State Bank of Patiala
5. State Bank of Travancore  
2017 All subsidiaries merged into Parent Bank
History of Banking System

Nationalisation of Banks :  Except SBI (2nd Round)

  • 1969 :  14 Banks having deposits of more than ₹ 50 Crore were nationalised (2019 : 50 years have passed i.e. Golden Jubilee of Nationalisation.)
  • 1980 : 6 more banks Nationalised having deposits more than ₹200 Crore .
Nationalised in 1969 Punjab National Bank, Canara Bank etc .
Nationalised in 1980 Punjab & Sind Bank, Vijaya Bank, Oriental Bank of Commerce etc.

Reasons of Nationalisation

  • To remove control & concentration of economic power in the hands of few industrialists .
  • Due to misuse of funds by owners .
  • Due to tendency of banks to ignore the needs of small scale industrial sector & agriculture .
  • To remove concentration of banking sector mostly in Urban areas .

Objectives after Nationalisation

  • To open more banks in rural & semi urban areas & to collect saving from these areas .
  • To provide credit facilities to areas defined as Priority Sector in economy.

Has the nationalisation of private banks benefitted India?

  • According to Economic Survey (2020) , due to nationalisation of banks ,  allocation of banking resources to rural areas, agriculture, and priority sectors have increased. For example in the period from 1969-1980
    • Number of rural Bank branches increased ten-fold.
    • Credit to rural areas increased twenty-fold.
    • Credit to agriculture expanded forty-fold, reaching 13% of GDP from a starting point of 2% of GDP .
  • But Economic Survey (2020) doubts  whether these benefits were entirely caused by Nationalization as the period also saw various other events like green revolution, anti-poverty programmes (like Integrated Rural Development Programme) and policies of RBI (such as RBI’s 4:1 formula).

Issues faced by Public Sector Banks due to Bank Nationalisation

  • Since government was the majority shareholder of the banks, it started to give loans at populistic ‘Government Administered Interest Rates’  which decreased the profitability of the banks.
  • Banks were forced to give loans to fund unviable projects based on political considerations which increased the NPAs of Public Banks as the recovery of such loans was low. In 2019 public sector banks reported NPAs of Rs. 7.4 lakh crore amounting to about 80 per cent of the NPAs of India’s banking system.
  • Public Sector Banks account for 92.9% of the cases of bank fraud, a large majority (90%) were related to advances, suggesting poor quality of screening and monitoring processes for corporate lending adopted by Public Sector Banks.
  • PSBs perform poorly on Return-on-Assets (RoA), Return-on-Equity (RoE) etc when compared with  Private Banks. Public Sector Banks are having negative RoA presently.   
performance of Public Sector Banks
  • Politicisation of Bank Boards happened with government placing it’s favourites in the Board of Directors irrespective of their knowledge and talent. This reduced the professionalism in the banks.
  • Due to above reasons, RBI feared that banks can collapse. Hence, it mandated high Cash Reserve Ratio (CRR)  , reducing the funds at the disposal of bank for loan purposes.
  • Large staff was hired in banks , even more than what was required, to create government jobs. This led to unionization of staff and inefficient customer services. Frequent hartals of bank employees were observed in the period after nationalization.

Side Topic : Number of Public Sector Banks Today

  • Public Sector Banks = 13 ( on July 2020 including Post Payment Bank).

Old Private Banks

  • All the Big Private Banks were nationalised.
  • But there were Small Private Banks whose deposits were less than limits and they were not nationalised.
  • These Banks are now called Old Private Banks .
  • There are 12 such banks in India .
  • These are Scheduled Banks and have to maintain Cash Reserve Ratio & Statutory Liquidity Ratio .
  • Examples : Catholic Syrian Bank, Dhanlaxmi Bank, Federal Bank, Jammu and Kashmir Bank etc. .

Narsimham Committee and (Rise of ) New Private Sector Banks

After the 1980 nationalization, Public Sector Banks had a 91% share in the national banking market which has reduced to 70% in recent times. Reduced stake has been absorbed by New Private Banks (NPBs) which came up in early 1990s after liberalization. This brings us to the topic of New Private Banks .

Share of different banks in India

Private Sector Banks

1991: Balance of Payment crisis finally forced Govt. to set up a Committee for Banking Sector Reforms under the former RBI Governor M Narsimham . He recommended :

  • Government should decrease its shareholding in Public Sector Banks.
  • The resources of the banks come from the general public and are held by the banks in trust that they are to be deployed for maximum benefit of the depositors.  Even the government had no business to endanger the solvency, health and efficiency of the nationalised banks under the pretext of using banks, resources for economic planning, social banking, poverty alleviation, etc.
  • RBI should decrease CRR and SLR .
  • Priority Sector Lending (PSL) given to agriculture and Small Scale Industries (SSIs) should be phased out gradually as they had already grown to a mature stage . They don’t require any special support; two decades of interest subsidy were enough.
  • Govt. should not dictate interest rates to Banks .
  • Liberalize the branch expansion policy .
  • Allow entry of New Private Banks and New Foreign Banks.

This led to 3 Rounds of Banking Licenses

1st Round (1993-95) 10 licenses were given to open following banks.
3. Indus
4. DCB
5. UTI => later Axis bank
6. IDBI => now owned by LIC
7. Global Trust Bank => Merged with Oriental Bank
#8-9-10: Bank of Punjab, Centurion Bank, Times Bank were merged into HDFC  
2nd Round (2001-04)  2 licenses were given in 2nd Round
1. Kotak Mahindra
2. Yes Bank   
3rd Round (2013) Bimal Jalan Committee made selections:
1. Bandan Microfinance  (A Microfinance company based in West Bengal) 
2. IDFC (An infra finance NBFC based in Maharashtra). Later on, another NBFC “Capital First” merged so renamed into IDFC-First

Side Topic : Number of Private Banks in India

  • 22 Presently ( after IDBI is privatised)

On Tap System of Banking License

  • Present System : Start & Stop System
    • RBI issues notification and interested entities can apply at that time only..
    • Till now , 3 such rounds have happened
  • New Proposed : On Tap System
    • In this system , there will be no deadline for application. No need to wait for notification.
    • When entity thinks that it is fit to become Bank , they can approach RBI with application.
    • RBI has issued guidelines regarding this too.

No one has applied for Banking License through this route yet .

Foreign Commercial Banks

  • In Nehruvian Socialist Economy there was disdain & apprehensions about Foreign Banks. Only a handful of them were allowed to open branches. But, Post-Narasimham-Reform, foreign banks approval policy was liberalized.
  • 1991 : M Narsimham Committee recommended to allow Foreign Banks on reciprocal basis . Government accepted this proposal.
  • There are 44 Foreign Banks in India
Foreign Commercial Banks in India
  • Foreign Bank has to first open Indian Subsidiary registered in India under Companies Act .

Core Banking Solution

  • Core Banking Solution (CBS) is networking of branches, which enables Customers to operate their accounts, and avail banking services from any branch of the Bank on CBS network, regardless of where he maintains his account. The customer is no more the customer of a Branch. He becomes the Bank’s Customer.
  • It has helped in converting Branch Banking to Branchless Banking .

This marks end of article on “History of Banking System.’

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