Banking Sector Reforms in India

The evolution of Indian banking can be broadly divided into three phases for analytical purposes:

• Phase I: Pre-Nationalization Era (1947–1969) – Characterized by a predominance of private banks, limited reach, and periodic challenges.
• Phase II: Nationalization Era (1969–1991) – Marked by public sector expansion, social banking, and directed lending under government ownership.
• Phase III: Liberalization Era (1991–Present) – Denotes the post-reform period with liberalization, entry of new players, technological advancement, and strengthened regulation.

Each phase had distinct features and reform measures, which we detail below.

Phase I (Pre-1969): Limited Outreach and Private Banking Challenges

In the first two decades after Independence (1947–1960s), India’s banking sector remained largely in private hands (except SBI). The growth and outreach of banking during this period were limited by several factors:

• Urban Concentration: Banking facilities were concentrated in cities and big towns. As of the late 1960s, only about 17–20% of bank branches were in rural areas. Vast rural regions had no access to formal banking, leaving the rural population dependent on informal moneylenders. Small farmers found it difficult to get crop loans from banks, which preferred financing trade and industry in cities. This urban bias meant a low level of financial inclusion.
• Private Ownership Issues: Most banks were controlled by business families or industrial groups (who often had allied companies). This led to connected lending – banks funding projects of their owners – which increased risks. There was also little pressure to lend to sectors with low returns (like agriculture or poverty alleviation) as the motive was profit. Some private banks were well-run, but many were under-capitalized and managed on old family practices, lacking professional management.
• Bank Failures and Confidence Crises: The early post-independence period saw a number of bank failures. For instance, in Bengal between 1946 and 1948 several banks collapsed amid economic turbulence. As noted earlier, bank failures continued into the 1960s (Palai Bank being a notable example in 1960). These failures hurt depositors and caused public distrust in the banking system. Though the Reserve Bank of India tried to supervise and merge weak banks (using powers from the Banking Regulation Act), the framework was still developing. The introduction of deposit insurance in 1962 helped improve confidence by guaranteeing small deposits, but preventing bank failures was a challenge in the fragmented private banking landscape.
• Limited Credit to Priority Sectors: Commercial bank lending was skewed towards commerce and large industries. Sectors like agriculture got a minuscule share. In 1951, for example, only about 0.9% of cultivators had access to credit from commercial banks. Co-operative credit societies tried to fill this gap, but their resources were limited to local membership. Thus, the credit needs of rural India and small enterprises were largely unmet. This was recognized as a bottleneck for development, as noted by various committees (like the All-India Rural Credit Survey of 1954).
• Regulatory and Infrastructure Constraints: RBI, after 1949, did impose stricter norms on banks (like maintenance of Cash Reserve Ratio, licensing of new branches, etc.), which improved stability gradually. However, infrastructure like telecommunications, transport, and credit information was underdeveloped, making branch expansion in remote areas difficult. Banking technology was primitive (manual ledgers, no computers), so scaling operations was slow and error-prone. Human errors, frauds and poor internal controls also led to occasional scams, undermining the sector.

Several government initiatives during this phase attempted to address these issues: the State Bank of India’s creation (to lead rural banking), encouraging cooperative banks, starting specialised financial institutions for industry (like IDBI in 1964), and enacting social control measures (RBI introduced Credit Authorization Scheme in 1965 to vet large bank loans). Despite these efforts, by 1967–68, it was evident that a more sweeping change (i.e., nationalization) would be necessary to achieve the breadth of outreach and credit allocation the government desired. The stage was set for the 1969 nationalization which closed Phase I and commenced Phase II.

Phase II (1969–1991): Expansion of Public Sector Banking and Directed Lending

The period from 1969 to 1991 corresponds to the era of nationalized banking dominance. It was characterized by aggressive expansion of banking services, the use of banks as instruments of government policy, and eventually, emerging stresses that called for reform.

Expansion and Social Orientation: Following the 1969 nationalization of major banks (and the 1980 round), the banking network expanded unprecedentedly. Banks opened branches in thousands of villages as part of the government’s drive to “bank the unbanked.” The Lead Bank Scheme (1969) assigned each district to a lead public bank to survey credit needs and coordinate branch opening. Bank staff were often given targets for opening new accounts and lending to priority sectors. This era saw banking reach far-flung areas, supporting the government’s slogan of “Jay Kisan, Jay Vigyan” (victory to the farmer, victory to science) by financing agriculture and rural development.

A noteworthy initiative was the creation of Regional Rural Banks (RRBs) in 1975. These were set up through an Ordinance (later RRB Act, 1976) to provide an alternative channel for rural credit alongside cooperatives and commercial banks. Starting with 5 RRBs on 2nd October 1975, the network grew to cover most districts, with each RRB sponsored by a major commercial bank. RRBs were focused on small farmers, rural artisans, and agricultural laborers – groups often bypassed by larger banks. While RRBs were small in size, their presence underscored the commitment to rural banking during this phase.

Similarly, to strengthen rural credit, the government established NABARD (National Bank for Agriculture and Rural Development) in 1982 as an apex refinancing and development institution. NABARD took over the agricultural credit functions of RBI and the Agricultural Refinance and Development Corporation (ARDC). It provides refinance support to banks for crop loans and monitors development projects. These measures, along with various targeted lending programs, ensured that by the 1980s a significant portion of bank credit was funneled into rural areas and priority sectors.

Directed Lending and Interest Regimes: During Phase II, banking was tightly controlled by the RBI and government directives. Interest rates were administered – for instance, low-interest rates were mandated for priority sectors and small loans, while higher rates were charged for others. Banks had to invest in government securities (high Statutory Liquidity Ratio often above 35%) and keep high cash reserves (CRR often around 15%) as part of the nation’s financial repression strategy to fund government spending. These pre-emptions limited the profitability of banks but were deemed necessary to ensure funds for public investment.

Branch Licensing and Penetration: The branch expansion had a clear impact – banking penetration (measured as bank branches per population or deposit accounts per capita) improved markedly. By 1991, over 60% of India’s rural adult population had access to a bank account (up from maybe 10% in 1969). The number of bank branches per 100,000 people more than quadrupled. This laid the groundwork for later financial inclusion initiatives.

Credit Planning: Banks were central to government’s Five-Year Plans financing strategy. They implemented schemes like Priority Sector Lending targets (formalized in 1974 and updated in 1980 to 40% of net credit for priority sectors). They also supported programs such as the Integrated Rural Development Programme (IRDP), Self-Employment Schemes, and subsidized credit to poverty alleviation programs. In 1989, a nationwide farm loan waiver was executed through banks, writing off loans to small farmers – which showcased both the reach of banks and the kind of political burdens placed on them.

Emerging Challenges by late 1980s: While Phase II succeeded in expanding banking’s footprint and deepening the credit delivery to desired sectors, it also led to institutional weaknesses. By 1991, many public sector banks were in poor financial shape. Factors included:

• Mounting NPAs (Non-Performing Assets) due to years of lending under mandate rather than on commercial principles. Loans to certain priority sectors or state-owned enterprises had low recovery rates.
• Erosion of profitability because interest rates were regulated and costs were rising (banks had large staffing and often had to operate branches in remote, loss-making locations as a social obligation).
• Capital Adequacy was not maintained at international standards – banks had thin capital relative to their risk-weighted assets, partly because profits were low and government as owner was not injecting capital regularly.
• Technological obsolescence: Indian banks still used manual or rudimentary computer systems in few branches by 1990, whereas globally banks had adopted automation. This affected efficiency and customer service.
• The broader macroeconomic problems of India by 1990 (fiscal deficit, balance of payments crisis) also strained banks, as high inflation and government borrowing crowds out private sector credit.

Thus, as India faced an economic crisis in 1991 and initiated liberalization in the economy, the banking sector too was earmarked for significant reforms. The government constituted the Narasimham Committee in 1991 to propose sweeping changes for banking sector revival (this begins Phase III).

Phase III (Post-1991): Liberalization and Modern Reforms

India’s financial sector reforms began in earnest in 1991–92 as part of a broader economic liberalization. For the banking industry, this period has been transformative – introducing market competition, modern prudential norms, and new technology to make the sector more efficient and robust. We can outline the key reforms and changes in this phase:

Narasimham Committee I (1991) – Financial Sector Reforms: In 1991, a high-level committee under former RBI Governor M. Narasimham was appointed to recommend banking reforms. Its report, submitted in November 1991, became the blueprint for India’s banking liberalization. Major recommendations included:

• Reduction of Statutory Pre-emptions: The committee noted that excessive SLR and CRR were impeding banks’ lending ability. It recommended gradually reducing the SLR from the then ~38.5% to 25%, and CRR from ~15% to around 3-5%. This was aimed at freeing up more funds for commercial lending. (In practice, SLR and CRR were indeed brought down in stages through the 1990s to early 2000s, closer to those target levels.)
• Introduction of Prudential Norms: For the first time, Indian banks were asked to adopt international Basel I standards of capital adequacy. A minimum Capital-to-Risk Assets Ratio (CRAR) of 8% was prescribed to be met by 1996. Banks were also required to follow stricter norms for asset classification, income recognition, and provisioning for bad debts. This meant classifying loans as standard, sub-standard, doubtful, or loss based on repayment status, and making provisions (reserves) for likely losses. The practice of not recognizing interest income on non-performing loans until actually recovered (known as NPA recognition norm) was enforced. These prudential norms, introduced in 1992–93, brought transparency and financial discipline, as banks could no longer hide bad loans or defer loss recognition.
• Deregulation of Interest Rates: The committee advocated moving away from administered interest rates to market-driven rates. Over the 1990s, RBI gradually liberalized interest rate controls – first on the lending side (allowing banks to set their prime lending rates) and later on deposit rates. This fostered competition and better pricing of risk.
• Diversifying Ownership and Autonomy: To improve efficiency, it was recommended that government reduce its stake in public sector banks (to 33% over time) and allow them to raise capital from the market. While core government ownership remains, many PSBs were later listed on stock exchanges and partial private shareholding introduced, which subjected them to market discipline. Banks were also granted more autonomy in operations – e.g. freedom to recruit skilled professionals, offer competitive salaries, and close or merge unviable branches – to enable a more commercial approach.
• Allowing New Private and Foreign Banks: A path-breaking reform was opening the sector to new entrants. In 1993, RBI issued guidelines for licensing new private sector banks, breaking a decades-long ban on new banks. As a result, by 1994–95, ten new private banks commenced operations – notable among them: HDFC Bank, ICICI Bank, Axis Bank (then UTI Bank), IndusInd Bank, IDBI Bank, Centurion Bank, Bank of Punjab, Global Trust Bank, etc. These banks brought fresh competition, modern customer service and technology. Foreign banks were also allowed to expand more easily in India; several global banks opened branches or increased their presence in the 1990s. The entry of new players spurred innovation in products and efficiency in services in what had been a static industry.
• Strengthening Banking Supervision: An independent Board for Financial Supervision within RBI was established in 1994 to focus on the supervision of banks and financial institutions. RBI introduced regular onsite inspections and offsite monitoring of banks’ financial health under the new norms. The legal framework was bolstered – for example, Debt Recovery Tribunals were set up (DRT Act, 1993) to help banks recover bad loans faster through special quasi-judicial processes.
• Development of Financial Markets: Reforms recognized that a competitive banking system needed efficient money and government securities markets. RBI introduced new instruments like 91-day Treasury Bills auctions, Certificates of Deposit (CDs) and Commercial Papers (CPs) for short-term funding, and later the Liqudity Adjustment Facility (LAF) for better monetary policy transmission. These helped integrate Indian banks into a more market-oriented financial system.

The implementation of the above reforms through the 1990s led to a leaner, more robust banking sector. Banks shored up their capital (the government infused capital in many PSBs and some raised equity from markets). By 1997, most banks met the 8% CRAR norm and had adopted the 90-day norm for NPA classification by 2004. Interest rates became largely deregulated by 1997, giving banks flexibility in pricing loans and deposits. The new private banks aggressively deployed technology and competition forced public banks to computerize and improve service. The immediate impact was visible in improved profitability and lower NPAs: through the mid-90s, public banks turned around from losses to profits, and by 2001 the gross NPA ratio in the sector declined significantly from mid-90s levels.

Narasimham Committee II (1998) – Second Generation Reforms: A second committee under Narasimham was set up in 1997–98 to review progress and suggest further reforms. Its report (submitted April 1998) focused on consolidating gains and addressing remaining weaknesses:

• It recommended a three-tier banking structure with 3 large internationally competitive banks at top, 8–10 national banks, and many regional/local banks – encouraging mergers and consolidation for size and strength. Following this, the late 1990s and 2000s saw several mergers (for example, mergers of New Bank of India into PNB in 1993, Times Bank into HDFC in 2000, Bank of Madura into ICICI in 2001, etc.). More recently, big mergers like SBI with its associate banks (2017) and merger of nationalized banks into 12 larger banks (2020) were in line with this vision of consolidation.
• It addressed the issue of high NPAs still plaguing some banks. The committee suggested creation of Asset Reconstruction Companies (ARCs) to take over bad loans and resolve them. This led to the enactment of the SARFAESI Act, 2002 which gave banks powers to seize and sell collateral of defaulted loans, and later the formation of ARCs. (In 2004, the first ARC – ARCIL – began operations to buy NPAs from banks.)
• Capital Adequacy norms were further tightened – the committee proposed raising the CRAR from 8% to 9% (this was implemented by 2000) and recommended adoption of Basel II norms in the 2000s. It also pushed for banks to have risk management systems in place for credit, market, and operational risks.
• It emphasized improving bank governance: reducing government ownership to 33% (still not implemented fully; most PSBs remain 51%+ government-owned), professionalizing boards, and giving banks flexibility in HR and branch decisions. It noted that government and RBI should ideally divest ownership roles (indeed, RBI later divested its stakes in SBI, NABARD, and NHB by 2007, so that these institutions are fully government-owned rather than central bank-owned).
• Prudential norms were to be taken to next level: like bringing down net NPAs to 3% by 2002, and moving towards zero NPA for healthy banks in the long run. Also, disclosure and accounting standards for banks were improved, aligning with international practices.

Many of these second-generation reforms were gradually rolled out in early 2000s. The result was a much stronger banking sector by the mid-2000s, capable of withstanding shocks. This was evidenced during the global financial crisis of 2008, where Indian banks remained largely stable thanks to conservative policies and good capital buffers.

Entry of New Categories of Banks: Liberalization also saw diversification in the types of banks. Besides the traditional commercial banks, RBI introduced new categories:

• Local Area Banks (LABs): A short-lived experiment around 1996 to allow small private banks in rural areas (only a few LABs were set up; this concept was eventually subsumed by small finance banks later).
• Payments Banks and Small Finance Banks: In 2015, as financial inclusion gained renewed focus, RBI licensed Payments Banks (e.g., Airtel Payments Bank, India Post Payments Bank) which can accept deposits and offer remittance services but not give loans. Also, Small Finance Banks (SFBs) were introduced to serve small borrowers (e.g., AU Small Finance Bank, Ujjivan SFB). These new banks started operations around 2016–2017. They represent the continuing evolution of the banking landscape to include niche players focusing on underserved segments using technology and innovative models.

Technological Adoption: A hallmark of the post-1991 phase is the rapid adoption of technology in Indian banking:

• In the 1990s, private banks led with ATM networks (the first ATM in India was installed in 1987 by HSBC; by late 90s most banks had ATMs in cities). Computerization of branch operations in public sector banks took off after 1993 under an RBI-formed committee’s plan. By early 2000s, most banks moved to Core Banking Systems (CBS), enabling anywhere banking, online transactions, and faster services.
• Internet Banking and Mobile Banking: The 2000s saw banks launching internet banking portals. By the 2010s, mobile banking apps and digital payment interfaces became common. The Unified Payments Interface (UPI), launched in 2016, further revolutionized digital payments, with banks as the backbone of UPI transactions. Today, India is a global leader in digital banking transactions.
• Modern Customer Services: Banks expanded services to include credit cards (which were introduced in India in the 1980s but proliferated in the 1990s), debit cards, electronic fund transfers (NEFT/RTGS started in early 2000s), and have adopted data analytics and AI in service delivery in the 2020s. Technology has improved efficiency and financial inclusion – for example, the Jan Dhan Yojana since 2014 leveraged digital methods to open over 400 million basic accounts, one of the world’s largest inclusion drives.

Strengthening Regulation and Corporate Governance: Post-liberalization, RBI has continually upgraded regulatory norms. In 2002, banks moved to 90-day overdue norm for NPAs (from 180 days earlier). Basel II norms were implemented by 2009, and currently banks are transitioning to Basel III (higher capital and liquidity standards) which makes them more resilient. Corporate governance norms were tightened – fit and proper criteria for CEOs and directors, audit committees, and later moves to amalgamate weak banks with stronger ones to protect depositors (e.g., merger of some private banks that failed, like Global Trust Bank merged into OBC in 2004). The Insolvency and Bankruptcy Code (2016) has given banks a faster route to resolve stressed loans via the National Company Law Tribunal (NCLT). All these have strengthened the banking sector’s stability.

Summary of Phase III Outcomes

The reforms have made Indian banking more competitive and service-oriented. Private sector banks now account for about 30% of banking assets, breaking the monopoly of PSBs and improving overall efficiency. Customers benefited through better products, lower loan interest (due to competition and lower inflation) and higher deposit rate choices. Banks themselves became profitable and healthy – for instance, by the mid-2000s, many banks had international presence and were listed on global exchanges. However, new challenges have also emerged, such as managing economic downturns, large corporate NPAs (especially during 2015–18 which led to recapitalization needs), and ensuring public sector banks keep pace with private peers in innovation. The journey of reforms continues, but there is no doubt that the post-1991 liberalization set Indian banking on a path of modernization and integration with global standards.