Narasimham Committee Reports 1991 and 1998: Banking Sector Reform

Between 1969 and 1991 Indian banking was an instrument of policy rather than a market. The State owned most of it, told it what rate to charge, told it whom to lend to, took a large part of its deposits through reserve requirements, and did not require it to say how much of what it had lent was likely to come back. The result was a system with reach but without strength. The reform of the nineteen nineties did not reverse the ownership. It changed everything else, and the committees that designed it still supply the vocabulary in which Indian banking policy is argued.

1. What the system looked like in 1991

1. Pre-emption. A statutory liquidity ratio of thirty eight and a half per cent and a cash reserve ratio of fifteen per cent together took more than half of every rupee of deposits before the bank could lend any of it.
2. Direction. Interest rates on both deposits and advances were administered, and a large share of credit was directed to specified sectors at specified rates.
3. Opacity. There was no requirement to stop recognising income on a loan that had stopped paying, no uniform classification of assets by quality, and no provisioning schedule. A balance sheet therefore did not disclose the condition of the bank.
4. No capital standard. Capital was whatever the owner chose to supply, and for a public sector bank the owner was the Government.
5. Closed entry. No new private bank had been licensed since nationalisation, and branch expansion required permission for each branch.

Figure 1: The sequence of reform

2. The Narasimham Committee, 1991

The Committee on the Financial System, chaired by M. Narasimham, a former Governor of the Reserve Bank, reported in November 1991, months after the balance of payments crisis had forced a general liberalisation. Its diagnosis was that the system was not short of resources but was prevented from using them, and that it could not be judged because its accounts did not disclose its condition.

What it recommended

• Reduce the pre-emptions. Bring the statutory liquidity ratio down to twenty five per cent over five years, and reduce the cash reserve ratio substantially, so that the reserve requirement serves monetary policy rather than government borrowing.
• Deregulate interest rates, and phase out the system of administered rates on both sides of the balance sheet.
• Phase out directed credit, redefining the priority sector more narrowly and reducing the target.
• Introduce prudential norms: income recognition on an accrual basis only while the asset is performing, classification of assets by quality, and a schedule of provisioning against each class.
• Introduce capital adequacy on the Basel pattern, to be reached in stages.
• Restructure the system into four tiers: three or four large banks with an international presence, eight or ten national banks, local banks confined to a region, and rural banks for agriculture.
• Create an Asset Reconstruction Fund to take bad debts off bank balance sheets, and special tribunals for recovery.
• Abolish branch licensing and allow banks to open and close branches on commercial judgement.
• Permit new private banks and liberalise the entry of foreign banks.
• End dual control by the Reserve Bank and the Banking Division of the Ministry of Finance, and place supervision in a separate quasi-autonomous body within the Reserve Bank.

3. The Committee on Banking Sector Reforms, 1998

The second committee, again chaired by M. Narasimham, reported in April 1998. Its task was different. The first round had opened the system and required it to disclose its condition; the disclosure had revealed how much of the loan book was impaired, and the second committee had to say what should be done about it.

• Raise capital adequacy to nine per cent and then to ten per cent, and assign a risk weight to government guaranteed advances, which had until then been treated as risk free.
• Reduce gross non-performing assets to three per cent and net to nil, and tighten the definition by moving from a one hundred and eighty day norm towards ninety days.
• Create asset reconstruction companies to acquire and resolve bad loans, with the legal powers to do so.
• Consolidate by merging strong banks with strong banks, and expressly not by merging a weak bank into a strong one, which merely transfers the problem.
• Apply narrow banking to weak banks, confining them to risk free assets until they recover.
• Reduce the Government's shareholding in public sector banks, to give them access to capital and the discipline of outside shareholders.
• Separate the Reserve Bank's ownership from its regulation, by divesting its holdings in the institutions it regulates.
• Reform the law: amend the Banking Regulation Act, 1949, the Nationalisation Acts and the State Bank of India Act, 1955 to give effect to the above.
• Depoliticise boards, professionalise appointments, and introduce integrated supervision of financial conglomerates.

Figure 2: The two reports compared

4. The committees that followed

• The Committee on Comprehensive Financial Services for Small Businesses and Low Income Households, chaired by Nachiket Mor, constituted in 2013 and reporting in January 2014, proposed a universal electronic bank account for every adult, and a system of differentiated licences, including payments banks and wholesale banks. The differentiated licence framework of 2014 is its direct result.
• The Committee to Review Governance of Boards of Banks in India, chaired by P. J. Nayak and reporting in 2014, found that the governance of public sector banks was constrained by the statutes that constitute them. It recommended repealing the Bank Nationalisation Acts and the State Bank of India Act, incorporating public sector banks under the general company law, and transferring the Government's shareholding to a Bank Investment Company that would hold it at arm's length, with professional boards and longer tenures for chief executives.
• The Internal Working Group on ownership and corporate structure of private sector banks, reporting in 2020, addressed the other half of the ownership question and led to the revised shareholding framework of 2023.

5. What was done, and what was not

The honest assessment is that the prudential agenda was carried out almost in full and the structural agenda was not. Reserve requirements came down, rates were deregulated, classification and provisioning became binding, capital adequacy was introduced and then raised, branch licensing went, private and foreign banks entered, and supervision was separated. The four tier structure was never adopted as such, directed credit was never phased out and has since been expanded, the Government's holding has not fallen below the statutory floor of fifty one per cent, and public sector banks remain creatures of their own statutes rather than companies.

6. Quick Revision

1. Both committees were chaired by M. Narasimham, a former Governor.
2. The first addressed the architecture of a directed system; the second addressed the losses that disclosure had revealed.
3. The Debts Recovery Tribunals and the Board for Financial Supervision both come from the first report.
4. Asset reconstruction companies and the ninety day norm come from the second.
5. The Mor Committee produced the differentiated licence; the Nayak Committee produced the proposal for a bank investment company.
6. The prudential agenda was implemented; the structural and ownership agenda was not.
7. Directed credit was not reduced but expanded, and the Government's statutory floor of fifty one per cent remains.

7. Frequently Asked Questions

Why did the first committee want supervision separated from the Reserve Bank's other work?

Because the Reserve Bank was, at the time, the monetary authority, the regulator, the supervisor, the banker to the Government, the manager of its debt and the owner of several of the institutions it regulated. Supervision, which requires a single-minded focus on whether a particular bank is sound, tends to lose to monetary policy and to debt management whenever they conflict, because those are the immediate and visible functions. The Board for Financial Supervision, constituted in 1994 as a committee of the Central Board with its own department, was the answer: supervision separated organisationally without being handed to a different authority.

What is narrow banking, and why was it proposed?

A narrow bank takes deposits and invests them only in risk free assets, chiefly government securities, and makes no loans. The 1998 committee proposed it for weak banks: a bank whose existing loan book was consuming its capital should be stopped from making the problem larger while its old book was worked out. The attraction is that depositors are protected absolutely. The objection, which prevailed, is that a bank that cannot lend cannot earn its way back to health, so narrow banking is a holding operation rather than a cure, and in practice India chose recapitalisation, enforcement under the securitisation statute and eventually merger instead.

Did the mergers of 2019 and 2020 follow the 1998 recommendation?

Only in part, and the divergence is significant. The committee said expressly that mergers should be of strong banks with strong banks, and that a weak bank should not be merged into a strong one because that merely transfers the weakness and damages the acquirer. The consolidations of 2019 and 2020 were decided administratively, by schemes framed by the Central Government, and several of them paired an anchor bank with institutions carrying materially worse asset quality. The justification offered was scale, technology and the cost of capital, rather than the principle the committee had stated.

Why has directed credit expanded when the 1991 committee wanted it reduced?

Because the premise of the recommendation was not accepted. The committee's view was that credit allocated by direction rather than by price is allocated badly, and that the social objective should be met by the budget rather than by the banking system. The contrary view, which successive governments have held, is that the banking system is the only machinery with the reach to deliver credit to agriculture, to small enterprise and to weaker sections, and that withdrawing the obligation would simply end that lending. The priority sector framework has accordingly been refined, with sub-targets, district weights and tradable certificates, rather than reduced.

What is the Bank Investment Company the Nayak Committee proposed?

A holding company into which the Central Government would transfer its shareholding in every public sector bank, and which would exercise the rights of a shareholder at arm's length from the Government. The purpose was to separate ownership from administration: boards would be appointed by the holding company on professional criteria rather than by the Government, directions to banks through administrative instructions would stop, and the vigilance and right to information regimes that attach to public authorities would no longer apply as they do now. The recommendation required repeal of the constituting statutes and was not implemented, though a Banks Board Bureau and its successor were created to professionalise appointments within the existing structure.

8. Related Topics and Provisions

• Capital adequacy and the Basel framework in Indian banking
• Public sector banks and the statutes that constitute them
• Non-performing assets: classification and provisioning
• Priority sector lending and directed credit
• Ownership, control and the licensing of private sector banks
• Instruments of monetary control