Social Control.docx

Introduction The banks are the custodians of savings and powerful institutions to provide credit. They mobilise the resources from all the sections of the community by way of deposits and channelize them to industries and others by way of granting loans. In 1955 the Imperial Bank of India was nationalised and SBI was constituted. It was observed that commercial banks were directing their advances to the large and medium scale industries and the priority sectors such as agriculture, small-scale industries and the exports were neglected. The chairmen and directors of banks were mostly industrialists and many of them were interested in sanctioning large amount of loans and advances to the industries with which they were connected. To overcome these deficiencies found in the working of the banks, the Banking Laws (Amendment) Act was passed in December 1968 and came into force on 1-2-1969. It is known as the scheme of 'social control' over the banks. The then deputy Prime Minister, Mr. Morarji Desai made a statement in the Parliament on the eve of introducing the bill to amend the banking laws Act. He explained that the aim of social control was, "to regulate our social and economic life so as to attain the optimum growth rate for our economy and to prevent at the same time monopolistic trend, concentration of economic power and misdirection of resources". The following are the main provisions of this amendment, Bigger banks had to be managed by whole time chairman possessing special knowledge and practical experience of the working of a banking company or of finance, economics or business administration. The majority of directors had to be persons with special knowledge or practical experience in any of the areas such as accountancy, agriculture and rural economy, banking, cooperative, economics, finance, law, small scale industries etc.The banks were also prohibited from making any loans or advances, secured or unsecured to their directors or to any companies in which they have substantial interest. The growth of commercial banking during the first three plan periods has been lopsided. Without demanding proper security some banks were diverting funds to large and medium industries. Bank branches were opened only in big cities. Rural areas were neglected. Banks made discrimination between private sector and public sector between rural and urban and between agriculture, trade and industry. The banks were financing those industries which were producing luxury goods. The government felt that this type of growth was not in consonance with planning. The growth appeared to be defiant in many respects. There was a growing demand for the bank credit for the development of agriculture, industry and self-employment. So it was essential for the banking system to attract savings. Therefore, the government felt that need for social banking as against capitalist banking. A scheme of social control was introduced in 1967. The government enacted Banking Laws Amendment Act in 1968.This act has given more power to the government to control banking. The objectives of this Act was to ensure more equitable distribution of the resources of the banking system. The priority sectors like agriculture, small-scale industry, public sector and self-employment were to receive their due share in obtaining bank finance. Apart from this the banks are required to reconstitute their board of directors . The government set up National credit council in 1968. The Finance Minister was the chairman and the Governor of the Reserve Bank was the vice chairman of the council. The main functions of the National credit council were:

1. assessing the volume of credit required for the economy as a whole. 2. providing guidelines for the distribution of credit to the priority sector. 3. ensuring equitable distribution of credit in the economy.

Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. Given the inter connectedness of the banking industry and the reliance that the national (and global) economy hold on banks, It is important for regulatory agencies to maintain control over the standardized practices of these institutions. Supporters of such regulation often hinge their arguments on the "too big to fail" notion. This holds that many financial institutions(particularly investment banks with a commercial arm) hold too much control over the economy to fail without enormous consequences . This is the premise for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would create rippling effects throughout the economy leading to systemic failure. India has a long history of both public and private banking . Modern banking in India began in the 18th century, with the founding of the English Agency House in Calcutta and Bombay. In the first half of the 19th century, three Presidency banks were founded. After the 1860 introduction of limited liability, private banks began to appear, and foreign banks entered the market. The beginning of the 20th century saw the introduction of joint stock banks. In 1935, the presidency banks were merged together to form the Imperial Bank of India, which was subsequently renamed the State Bank of India. The post independence period witnessed massive growth in the Indian banking system. The first step taken in this direction was nationalization of the Reserve Bank of India in 1948. It changed the outlook of the Reserve Bank by giving them the status of monitoring authority to regulate and control the socio-economic activities laid down by the government. In order to have sound and balanced growth of banking business in the country, The Reserve Bank of India Act, 1949 was passed to have control of the Reserve bank over the banking industry. In 1955, the Imperial Bank of India was nationalized under the name of State Bank of India. The scheme of social control was initiated by the government in the year 1967. Followed by it, the government nationalized 14 major banks which held a deposit of around Rs 50 crores on 19th July 1969 and 6 more banks which held deposit of around Rs 200 crores on 15th April 1980. This process was done to ensure more equitable and purposeful distribution of the credit. Besides the above developments, financial institutions were established for meeting the specialized needs. These include Industrial Development Bank of India (IDBI), Industrial Credit and Investment Bank of India for meeting the long – term financial needs of the large scale operations. Similarly for meeting the requirements of the Small Scale Industries (SSIs), State Financial Corporation (SFC), Small Industries Development (SIDC) and Small Industries Development Bank of India (SIDBI) have been established. The National Bank for Agriculture and Rural Development (NABARD), Land Development Bank (LDB), Regional Rural Bank (RRB) etc. has been established for taking care of the credit needs in the agriculture sector. NATIONALIZATION Barely four months after the third meeting of the National Credit Council, on 9 July 1969, Indira Gandhi sent a note to the Congress Working Committee through Fakhruddin Ali Ahmed, who was the Minister for Industrial Development, suggesting the nationalization of major banks. This came as a complete surprise, for the prevalent belief in Congress circles was that What was most disturbing for the Reserve Bank was the impression that was created in the media that it was opposed to nationalization. This perhaps had to do with the personality of Jha himself, and with the fact that the Bank had striven hard to make a success of the social control experiment. As Vice Chairman of the National Credit Council, Jha ensured that a large number of documents were submitted on different aspects of social control. The Bank had substantial inputs in the work of the groups formed by the

Council. It also helped to provide the secretariat for the Council, and to create in March 1969 a cell attached to the Banking Commission. These actions by themselves did not imply that Jha was opposed to nationalization of major Indian banks. All the oral accounts point out that while Jha did not favour bank nationalization, he did not openly articulate his personal view on the subject. The real issue was summed up by I.G. Patel in his book, Glimpses of Indian Economic Policy: An Insider’s View: ‘For me, one consequence of nationalization was controversy once again about my jurisdiction and that of my department. A new banking department was created in the ministry under A. Bakshi from the RBI, an old leftist and acerbic friend of Haksar who could obviously be more relied upon to run nationalized banks than L.K. or I.G.’ (p. 137). As Patel’s quote shows, Jha was identified with forces that did not figure in the leftist groups that considered social control as an apology and a dilatory tactic to prevent the state from gaining the commanding heights of Indian finances. After the legal tangle over nationalization was temporarily sorted out, Jha convened a Rural Credit Survey Committee commercial banks only provided 0.9% of the total volume of advances and loans to the agricultural sector (Reserve Bank of India 2008a). Rural India continued to rely mostly on moneylenders that charged them very high interest rates on their loans. The government had to make some major changes to promote equal socio-economic development. The Government of India nationalized the Imperial Bank of India, with the purpose of, “extension of banking facilities on a large scale, more particularly in the rural and semi-urban areas, and for diverse other public purposes.” The State Bank of India Act (1955) renamed the Imperial Bank of India as the State Bank of India (SBI). However to prevent it from being under administrative pressure its ownership was vested with the RBI. SBI underwent rapid expansion and opened 416 branches in 5 years all over the country (Reserve Bank of India2008a). The security that the government owned SBI helped it compete against deposits in safe avenues‟ such as the post offices and savings at home. Five years later in 1960 eight more banks were nationalized and they formed the subsidiaries of the State Bank of India. With the nationalization of these eight banks one third of the banking sector was under the direct control of the government. The Indian banking system had made considerable progress since independence: (1) bank failures had decreased, (2) bank presence in the country increased, (3) banking legislation had a stronger foundation, and (4) deposits had increased. However, the benefits had still not flowed in their entirety to the general public, because credit was not reaching sectors that most needed it, and the banking industry did not have a national presence, because of its concentration in metropolitan and urban areas. On December 1967, through the Banking Laws Amendment Act (Reserve Bank of India 2008), the idea of social control was introduced. The main objective of social control was to achieve: (1) bank credit allocation to the right sectors, (2) prevent misuse of bank funds, and (3) use banks to promote and help finance socioeconomic development. The National Credit Council was established in 1968 to help allocate credit according to the Five Year Plan priorities .In 1969 by putting into effect the Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, fourteen banks were nationalized. Nationalization led to major structural changes in the banking sector of India. Branch expansion was accompanied by development of priority sectors of the economy, with credit being directed towards these sectors contrary to profit motives of the banks. The Credit Guarantee Corporation of India Ltd. was established for providing guarantees

against the risk of default in payment, which increased the number of loans to smaller borrowers by the banks. . The interest rate paid by the banks on deposits. The nationalization phase was marked by stringent controls on the banking industry. As of September 22nd, 1990 the Cash Reserve Ratio was 15.00% and the Statutory Liquidity Ratio was 38.5% (Reserve Bank of India), combined they amounted to 53.5% of all demands and liabilities being saved in liquid government securities or as cash with the RBI. The banks were being used by the government to fund their projects for economic development. This led the banks to be unprofitable forcing the government to adopt changes and thus, came about the reforms of 1991 led by the Narasimham Committee. There are two main approaches to banking regulation. One endpoint is government. ownership of the banking industry and the other endpoint is free banking system. Barth, Caprio and Levine (2008) describe the two main approaches as the “Public Interest Approach” and the “Private Interest View of Regulation.” In India up until 1991 there was an increased amount of government regulation in the banking industry, and social control over the banks was mandated successful. Social control in banking would realize if the banks to manage to allocate resources efficiently while mobilizing credit in all sectors including the marked out priority sectors. Barth,Caprio and Levine (2008) define socially efficient as, “that the banking system allocates resources in a way that maximizes output,while minimizing variance, and is distributionally preferred.” The government of India initially put in process the policy of social control to help regulate, stabilize and expand the banking system. The government had good intentions, and it led to a banking system that spanned across the nation and was undergoing fewer banking failures, and actually making profits while lending to priority sectors. THE SECOND ROUND Nationalization that incorporated six more banks, and increased government regulation, made the banking system very inefficient and unprofitable; Joshi and Little (1997) said, “By 1991, the country had erected an unprofitable, inefficient, and financially unsound banking sector.” There are various ways a government can interfere with the banking system of an economy, and the Indian government, participated in all the below mentioned measures. Barth, “rate of economic growth within those states accelerated and quality of bank lending improved.” Caprio and Levine (2008) outline the main ones as: (1) restrictions on banks, (2) entry, (3) capital requirements, (4) supervisory powers, (5) safety net support the, (6) market monitoring and (7) government ownership.

(1)

Restrictions on Banks: It can be in the form of activity restrictions. It is critical to impose activity restrictions on banks, and that helps define the term bank. Regulatory restrictions can decrease efficiency of the banks and reduces their ability to diversify their income streams and decrease overall risk of operations. A cross country data study by Barth, Caprio and Levine (2001) finds that greater regulatory restrictions lead to a higher probability of a country suffering from a major bank crisis and lower banking sector efficiency. The Indian banks operated under many regulatory restrictions which limited their activities in off balance sheet activities.

(2)

Entry restriction: Governments have control over the banking system by regulating the entry of new private and foreign banks. Jayaratne and Strahan (1998) have

performed studies that suggest when US created a more competitive environment by removing branching restrictions ,The Indian government had placed restrictions on entry of foreign banks and private banks. These banks required government licenses to operate in India. In 1993 the RBI permitted private entry into the banking sector, but imposed restrictions on branch expansion. Various studies have shown that entry restrictions are not favorable for the banking industry.

(3)

Capital Requirements: In addition to entry restrictions, governments can enforce regulations on minimum capital requirements. It can affect risk taking activities and it helps create a pseudo overall economy. with the benefits derived from imposition of capital requirements by the government.

(4)

Supervisory Powers and Market Monitoring: It can be combined into one category and it refers to official supervision of banking activities in the country. Developing countries usually have directed credit programs and high reserve and liquidity requirements, this helps provide a cushion in times of crisis and as they liberalize these requirements, the banks need to have proper supervision of their activities. However, the private interest view argues otherwise. However there are not many studies on this that promote either view. The private interest view argues that excessive supervision can lead to corruption by government officials. It also says that government employees have no motivation to work in the government as the government pays them lesser than private banks and they would be willing to take bribes to produce a good report on a bank. India has instituted agencies that monitor banks‟ performance. RBI also has supervisory powers and it places them in effect by looking at the financial statements of banks on a regular basis through the course of the year. “Safety Net Support”: It has two main parts, one being the “lender of the last resort” and the other an “explicit deposit insurance system.” Proponents of the private interest view feel that it is a moral hazard and present several other ways to protect small depositors.

(5)

The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are: Prudential—to reduce the level of risk to which bank creditors are exposed (i.e. to protect depositors) 1. Systemic risk reduction—to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures

1. Avoid misuse of banks—to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime.

2. To protect banking confidentiality. 3. Credit allocation—to direct credit to favored sectors. 4. It may also include rules about treating customers fairly and having corporate social responsibility(CSR). EVALUTION. PRIVATE OWNERSHIP, NATIONALIZATION AND DISINVESTMENT

Effects of these reforms on the private and public banking system Credit structure and setting up of institutional framework for providing longterm finance to agriculture and industry. Banking sector, which during the pre—independence India was catering to the needs of the government, rich individuals and traders, opened its door wider and set out for the first time to bring the entire productive sector of the economy – large as well as small, in its fold. During this period number of commercial banks declined remarkably. There were 566 banks as on December, 1951; of this, number scheduled banks was 92 and the remaining 474 were non-scheduled banks. This number went down considerably to the level of 281 at the close of the year 1968. The sharp decline in the number of banks was due to heavy fall in the number of non-scheduled banks which touched an all time low level of 210. The banking scenario prevalent in the country up-to—the year 1968 depicted a strong stress on class banking based on security rather than on' purpose. Before 1968, only RBI and Associate Banks of SBI were mainly controlled by Government. Some associates were fully owned subsidiaries of SBI and in the rest, there was a very small shareholding by individuals and the rest by RBI. EXPANSION PHASE (1968-1984) The motto of bank nationalization was to make banking services reach the masses that can be attributed as "first- banking revolution". Commercial banks acted as vital instruments for this purpose by way of rapid branch expansion, deposits mobilization and credit creation. Penetrating into rural areas and agenda for geographical expansion in the form of branch expansion continued. The second dose of nationalization of 6 more commercial banks on April 15, 1980 further widened the phase of the public sector banks and therefore banks were to implement all the government sponsored programmes and change their attitude in favour of social banking, which was given the highest priority. This phase witnessed socialization of banking in 1968. Commercial banks were viewed as agents of change and social control on banks. However, inadequacy of social control soon became apparent because all banks except the SBI and its seven associate banks were in the private sector and could not be influenced to serve social interests. Therefore, banks were nationalized (14 banks in 1969 and 6 banks in 1980) in order to control the heights of the economy in conformity with national policy and objectives. This period saw the birth and the growth of what is now termed as directed lending’ by banks. It also saw commercial banking spreading to far and wide areas in the country with great pace during which a number of poverty alleviation and employment generating schemes were sought to be implemented through commercial banks. Thus, this period was characterized by the death of private banking and the dominance of social banking over commercial banking. It was hardly realized that banks 'were organizations with social responsibilities but not social organizations. This period also witnessed the birth of Regional Rural Bank (RRBS) in 1975 and NABARAD in 1982 which had priority sector as their focus of activity. Although number of commercial banks declined from 281 in 1968 to 268 in 1984, number of scheduled banks shot up from 71 to 264 during the corresponding period, number of non-scheduled banks having registered perceptible decline from 210 to 4 during the period under reference. The rise in the number of scheduled banks was, as stated above, due to the emergence of RRBS. The fifteen years following the banks’ nationalization in 1969 were dominated by the Banks’ expansion at a path breaking pace. As many as 50,000 bank branches were set up; three-fourths of these branches were opened in rural and semiurban areas. Thus, during this period a distinct transformation of far reaching significance occurred in the Indian banking system as it assumed a broad mass base and emerged as an important instrument of socio-economic changes. Thus, with growth came inefficiency and loss of control over widely spread offices. Moreover, retail lending to more risk-prone areas at

concessional interest rates had raised costs, affected the quality of assets of banks and put their profitability under strain. The competitive efficiency of the banks was at a low ebb. Customer service became least available commodity. Performance of a bank/banker began to 61 be measured merely in terms of growth of deposits, advances and other such targets and quality became a casualty.