Financial sector reforms

Topic: The 1991 Crisis and LPG Reforms: An Appraisal · NCERT: Class 11, Ch 3 "Liberalisation, Privatisation and Globalisation: An Appraisal"

Meaning

Financial sector reforms are the changes made from 1991 onwards to the way banks, stock markets, insurance and foreign exchange markets are run in India. The RBI stopped controlling small details of banking (micro-controls) and moved to setting broad safety rules (prudential regulation). At the same time, private banks, foreign banks and foreign investors were allowed in. The RBI became a "facilitator" but stayed the regulator.

These reforms matter because they freed bank money for lending to farmers and firms, and they made finance more competitive. They also opened India to foreign capital, which brings both money and new risks.

Two formulas sit at the heart of these reforms:

• Money free for lending ≈ Deposits × [1 − (CRR + SLR)]
• CRAR = (Bank's own capital ÷ Risk-weighted assets) × 100

Explanation

What the financial sector is, and what went wrong before 1991

• The financial sector is the set of institutions that move money from savers to borrowers:
• commercial banks take deposits and give loans
• investment banks help companies raise money by selling shares and bonds
• stock exchanges are markets where shares are bought and sold

• the forex market is where rupees are exchanged for dollars and other currencies

• Before 1991, the RBI controlled small details (micro-controls):

• the reserve ratios, meaning how much money banks had to lock away
• the interest rates banks charged and paid (these were administered, meaning fixed by the RBI)

• directed lending, meaning which sectors got loans and how much

• Why this hurt:

• High reserve ratios left banks with little money to lend.
• A high SLR also forced banks to fund the government's deficit.
• Fixed interest rates meant banks could not compete on price.

From regulator to facilitator: the Narasimham Committees

• Narasimham Committee I (1991) was the "Committee on the Financial System". It was set up just after the balance of payments (BoP) crisis (when India was running out of foreign exchange to pay for imports and debt).

• Its advice became the base for reforms in banks, development financial institutions (DFIs) (government-backed lenders for long-term industrial projects) and the capital market [2].

• Narasimham Committee II (1998) was the "Committee on Banking Sector Reforms (CBSR)". It reported in April 1998 and set the plan for the second phase of bank reform [2][3].

• After 1991, banks decide many things without asking the RBI. These include interest rates, branches and lending.
• But they must follow prudential norms (safety rules that keep a bank healthy):
• Income recognition: a bank cannot count interest as income until it actually receives it. Loans that stop paying become NPAs (non-performing assets).
• Asset classification: loans are sorted into standard, sub-standard, doubtful and loss.
• Provisioning: a bank must set aside part of its profit to cover loans that may go bad.

• CRAR (Capital to Risk-weighted Assets Ratio): the bank's own capital as a share of its loans and assets, weighted by how risky each one is.

• These norms were brought in step by step [2][3].

Area	Before 1991	After reform
SLR	38.5% (statutory peak). The average effective rate was 37.4% (1992) [2]	Committee I advised cutting it to 25% over five years. It reached the 25% statutory minimum in 1997 [2]. It is lower today
CRR	15%	Committee I advised a progressive (step-by-step) reduction [2]. It later fell to single digits
Interest rates	Administered	Largely deregulated (banks set their own rates)
Prudential norms	Weak	Income recognition, asset classification and provisioning [2][3]. CRAR 8%
Branch licensing	RBI approval needed	Banks that meet the conditions can open or close branches freely

Worked examples: reserve ratios and CRAR

Key terms

• SLR (Statutory Liquidity Ratio) is the share of deposits a bank must keep in safe, liquid assets, mainly government securities.
• CRR (Cash Reserve Ratio) is the share of deposits a bank must keep as cash with the RBI. The bank earns no interest on this money.

Example 1: why high CRR and SLR hurt lending (a bank with deposits of ₹100 crore)

• Before reform (CRR 15%, SLR 38.5%):
• Locked money = 15 + 38.5 = ₹53.5 crore.

• Only ₹46.5 crore is left to lend.

• After reform (SLR 25%; CRR taken as 10% only for this example):

• Locked money = ₹35 crore.

• ₹65 crore is free to lend.

• The chain:

• lower reserves → more money for loans
• more loans → more investment
• more investment → faster growth

Example 2: CRAR

• A bank has its own capital of ₹8 crore and risk-weighted assets of ₹100 crore.
• CRAR = (8 ÷ 100) × 100 = 8%.
• Riskier loans get a higher weight, so the bank needs more capital to give them.
• Committee I set a first target of 4% by March 1993. This was later raised to 8% [2].

New players and new institutions

• Banking:
• New private banks came in under the 1993 RBI guidelines. Examples: ICICI, HDFC, UTI Bank (now Axis Bank) and IndusInd.
• Foreign banks opened more branches.

• FDI (foreign direct investment) limit in private banks: about 74%. In public sector banks: 20%.

• Capital market:

• FIIs (Foreign Institutional Investors), such as merchant bankers, mutual funds and pension funds, were allowed from 1992.
• SEBI became a statutory body (one created by an Act of Parliament) in 1992.
• The Controller of Capital Issues (CCI) was abolished in 1992. Companies now set the price of their own new shares and must disclose information to SEBI.

• The NSE was incorporated in 1992 and began trading in 1994. It brought screen-based (electronic) trading across India.

• Insurance:

• The Malhotra Committee (1994) advised opening insurance to private companies.
• The IRDA Act 1999 created the Insurance Regulatory and Development Authority. This ended the public-sector monopoly of LIC and GIC.

In India

• Who manages it:
• the RBI for banks (it sets prudential norms and still controls managerial matters)
• SEBI for stock markets

• IRDA (now IRDAI) for insurance

• The rule behind it: NCERT (Class 11) says the RBI keeps control over managerial matters "to safeguard the interests of the account-holders and the nation". That is why the RBI is a facilitator, not a bystander.

• Key milestones:
• Narasimham I (1991) [2]
• FIIs allowed, SEBI made statutory, CCI abolished (all 1992)
• private bank guidelines (1993)
• NSE trading begins (1994)
• SLR reaches 25% (1997) [2]
• Narasimham II (April 1998) [2][3]

• IRDA Act (1999)

• Current rates: SLR is now below 25% and CRR is in single digits. Check the latest CRR on rbi.org.in.

• For NPAs and Basel norms, see the banking-regulation-npas note.

Don't confuse with

• RBI as regulator vs RBI as facilitator: after 1991 the RBI stopped micro-controlling banks, but it is still the regulator. Any statement that it "stopped regulating" is false.
• CRR vs SLR: CRR is cash kept with the RBI and earns no interest. SLR is kept with the bank itself, mainly in government securities.
• FDI vs FII: FDI is long-term ownership in a company, such as the 74% limit in private banks. FII money buys shares and bonds and is "hot money" that can leave quickly.
• Narasimham I vs Narasimham II: Committee I (1991) was on the Financial System. Committee II (1998) was on Banking Sector Reforms [2].

Prelims Hooks

• Narasimham Committee I (1991) was the "Committee on the Financial System". Committee II (April 1998) was the "Committee on Banking Sector Reforms" [2][3].
• Pre-reform SLR was 38.5% and CRR was 15%. Committee I aimed to cut SLR to 25% over five years, and it reached 25% in 1997 [2].
• CRAR = Capital ÷ Risk-weighted assets × 100. The first target was 4% by March 1993, later raised to 8% [2].
• 1992 was a big year: FIIs were allowed, SEBI became statutory, the CCI was abolished and the NSE was incorporated. NSE trading began in 1994.
• FDI limits in banks: about 74% in private banks, 20% in public sector banks.
• Trap: "After 1991 the RBI stopped being the regulator." This is false. It became a facilitator but is still the regulator.

Mains Points

• Prudential regulation vs micro-control:
• Lower SLR and CRR freed bank money for private investment, and deregulated interest rates made banks more efficient.
• But weak loan checks in the 2000s-2010s led to the twin balance sheet problem (high NPAs in banks and heavy debt in companies).

• Lesson: a "facilitator" RBI still needs strong supervision.

• Financial openness brings both gains and risks:

• Higher FDI and FII limits brought capital and technology.
• But FII money can leave quickly, as it did in 2008 and 2013. This puts pressure on the current account and the rupee.

• So opening up needs strong regulators (SEBI, IRDAI) and enough forex reserves.

• Competition and inclusion (GS-III link):

• New private and foreign banks, the NSE's electronic trading and private insurers widened choice and improved service.
• Their growth has to be balanced against the RBI's duty to protect account-holders. This is why reform moved to prudential rules, not to no rules at all.

Read more

• Financial sector and tax reforms