The Indian economy has recovered strongly. The government's poverty alleviation programs have focused on generation of employment in rural areas. The overall deficit of the consolidated public sector has risen sharply in recent years, erasing most of the consolidation that was achieved during the first half of the 1990s. The paper discusses the monetary and financial market developments, reforms and performance, external sector, trade policy, and structural policy developments in India. The new government has taken a number of initiatives committed to structural reform.


The Indian economy has recovered strongly. The government's poverty alleviation programs have focused on generation of employment in rural areas. The overall deficit of the consolidated public sector has risen sharply in recent years, erasing most of the consolidation that was achieved during the first half of the 1990s. The paper discusses the monetary and financial market developments, reforms and performance, external sector, trade policy, and structural policy developments in India. The new government has taken a number of initiatives committed to structural reform.

V. Financial Sector Reforms and Performance1

1. After showing a gradual improvement in recent years, the operating performance of commercial banks deteriorated in 1998/99 (Table V.1). Gross profits declined from 1.8 percent to 1.5 percent of total assets, while net profits (i.e., after accounting for provisions) declined from 0.8 percent to 0.5 percent of assets. The decline in profitability was due to both weaker interest and noninterest income. Interest income fell as lending rates declined and banks moved to provide financing for blue-chip companies through instruments such as commercial paper at interest rates lower than the prime lending rate, while interest expenses rose as banks faced increasing competition for deposits from government-sponsored saving schemes and other saving vehicles.

Table V.1.

India: Financial Performance of Indian Commercial Banks, 1994/95-1998/99

(As a percent of total assets)

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Source: Report on Trends and Progress of Banking in India, Reserve Bank of India, 1998/99.

2. Public, domestic private, and foreign banks all experienced lower profits. The decline in gross profits was particularly marked among the foreign banks which, in addition to a decline in interest margins, also saw their operating expenses rise substantially. Gross profitability of foreign banks, however, remains considerably higher than that of the domestic banks because they enjoy considerably higher net interest income, partly due to their lower level of nonperforming assets. The differential in net profitability is not as great because of the higher provisioning of the foreign banks.

3. The average capital adequacy ratio of the public sector banks fell marginally to 11.2 percent in 1998/99, with all but one of the 27 public sector banks meeting the 8 percent minimum capital ratio (Table V.2). Nonperforming loans (NPLs) of the public sector banks, on both a gross and net basis, declined slightly during 1998/99 to 15.9 percent and 8.1 percent of advances respectively, despite the difficult conditions in the industrial sector during the year. The gross NPLs of the domestic private and foreign banks have risen quite sharply over the past two years, although aggressive provisioning by the foreign banks has meant that their net NPLs have remained broadly unchanged. During 1998/99, the government contributed an additional Rs 4 billion to the capital of three public sector banks bringing its recapitalization contribution since 1994 to a cumulative Rs 204 billion (1¼ percent of current GDP) of which Rs 64 billion has subsequently been returned by four of the banks.

Table V.2.

India: Indicators of Financial System Soundness, 1994/95 - 1999/00

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Source: Data provided by the Indian authorities.

Loan classification and provisioning standards do not meet international standards.

Gross nonperforming loans less provisions.

Not weighted by asset size.

External deposits comprise foreign currency deposits and non-resident (external) rupee accounts (NRE accounts) which can be freely repatriated abroad. Several classes of deposit were reclassified as external in June 1997.

As of October 1999.

As of August 1999.

Refers only to commercial bank purchase or discount of foreign bills. No other information is available.

June 1999.

4. The RBI has continued to strengthen the supervisory and regulatory framework for commercial banks. Recent measures have included:

  • An increase in the minimum capital adequacy ratio to 9 percent effective March 31, 2000 (to be raised to 10 percent at some unspecified point in the future).

  • A tightening of provisioning norms. Banks are required to make a general provision of 0.25 percent of assets for the year ending March 31, 2000. Further, an asset will be treated as doubtful if it has remained in the substandard category for 18 months from March 31, 2001 (previously a 24-month period applied), while banks are required to assign a 100 percent risk weight to state government guaranteed securities issued by defaulting entities (from April 1, 2000).

  • Introduction of additional risk weights. A 2.5 percent risk weight was imposed for market risk on government/other approved securities from March 31, 2000, while a 100 percent risk weight for open foreign exchange and gold positions was introduced on March 31, 1999.

  • Continued tightening of mark-to-market requirements. In the 1999/00 financial year, 75 percent of a bank’s portfolio of government and other approved securities was required to be marked-to-market.

  • Greater disclosure. Effective March 31, 2000, banks will be required to disclose the maturity pattern of their loans and advances, investment securities, deposits and borrowings, foreign currency assets and liabilities, movements in NPLs, and lending to sensitive sectors.

5. In the 2000/01 budget, it was announced that the government’s minimum shareholding in the nationalized banks would be reduced to 33 percent from its current level of 51 percent to enable the banks to raise the capital needed for them to continue to meet the new capital adequacy standards. However, the government stated that such equity sales would be done “without changing the public sector character of the banks.”

6. The Development Finance Institutions had a difficult year in 1998/99 as their large exposures to hard hit sectors such as steel, cement, and textiles put pressure on their loan portfolios. While the increase in NPLs and decline in capital ratios was generally modest, the Industrial Finance Corporation of India (IFCI) was particularly hard hit and saw a sharp increase in NPLs and a decline in its capital ratio to near the 8 percent minimum. To help shore up the capital of IFCI, the government is reported to have injected Rs 5.6 billion, partly through subscription to a rights issue. The regulatory and supervisory framework applying to the DFIs has also been tightened along similar lines to the measures introduced for the commercial banks.

7. A new regulatory framework for Nonbank Finance Companies (NBFCs) was put in place by the RBI in January 1998 and was subsequently amended in December 1998. Under the new framework, all NBFCs are required to register with the RBI and need to meet a minimum net-owned funds requirement to operate. NBFCs that are approved to accept public deposits will be subject to extensive regulation, while those not accepting public deposits will be regulated in a limited manner. Those companies accepting public deposits are required to comply with prudential norms on income recognition, asset classification, accounting standards, provisioning, capital adequacy, and credit/investment concentration norms. Capital adequacy norms were raised to 10 percent (by end-March 1998) and to 12 percent (by end-March 1999). As of November 1999, registration had been granted to 641 NBFCs to accept public deposits and to 7,322 nondeposit taking companies. The applications of 1,370 NBFCs had been rejected, while the applications of 26,744 companies were pending because they did not meet the minimum net-owned funds requirement.

8. The stock market performed very strongly between late 1998 and mid-February 2000, rising by over 100 percent. However, more recently, the market has weakened, declining by 30 percent from its mid-February high. With the strengthening of the secondary market, there has also been some recovery in the primary market. During the first nine months of 1999/00, private placements, which dominate equity issues, rose by 23 percent to Rs 415 billion, although funding raised by prospectus and rights issues declined to Rs 77 billion in 1999/00 from Rs 94 billion in 1998/99. Investments in mutual funds actually fell in 1998/99 due to the withdrawals from the Unit Trust of India (UTI) following the financial problems experienced by the U.S.-64 scheme in 1998.2 However, inflows into mutual funds strengthened during 1999/00 with the strong performance of the stock market and tax incentives offered in the 1999/00 budget.

9. Recently introduced legislation will allow private sector companies to enter the insurance industry, breaking the current public sector monopoly held by the General Insurance Company of India (GIC) and the Life Insurance Company of India (LIC). Under the new legislation, these private companies will be allowed to have up to 26 percent foreign ownership. In January 2000, the RBI issued draft guidelines for banks and financial institutions who wish to enter the insurance sector.

India: The Verma Report on Restructuring Weak Public Sector Banks

In February 1999 the RBI established a working group under the Chairmanship of M.S. Verma to establish criteria for assessing the strength of banks and to suggest measures for the revival of weak public sector banks. The Working Group submitted its report in October 1999.

To identify weak banks, the Committee suggested the use of seven parameters: the capital adequacy ratio; the coverage ratio (defined as the ratio of equity capital and loan loss provisions less nonperforming loans to total assets); the rate of return on assets; the net interest margin; the ratio of operating profit to average working funds; the ratio of costs to income; and the ratio of staff costs to income. For five of these parameters, the median of all public sector banks was suggested as the threshold, while 8 percent and 0.5 were suggested as the threshold for the capital adequacy and coverage ratios respectively. On this basis the Committee identified three weak banks and a further six that were “showing strong signs of distress and runned a high risk of slipping into the category of weak banks.”

For the three weak public sector banks, the working group recommended a revival strategy consisting of: (i) operational restructuring involving basic changes to work practices, the adoption of modern technology, and a significant reduction in the number of staff, primarily through Voluntary Retirement Schemes (VRSs); (ii) cleaning up of the balance sheets by transferring a portion of the nonperforming loans to an Asset Reconstruction Fund (ARF); and (iii) improved governance practices and managerial efficiency. The group recommended the establishment of a Financial Restructuring Authority with statutory backing to oversee the restructuring process of the three weak banks (and of other banks in the future if needed). The group also highlighted the importance of institutional reform, particularly changes in the legal system, to improve debt recovery mechanisms.

The overall cost of restructuring the three weak banks over the next three years was estimated by the working group to be of the order of Rs 5.5 billion, broadly equivalent to the capital injections the three banks have received since 1994. Of this, Rs 3 billion would go toward enhancing the capital of the banks, Rs 1 billion would finance the transfer of NPLs to the ARF, and the remainder would finance the staff rationalization measures and the upgrading of technology.


Prepared by Tim Callen.


See Chapter VII of the accompanying Selected Issues volume.