Narasimham Committee Report on Banking Reforms

Narasimham Committee Report on Banking Reforms!

In order to initiate the second stage of financial sector reforms, the then Finance Minister Mr. P. Chidambaram constituted the Committee on financial sector reforms headed by Mr. M. Narasimham, the former Governor of RBI. This is the second time M. Narasimham has headed a financial sector reform committee.

The first one set up in 1991 by the then Finance Minister Mr. Manmohan Singh went into all aspects of financial sector while the second one looked specifically at the banking sector.

The Committee which submitted its voluminous report to the Finance Minister Mr. Yashwant Sinha of the BJP-led government on 23rd April, 1998, had called for banking sector mergers and acquisitions and had observed that the central Bank’s role should be separated from being monetary authority to that of regulator of the banking sector.

The Committee recommended substantial dilution of government stakes in nationalized banks. The Committee also called for far reaching financial sector reforms. The Narasimham Committee on banking sector reforms favoured the merger of strong public sector banks and closure of some weaker banks if their rehabilitation was not possible.

Thus it favoured merger of strong banks as this would have a “multiplier effect” on industry.

At the same time, it argued against the merger of strong banks with the weak as it has negative impact on the asset quality of the stronger bank because of the “Contaminated portfolio” of the weak bank.

Underlining the need for dealing with the issue of weak banks separately, it recommended that for potentially viable weak banks, corrective measures such as recapitalisation be undertaken but only for those banks, where early or complete correction was not possible, alternative approaches including closure be carefully examined.

The executive summary of the report did not, however, make any suggestion regarding disinvestment of government equity in public sector banks. Suggesting a possible short term solution to weak banks, the report observed that the narrow banks could be allowed as a means of facilitating their rehabilitation.

Strategic revival plans formulated by some weak banks and approved by the Government and the RBI as well as memoranda of undertaking entered into by management and staff unions was indicative of this approach. The report observed, “The issue of closure will need to be examined if it were concluded that the narrow banks approach does not enable rehabilitation of some banks.”

Elaborating on the merger of strong banks the report observed that the mergers would be “meaningful and useful” only when they were not a mere arithmetical merger of balance sheets and staffs. The Committee has also called for an amicable golden handshake scheme for surplus banking sector staff.

Mergers would have to yield benefits in terms of staff and branch network without which they would tie down managements with operational issues and merely distract attention from the real issues without giving any commensurate benefits.

The Committee expressed concern over the rising non-performing assets of banks. Moreover, the Committee revived the idea of setting up an assets reconstruction fund to tackle the problem of huge Non- performing Assets (NPAs) of banks as recapitalisation of public sector banks was increasingly becoming expensive. “Such recapitalisation is costly and not sustainable over time.”

The report emphasised the need to consider enhancement of capital adequacy norms from the present level of eight per cent. But it did not prescribe by what percentage it should be raised. This is necessary as greater volatility in exchange markets and greater use of interest rate as an instrument of monetary policy have made the market or asset price risk of foreign assets and domestic investments “considerable”.

Referring to the currency crisis in Southeast Asian Countries, the report said it had only reinforced the fact that a strong and efficient financial system was necessary to strengthen the domestic economy and make it more efficient so as to meet the challenges posed by financial globalisation.

Building such a system constituted the unfinished agenda of financial sector reforms of which the banking sector accounted for 80 per cent of the funds. The Committee further observed that the developments in South East Asian nations underscored the importance of a strong domestic financial system.

The report further observed that there is also need to impart greater competition between public sector banks and private sector banks. Thus the second report submitted by Narasimham Committee has touched many new areas of banking sector for their necessary reform although in some areas the Committee’s recommendations were almost identical to the one it had submitted in its first report in 1991.

Thus some of the recommendations of the Narasimham Committee’s second report such as closure of weak banks, merger of strong public sector banks, substantial dilution of the government stakes in nationalized banks etc. have evoked stiff resistance from trade unions of bank employees—but it these are implemented with caution, they are bound to change the lot of the banking sector favorably.

In addition to major structural changes in the banking sector, the Committee report envisaged infusion of capital to meet higher and unspecified levels of capital adequacy and reductions in the volume of targeted credit.

While the first phase of banking sector reforms has rescued the banks out of drowsiness or slumber, the second phase of banking reforms brought competitive existence for its viable units. Success of the second phase of reforms depends mainly on the organisational effectiveness of banks to be initiated by banks themselves.

While attaining strong fundamental commercial viability, banker’s performance cannot be reflected by the number of branches and the volume of deposits and credits rather it is depending on organisational efficiency.

Main factor responsible for low profitability levels in banks is its high level of non-performing assets (NPAs). The report suggested to keep the NPAs at the lower levels. Among all the banks with large NPAs, the State Bank of India group was at the top with NPAs worth Rs 14,367 crore and the others maintained the level of NPAs to the extent of Rs 29,207 crore.

In order to improve the performance of the banking system, the Narasimham Committee in its second report has suggested for creation of Asset Reconstruction Fund (ARF) so as to reduce the high level of NPAs, impairing the viability as well as working of the public sector banks.

The report seriously opposed the policy of recapitalization of banks through infusion of capital by the Government. The committee observed that the system is “costly and over time, not a sustainable option”. It is also true that the provision for the flow of huge budgetary funds to recapitalize banks in the public sector is making them complacent, irresponsible and unaccountable over the years.

The Committee argued in favour of mergers among the strong banks for strengthening of these units and also to pave the way for greater opportunities, for competition. Here the very criterion for merger puts emphasis on creation of 2-3 banks with international orientation and 8-10 large banks with national base and character so as to take care of large and medium corporate sectors.

Besides, the third set of local banks has been suggested so as to cater to the requirements of small enterprises.

Although there is some degree of justification to build up an Indian mega bank to play a major role in international market and to maintain other two sets of banking set up in the national market but in the context of developments in the global financial sector, a fresh restructuring of the entire banking industry through merger of stronger banks in India may not be done hastily which needs further testing and consideration.

In the mean time, such type of mergers followed in other countries have proved counter-productive. Japan is an example in this respect where a number of bank mergers done in the past have backfired. The east-Asian countries facing crisis are presently grappling with the problem to manage their over-sized banks.

Considering the notion of profitability and efficiency of the banking sector, the recommendations of the Narasimham Committee may have some good sense. But the Government would have to strike a difficult balance between profitability and meeting social objectives of banks.

Besides, it has to determine the crucial issue of ownership and autonomy. But there cannot be any compromise in respect of viability of bank branches.

Therefore, the un-remunerative branches have to be closed down so that the precious resources of the banking sector would not be wasted unnecessarily to maintain the existence of those un-remunerative banks like a monument and the social role of the banking sector can be performed effectively with these resources.

But the question that normally arises—will the Central Government in power be able to take courageous step to close the weak banks, or to shed of surplus staff existing in the banking sector? Answering this question is a difficult task and only time can show the path in right direction. But too much delay in taking such policy decisions would jeopardies the viability of the entire banking sector.

Meanwhile, the working Group for harmonizing the role and operations of development financial institutions (DFIs) and banks, led by the IDBI Chairman-cum-Managing Director S.N. Khan recommended a progressive step in the direction of universal banking and suggested to develop a regulatory framework for achieving the said objective.

The report submitted by the RBI Group on April 24, 1998 suggested a gradual elimination of boundaries between the banks and DFIs on its assets and liabilities side. Thereby it suggested to give full banking licence to the DFIs and the same has to be regulated as per the recommendations of the Narasimham Committee.

The Working Group led by Khan has also mooted an idea to merge the banks and DFIs as well. The restructuring process of the banking sector will remain incomplete unless other wings of the banking sector comprised of regional rural banks (RRBs) and co-operative banks are also included in this process.