Final PHD Commerce Thesis PDF

IMPACT OF FINANCIAL SECTOR REFORMS ON
INDIAN ECONOMY
A
THESIS
SUBMITTED TO THE HIMACHAL PRADESH UNIVERSITY, SHIMLA

FOR THE AWARD OF THE DEGREE OF
DOCTOR OF PHILOSOPHY
IN
COMMERCE
(2015)
Supervised by: Submitted by:
Dr. Vijay Kumar Sharma Neeraj Kumar

Professor
DEPARTMENT OF COMMERCE
FACULTY OF COMMERCE AND MANAGEMENT
HIMACHAL PRADESH UNIVERSITY
SHIMLA-171005 (INDIA)
DEPARTMENT OF COMMERCE
HIMACHAL PRADESH UNIVERSITY
SUMMER HILL, SHIMLA-171005
Dr. Vijay Kumar Sharma

Professor
Dated:…………………
CERTIFICATE
Certified that the thesis entitled “IMPACT OF FINANCIAL

SECTOR REFORMS ON INDIAN ECONOMY” Submitted by
Mr. Neeraj Kumar has been carried out under my Supervision and
guidance.
The data reported in it is genuine. The references and help taken

from various sources have been duly acknowledged. It is further
certified that no part of the thesis has been submitted in full or in
part of any other degree or diploma of any University. The thesis is
worthy of the consideration for the award of degree of Doctor of
Philosophy in Commerce.
(Dr. Vijay Kumar Sharma)

Professor
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3. JOURNALS/NEWS PAPERS/MAGAZINES
Abstracts of Working Papers in Economics, Published by Cambridge

University Press.
American journal of Agricultural Economics, Published by Oxford Journals, A
Division of Oxford University Press.
Asian Journal of Research in Banking and Finance, Published by Asian

Research Consortium.
Asian Journal of Research in Business Economics and Management, Published

by Asian Research Consortium.
Business Standard
Cambridge Journal of Economics, Published by Oxford Journals, A Division of

Oxford University Press
Chartered Secretary- The Journal for Corporate Professionals, The Institute of

Company Secretaries of India, New Delhi
Compendium of Working Papers and Articles, Conference presentations and

Working Papers for 2007-08, 2008-09, 2009-10 and 2010-11 by Faculty
of National Institute of Bank Management, Pune
Delhi Business Review, Published by Delhi School of Professional studies and

Research
Econometric Theory, Published by Cambridge University Press
Economic and Political weekly- A Sameeksha Trust Publication, Mumbai
Finance India- The Quarterly Journal of Indian Institute of Finance, New Delhi
Financial History Review, Published by Cambridge University Press
IBA Bulletin (Monthly)- A Banking Journal Published by IBA, Mumbai.
Indian Journal of Economics- The Department of Economics and Commerce,

University of Allahabad, Allahabad
Journal of Commerce and Management Thought, Published by SSK Busilink

Journal of Financial and Quantitative Analysis, Published by Cambridge
University Press
Journal of Financial Econometrics, Published by Oxford Journals- A Division

of Oxford University Press
Journal of Management Research, Published by South Asia Publication on

Behalf of Management Science Association, Faculty of Management
Studies, University of Delhi, Delhi
Journal of Banking Financial Services and Insurance Research, Published by

Sri Krishna International Research and Educational Consortium
Kurukshetra- A Journal of Rurla Development, (Monthly Journal), Ministry of

Rural Development, New Delhi
Management of Innovation, Technology, Transfer and Flexibility for

Competitiveness in the Globalized World, Published by Gobal Institute of
flexible Systems Management.
Money and Finance, Published by ICRA Limited
Oxford Economics Papers, Published by Oxford Journals- A Division of

Oxford University Press
Prajnan- A Journal of Social and Management Sciences, Published by National

Institute of Bank Management, Pune.
Review of Finance, Published by Oxford Journals- A Division of Oxford

University Press
The Chartered Accountant- A Journal of the Institute of Chartered Accountants

of India, New Delhi
The Economic Times
The Financial Express

The Hindu
The Quarterly Journal of Economics, Published by Oxford Journals- A

Division of Oxford University Press
The World Bank Economic Review, Published by Oxford Journals- A Division

of Oxford University Press
Vinimaya- A Journal of Social and Management Sciences, Published by

National Institute of Bank Management, Pune
World Trade Review, Published by Cambridge University Press.
Yojana- A Development Monthly, Published by Ministry of Information and

Broadcasting, Government of India, Patiala House, New Delhi
4. REPORTS
-------- (1972), Report of the Banking Commission.
-------- (1985), Report of the Ghosh Committee to Consider Final Accounts of

Banks, Reserve Bank of India.
-------- (1991), Report of the Committee on Financial System, (Chairman: M.

Narasimham, Committee-I), Reserve Bank of India.
-------- (1991), Report of the Committee on Financial System, (Chairman:

M.Narasimham, Committee-I), Reserve Bank of India.
-------- (1991), Report of the Shere Committee for Proposing Legislation on

Electronic Funds Transfer and Electronic Payments, Reserve Bank of
India.
-------- (1991), Report of the Shetty Committee on the Customer Service in

Banks, IBA Publication.
-------- (1998), Report of the Committee on Banking Sector Reforms,

(Chairman: M. Narasimham, Committee-II), Reserve Bank of India.
-------- (1999), Report of the Committee on Technology Up-gradation in the
Banking Sector, (Chairman: A. Vasudevan), Reserve Bank of India.
-------- (1999), Report of the Working Group to Explore the Possibilities of

Setting up of Credit Information Bureau, (Chairman: N.H. Siddiqui),
Reserve Bank of India.
-------- (2002), India-Financial Sector Strategy, Washington DC.
-------- (2002), Report of the Working Group to Examine the Role of Credit
Information Bureau in Collection and Dissemination of Information on
Suit-filed accounts and Defaulters, (Chairman: S.R.Iyar), Reserve
Bank of India.
-------- Government of India (1985), Report of Chakravartee Committee to

Review the Working of Monetary System, Reserve Bank of India.
-------- Government of India (1991), Report of the Goiporia Committee on

Customer Service in Banks, IBA Publication.
-------- Government of India (2009), A Hundred Small Steps, Report of the

Committee on Financial Sector Reforms, Planning Commission.
Government of India, Economic Survey (various issues), Ministry of

Finance, economic division.
5. RBI PUBLICATIONS
Banking Statistics- Quarterly Handouts, RBI Publication, Mumbai.
Branch Banking Statistics, Volume-I, March, 1999 published by RBI,

Mumbai.
Branch Banking Statistics, Volume-II, March, 2001 published by RBI,

Mumbai.
Branch Banking Statistics, Volume-III, March, 2002 published by RBI,

Mumbai.
Expenditure pattern and IT initiatives of Banks, RBI Bulletin, December
2002. RBI – Occasional Papers (various issues).
Report on Currency and Finance (various issues) published by RBI,

Mumbai.
Report on Trend and Progress of Banking in India (various issues), RBI

Publication, Mumbai.
Statistical Tables Relating to Banks in india – 1979-2007 in CD-ROM

format.
Statistical Tables Relating to Banks in India (various issues), RBI

Publication, Mumbai.
6. IBA PUBLICATIONS
Banking Glossary 2010, Published by IBA.
Database on Indian Banking 1987-1998, IBA Publication, Mumbai.
Financial Analysis of Banks (various issues), IBA Publication, Mumbai.
Guidelines on Storage of Electronic Records in Business
IBA Bulletin (various issues)
IBA Bulletin (various Special issues)
Indian Banking at a Glance (various issues), IBA Publication, Mumbai.
Indian Banking Year Book (various issues), IBA Publication, Mumbai.
KYC Norms and AML Standards, July 2009.
Performance Highlights of Banks (various issues), IBA Publication,

Mumbai.
The Indian Banker, A Monthly Journal published by IBA.

ACKNOWLEDGEMENT
Words cannot be adequate to express ones gratitude to the teachers, colleagues,

friends, relatives and well wishers. Yet I would like to express my heartfelt gratitude
to all who render their valuable and generous help in their own ways.
The study embodied in this thesis has been carried out under the supervision of
Dr. Vijay Kumar Sharma, faculty member of Commerce and Management Studies,
Himachal Pradesh University, Shimla. I am highly indebted to him for his unstinted
co-operation in the preparation of this work. In spite of his pre-occupations and
engagements, he has spared his precious time, evinced keen interest and meticulous
care at every stage of my study. His able guidance, inspiration, encouragement and
support helped me a lot during the critical periods of my study. I owe him much more
than I can render in words.
I wish to express my deep sense of core gratitude and indebtedness to all faculty
members of department of Commerce and Management Studies, Himachal Pradesh
University, Shimla, who have been kind enough to go through the entire work by way
of giving fruitful suggestions.
I should render my profound respect and eternal gratitude to all the professors who are
not named but from whom I received their advice at different stages of this work. I
also wish to express my gratitude to the administrative staff of the Department of
Commerce and Management Studies who helped and supported me at various stages
of my study.
I am thankful for providing the necessary information for the present work, which
became available because of library staff co-operation of Himachal Pradesh
University, Shimla.
I am highly thankful to the library staff of Delhi School of Economics, Delhi

University, Panjab University, Chandigarh, Punjabi University, Patiala for allowing
me to avail the library facility during the course of this work.
i
I acknowledge my deep sense of gratitude to Dr. Hem Raj Vohra, Principal Smt.
Jawala Devi College of Education, Sanghol, Dist- Fatehgarh Sahib, Punjab, who
constantly inspire, motivate and encouraged me a lot during my work.
I would also like to acknowledge the help, support and Constructive criticism so
generously offered by many friends, relatives and colleagues of mine to enable me to
carry out this work.
Finally I am extremely thankful to my family members for having inconvenience

caused during the preparation of this work and particularly for their moral support at
difficult times of my study. Their patience, encouragement and co-operation enabled
me to devote myself to complete this work even at the cost of my domestic
responsibilities.
Neeraj Kumar
ii
PREFACE
The financial sector is a set of complex and closely connected or interlined

institutions, agents, practices, markets, transactions, claims, and liabilities in the
economy that work together to provide funds for different economic activities. A
financial sector helps to promote savings and appropriately allocate the available
funds. It is concerned about money, credit and finance, closely correlated yet different
from each other. Money refers to the means of payment or medium of exchange for
anything and it also serves as a store of value. Money consists of coins, notes and
deposits with banks withdrawal on demand. It is the liability of the banking system.
Credit/loan means a sum of money lend by one party to another to be returned with
interest. It is asset for the lender of the lending institution and liability for the holding
person. Finance is the monetary resources for funding the various activities. It
includes debt and owner funds of an economic entity.
The relationship between finance and economic development is a long debated issue.
There is a long list of economists who stress the importance of a sound financial
sector for economic growth. Though the branches, deposits and credits of the
commercial banks registered an unprecedented quantitative growth in post
nationalisation period yet, it was observed that over a period of time certain inherent
weaknesses have cropped up in the Indian banking system. Banks, other financial
institutions and financial markets were all operating in a highly controlled regulated
environment in the period before 1980s. Some steps towards liberalisation were taken
during 1980s. In 1991, wide ranging economy wide reforms were undertaken. In
August, 1991, the government of India appointed a committee on the financial sector
under the chairmanship of Shri. M. Narasimham, a former Governor of RBI. The
committee was to examine the existing structure of the financial system and its
various components and to make recommendations for improving the efficiency and
effectiveness of the system with particular reference to the economy of operations,
accountability and profitability of commercial banks and financial institutions (Report
of the committee on the financial system, 1992). The Report of the Narasimham
Committee-II in 1998 provided the road map for the second-generation reform
process.
iii
Since the initiation of the reforms in 1991, almost two and half decades have been
completed. It is therefore desirables to evaluate the response of banks and stock
markets to various reform measures and to assess the performance and relationship
between financial sector development and economic growth. It is also important to
check the direction of causality that financial development leads to economic growth
or economic growth leads to financial development.
The whole study has been divided into three sections. In the first section, first chapter
deals with meaning and role of the banking sector in the economic development of the
Indian economy. Various reforms have been discussed in this chapter. The second
chapter brings the review of literature based on the library and online research. The
third chapter brings the need, scope, objectives, limitations and research methodology
used in the study.
The second section comprises three chapters. In the fourth chapter, a comparative
analysis has been done for the banking sector development in the pre and post- reform
periods, performance of the Indian financial institutions also has been analysed. The
last section of this chapter analysed the relationship among banking sector
development and economic growth in India along with the direction of causality. In
the fifth chapter, growth of the Indian financial markets, the relationship between
stock market development and economic growth in India along with the direction of
causality is analysed in the post-reform period. In the sixth chapter, relationship
among banking sector development, stock market development and economic growth
in India is analysed along with the direction of causality.
The third section comprises seventh chapter which summarises the findings and
conclusions of the present research and offer suggestions to make the banking system,
stock markets more efficient and profitable so that they can affect economic growth
positively.
NEERAJ KUMAR
iv
CONTENTS
CERTIFICATE
ACKNOWLEDGMENT
PREFACE
LIST OF CONTENTS
LIST OF TABLES
LIST OF FIGURES
LIST OF ABBREVIATION
Chapter Title Page No.
CHAPTER 1: INTRODUCTION 1–75

1.1 The Financial Sector 1–2
1.2 Components of Indian Financial Sector 2–7
1.3 Functions of Financial Sector 7
1.4 Role of Financial Sector in Economic Development 7–12
1.5 Evolution of Commercial banks in India 12–18
1.6 Rationale of Banking Sector reforms 19–23
1.7 Objectives of Financial Sector Reforms 23–24
1.8 Commercial banking reforms in India 24–67
1.9 Structure of Indian commercial banks 67–68
1.10 Conclusion 69–71
References 72–75
CHAPTER2 : REVIEW OF LITERATURE 76–112

2.1 Introduction 76–104
References 106–112
CHAPTER 3: RESEARCH METHODOLOGY 113–145

3.1 Need of the study 113–116
3.2 Scope of the study 117–121
3.3 Objectives of the study 121
v
3.4 Hypothesis 121–122
3.5 limitations of the study 122–123
3.6 Data sources 123
3.7 Methodology 123–125
3.8 Econometric methodology 126
3.8.1 The determinants of growth 126–128
3.8.2 Variables in the model 128–132
3.8.3 Time series analysis 132–142
3.9 Scheme of the study 142
CHAPTER4: BANKING SECTOR DEVELOPMENT

ECONOMIC GROWTH IN INDIA: PRE
AND POST FINANCIAL SECTOR REFORMS146–274
4.1 Indicators of banking sector development 146
4.1.1 Gross Domestic Savings 146–151
4.1.2 Gross Domestic Capital Formation 151–155
4.1.3 Deposits 155–160
4.1.4 Deposits of non banking companies (NBCs) 160–163
4.1.5 Deposits area wise 163–167
4.1.6 Institutional finance/ Credit 167–171
4.1.7 Credit Area Wise 172–175
4.1.8 Density of the financial system 175–178
4.1.9 Branch Expansion 179–182
4.2 Comparative performance of banks in pre and 183
post-financial sector reforms
4.2.1 Total Deposits 183–189
4.2.2 Total Advances 189–195
4.2.3 Total Business 195–201
4.2.4 Total Assets 201–207
4.2.5 Total income 207–213
4.2.6 Profitability 213–217
4.2.7 Non Performing assets (NPA) / Advances 217–221
4.2.8 Capital Adequacy 222–224
4.2.9 Productivity 225
vi
4.2.9.1 Ratio of intermediation cost to total assets (ICR): 225–228
4.2.9.2 Operating profit to wage bill 228–231
4.2.9.3 Business per employee/ labour inputs 231–234
4.2.10 Competition 234–238
4.3 Relationship between Banking Sector Development 239
and Economic Growth
4.3.1 Variables and methodology 239–240
4.3.2 Results for the Total period (1968-2013) 240–251
4.3.2.1 Existence of Structural Break 251
4.3.3 Pre financial sector reform period (1968-1991) 251–258
4.3.4 Post financial sector reform period (1992-2013) 258–267
4.4 Direction of Causality 267–271
4.5 Conclusion 271
CHAPTER 5 : STOCK MARKET DEVELOPMENT AND
ECONOMIC GROWTH 275–325

5.1 Importance of Financial Markets 275–277
5.2 The Stock Market in India: Organisation and Structure 277–279
5.3 Objectives of Stock Market Reform 279
5.4 Reforms in Indian Stock Market 279–285
5.5 Recent reforms 285–294
5.6 Impact of reforms 294
5.6.1 Size of the market 294–296
5.6.2 Marker Capitalisation Ratio 296–298
5.6.3 Liquidity 298–301
5.6.4 Volatility 301–305
5.7 Relationship between Stock market development and economic
growth 305–308
5.7.1 Variables and methodology 308
5.7.2 Result of the analysis 308–319
vii
CHAPTER 6 : RELATIONSHIP BETWEEN FINANCIAL
DEVELOPMENT AND ECONOMIC GROWTH 326–375
6.1 Financial Development 326–328
6.2 Economic growth 328–331
6.3 Role of Financial Development in Economic Growth 331–332
6.4 Relationship between Financial Development and Economic 332–333
growth
6.5 Variables and methodology 334–335
6.6 Results for the entire period (1968-2013) 336–346
6.7 Existence of Structural Break 346
6.8 Results for Pre- reform period (1968-1991) 347–354
6.9 Results for Post- reform period (1992-2013) 355–363
6.10 Discussion of the results 363–366
6.12 Conclusion 372
CHAPTER 7 : CONCLUSION AND SUGGESTIONS 376–403

7.1 An overview 376
7.2 Banking sector development 376–388
7.3 Stock Markets Development 388–390
7.4 Relationship between Financial Sector development and economic
growth 390–394
7.6 Suggestions 396–401
BIBLIOGRAPHY
viii
LIST OF TABLES
Table Title of Tables Page No.

No.
3.1 Rank of matrix and its implications 137
4.1.1 Gross Domestic Savings as percentage of GDP 148
4.1.2 Regression Coefficients and Growth Rate for Savings 150
4.1.3 Gross Domestic Capital Formation as percentage of 152
4.1.4 Regression Coefficients and Growth Rate for Gross Domestic 154
Capital Formation
4.1.5 Deposits of Scheduled Commercial Banks 156
4.1.6 Deposits of the Banking System (1970-71 to 1990-91) 157
4.1.7 Deposits of the Banking System (1991-92 to 2012-13) 158
4.1.8 Regression Coefficients and Growth Rate for Deposits 160
4.1.9 Deposits of NBCs. 161
4.1.10 Deposits of NBFCs. 162
4.1.11 Deposits area wise 164
4.1.12 Regression Coefficients and Growth Rate for area wise 166
Deposits
4.1.13 Rate of institutional finance to the private sector 169
4.1.14 Regression Coefficients and Growth Rate for 171
Institutional Finance to the Private Sector
4.1.15 Credit area wise as percentage to total credit 172
4.1.16 Regression Coefficients and Growth Rate for area wise Credit 174
4.1.17 Density of the Financial System 176
4.1.18 Regression Coefficients and Growth Rate for Density of 178
Financial System
4.1.19 Population Group wise branches of Scheduled Commercial 179
Banks as percentage to total scheduled commercial banks
4.1.20 Regression Coefficients and Growth Rate for branches of 181
SCBs
4.2.1 Bank Group Wise Trend Values, Regression Coefficients and 184
Growth Rate for Deposits (1980-1991)
ix
Growth Rate for Advances (1980-1991)
Growth Rate for Total Business (1980-1991)
Growth Rate for Total Assets (1980-1991)
Growth Rate for Total Income (1980-1991)
4.2.16 Operating profit as percentage of total assets (1980-2013) 214
4.2.17 Non Performing assets of scheduled commercial banks as 219
percentage of net advances
4.2.18 Capital Adequacy Ratio I (CRAR) 223
4.2.19 Capital Adequacy Ratio II 224
x
4.2.20 Ratio of intermediation cost to total assets of scheduled 226
commercial banks ( 1980-2013)
4.2.21 Operating profit per employee 229
4.2.22 Business per employee 232
4.2.23 Net interest margin /total assets 237
4.3.1 Descriptive Statistics of variables (1968-2013) 240
4.3.2 Results of Unit Root Test for the entire period (1968-2013) 242
4.3.3 VAR Lag order Selection Criteria for the entire period 243
( 1968-2013)
4.3.4 Trace Cointegration Rank Test (1968-2013) 244
4.3.5 Maximum Eigenvalue Cointegration Rank Test(1968-2013) 244
4.3.6 Long Run Relationship (1968-2013) 245
4.3.7 Short run relationship (1968-2013) 246
4.3.8 Diagnostic Test Result of Economic Growth and Financial 248
Development
4.3.9 Chow Test Result (1968-2013) 251
4.3.11 Results of unit root test for pre-reform period (1968-1991) 253
4.3.12 VAR Lag order Selection Criteria (1968-1991) 254
4.3.14 Maximum Eigenvalue Cointegration Rank Test(1968-1991) 255
4.3.15 Short run relationship during pre reform period (1968-1991) 255
4.3.16 Diagnostic Test Result (1968-1991) 256
4.3.17 Descriptive statistics of variables during post reform period 259
(1992-2013)
4.3.18 Results of Unit Root Test for post-reform period (1992-2013) 261
4.3.19 VAR Lag order Selection Criteria(1992-2013) 262
4.3.21 Maximum EigenvalueCointegration Rank Test (1992-2013) 263
xi
4.4.1 VAR Granger Causality/Block Exogeneity Wald Tests Result 268
(1968-2013)
(1968-1991)
(1992-2013)
5.6.1 Number of listed companies 295
5.6.2 Market Capitalisation Ratio 297
5.6.3 Liquidity ratios 299
5.6.4 Volatility Index 303
5.6.5 Volatility of International Stock Indices, 2013 (percentages) 304
(1992-2013)
5.7.2 Unit root test (1992-2013) 311
(1992-2013)
6.2.1 Gross Domestic product at factor cost 330
6.6.2 Results of Unit Root Test for the entire period (1968-2013) 338
6.6.3 VAR Lag order Selection Criteria for the entire period 339
(1968-2013)
6.6.4 Trace Cointegration Rank Test(1968-2013) 340
6.6.5 Maximum Eigenvalue Cointegration Rank Test (1968-2013) 340
6.6.8 Test Results for Serial Correlation (1968-2013) 343
6.6.9 Test Results for Heteroscedasticity: ARCH Test (1968-2013) 344
xii
6.7.1 Chow Test Result (1968-2013) 346
6.8.2 Results of unit root test for pre reform period (1968-1991) 349
6.8.5 Maximum Eigen value Cointegration Rank Test(1968-1991) 351
6.8.6 Short run relationship during pre reform period (1968-1991) 351
6.8.7 Test Results for Serial Correlation (1968-1991) 353
6.8.8 Test Results for Heteroscedasticity ARCH Test(1968-1991) 353
(1992-2013)
6.9.2 Unit root test (1992-2013) 357
6.9.6 Long Run Relationship, Dependent variable is LNEGFC 359
(1992-2013)
6.9.8 Test Results for Serial Correlation(1992-2013) 361
6.9.9 Test Results for Heteroscedasticity ARCH Test(1992-2013) 362
(1968-2013)
(1968-1991)
(1992-2013)
xiii
LIST OF FIGURES
Figure No. Title of figure Page No.
1.1 Schedule Banking Structure in India as on March, 2013 67
4.1.1 Savings as percentage of GDP 149
4.1.2 Gross Domestic Capital Formation as percentage of GDP 153
4.1.3 Bank Deposits as percentage to GDP 159
4.1.4 Deposits of NBFCs 163
4.1.4(a) Deposits area wise 165
4.1.5 Rate of institutional finance to the private sector 170
4.1.6 Credit area wise as percentage to total credit 173
4.1.7 Density of the Financial System 177
4.1.8 Population Group wise branches of Scheduled Commercial 180

Banks as percentage to total scheduled commercial banks
4.2.1 Operating profit as percentage of total assets 215
4.2.2 Non-performing assets of scheduled commercial banks 221

as percentage of net advances
4.2.3 Ratio of intermediation cost to total assets 227
4.2.4 Operating profit per employee 230
4.2.5 Business per employee 233
4.2.6 Net interest margin /total assets 238
4.3.1 Line graph of the variables (1968-2013) 241
4.3.2 Plot of Cumulative Sum of Recursive Residuals (1968-2013) 250
4.3.3 Plot of Cumulative Sum of Squares of Recursive Residuals 250

(1968-2013)
4.3.4 Line graph of variables (1968-1991) 252

(1968-1991)
xiv

(1992-2013)
5.6.1 Number of listed companies 296
5.6.2 Market Capitalisation Ratio 298
5.6.3 Liquidity Ratios 300
5.6.4 Volatility index 304

(1992-2013)
6.2.1 331
Gross Domestic product at factor cost
6.6.1 Line graph of the variables (1968-2013) 337
6.6.2 Histogram normality test of Jarque-Bera (1968-2013) 344

(1968-2013)
6.8.1 348
Line graph of variables (1968-1991)
6.8.2 Histogram normality test (1968-1991) 352

(1968-1991)
6.9.2 Histogram Normality test (1992-2013) 362

(1992-2013)
xv
LIST OF ABBREVIATIOINS
ADF Augmented Dickey-Fuller

ADR American Depository Receipts
AFC Asset Finance Company
AIC Akaike information criterion
AIFIs All India Financial Institutions
AIFs Alternate Investment Funds
AML Antimony Laundering
ANBC Adjusted Net Bank Credit
ARC Asset Reconstruction Company
ARCH Autoregressive Conditional Heteroscedasticity
ARDL Autoregressive Distributed Lag
ARFs Asset Reconstruction Funds
ATM Automated Teller Machine
BCA Business Correspondent Agents
Bank of International Settlement's Committee on Banking
BCBS
Supervision
BCBS Basel Committee on Banking Supervision
BCPS Bank Credit to Private Sector
BCs Business Correspondents
BFS Board for Financial Supervision
BIS Bank for International Settlements
BOLT BSE Online Trading Platform
BPLR Basic Prime lending Rate
BSE Bombay Stock Exchange
CBS Core Banking Solutions
CCB Capital Conservation Buffer
CCFS Committee on Comprehensive Financial Services
CCI Controller of Capital Issues
CCP Central Counter Party
CDs Certificate of Deposits
CDS Credit Default Swaps
xvi
CDSL Central Depository Services Limited
CE Cointegrating Equations
CFT Combating the Financing of Terrorism
CIC Core Investment Companies
CMS Capital Market Segment
COD commercial operations date
CoR Certificate of Registration
CP Commercial Paper
CRAR Capital to Risk Weighted Assets Ratio
CRAs Credit-Rating Agencies
CRR Cash Reserve Ratio
CTT Commodities Transaction Tax
CUSUM Cumulative Sum
CUSUMSQ Cumulative Sum of Squares
CV Critical Values
DBT Direct Benefit Transfer
DCA Department of Company Affairs
DCP Directed Credit Programme
DEA Department of Economic Affairs
DFIs Developmental Financial Institutions
DRs Depository Receipts
DRT Debts Recovery Tribunal
ECBs External Commercial Borrowings
ECM Error Correction Model
ECT Error Correction Term
EFT Electronic Fund Transfer
FATF Financial Action Task Force
FCCB Foreign Currency Convertible Bonds
FCNR[B] Foreign Currency Non-Resident Bank Account
FDI Foreign Direct Investment
FI Financial Inclusion
FIIs Foreign Institutional Investors
FMOLS Fully Modified Ordinary Least Squares
xvii
FPI Foreign Portfolio Investor
FSB Financial Stability Board
FSDC Financial Stability and Development Council
FSLRC Financial Sector Legislative Reforms Commission
GCC General Credit Cards
GDCF Gross Domestic Capital Formation
GDP Gross Domestic Product
GDR Global Depository Receipts
GIC General Insurance Corporation
GMM Generalized Method of Moment
GOI Government of India
G-Secs Government Securities
HQ Hannan-Quinn information criterion
IC Investment Company
ICR Intermediation Cost Ratio
IDBI Industrial Development Bank of India
IDF Infrastructure Debt Fund
IDFNBFC Infrastructure Debt Fund- Non- Banking Financial Company
Institute for Development and Research in Banking
IDRBT
Technology
IFC International Financial Statistics
IFCI Industrial Finance Corporation of India
IFCs Infrastructure Finance Companies IFCs
IMF International Monetary Fund
INFINET Indian Financial Network
IRF Interest Rate Futures
IVCF IFCI Venture Capital Funds
JLGs Joint Liability Groups
KCC Kisan Credit Cards
KYC Know Your Customer
LABs Local Area Banks
LC Loan Company
LIBOR London Interbank Offered Rate
xviii
LIC Life Insurance Corporation
LM Lagrange Multiplier
LNCR Natural Log of Credit,
LNEGFC Natural Lag of Economic Growth at Factor Cost,
LNGDCF Natural Log of Gross Domestic Capital Formation.
LNMCR Natural Log of Market Capitalisation Ratio,
LNVTR Natural Log of Value Traded Ratio.
LTV Loan-To-Value
MCA Ministry of Corporate Affairs
MCR Marker Capitalisation Ratio
MFs Mutual Funds
MoUs Memorandum of Understandings
MSE Micro and Small Enterprises
MSMEs Micro, Small and Medium Enterprises
MTC Minimum Total Capital
NABARD National Bank for Agriculture and Rural Development
NBC Non Banking Companies
NBFC Non Banking Finance Companies
NBFC-MFI Non Banking Financial Company-Micro Finance Institution
NBFI Non Bank Financial Intermediaries
NBNFC Non Bank Non Financial Companies
NBs Nationalised Banks,
NBSFOs Non Banking Statutory Financial Organisations
NEAT National Exchange for Automated Trading
NHB National Housing Bank
NIM New Issue Market
NOF Net Owned Funds
NPAs Non Performing Assets
NRETM Non-Resident External Term Deposits
NSCCL National Securities Clearing Corporation Ltd.
NSDL National Securities Depository Limited
NSE National Stock Exchange
OBE Off Balance Sheet Exposures
xix
OLS Ordinary Least Squares
OTCE Over The Counter Exchange of India
PACS Primary Agricultural Cooperative Credit Societies
PCA Principal Component Analysis
PM Primary Market
PMJDY Pradhan Mantri Jan-DhanYojana
PoS Points of Sale
PP Philips Perron
PPP Public Private Partnership
PSB Private Sector Banks,
QFIs Qualified Foreign Investors
RBI Reserve Bank of India
RIDF Rural Infrastructure Development Fund
RRBs Regional Rural Banks
RWA Risk Weighted assets
Securitization and Reconstruction of Financial Assets and
SARFAAESI
Enforcement of Security Interests
SBG State Bank of India and its associates,
SBI State Bank of India
SCBs Scheduled Commercial Banks
SEBI Securities and Exchange Board of India
SFCs State Financial Corporations
SHG Self Help Groups
SIC Schwarz Information Criterion
SIDBI Small Industries Development Bank of India
SIDCs State Industrial Development Corporation
SLR Statutory Liquidity Ratio
SM Secondary Market
SMC Stock Market Capitalisation
SMEs Small and Medium Enterprises
SOEs State-Owned Enterprises
SOI Statement of Intent on Annual Goals
SSI Small Scale industries
xx
STT Securities Transaction Tax
T-Bill Treasury Bills
TFCI Tourism Finance corporation of India
TFP Total Factor Productivity
TS Test Statistics
USB Ultra Small Branches
UTI Unit Trust of India
VAR Vector Autoregressive
VECM Vector Error Correction Model
VTR Value Traded Ratio
WALR Weighted Average Lending Rate
WDMS Wholesale Debt Market Segment
WHT Withholding Tax
xxi
CHAPTER-1
INTRODUCTION
Finance is the life blood of the process of economic growth. ‗Money makes the mare
go‘ is an age old good saying which is applicable to all times. Economic growth and
development of any country depends upon a well-knit financial sector. Financial
sector comprises a set of sub-systems of financial institutions, financial markets,
financial instruments and services which help in the formation of capital. It provides a
mechanism by which savings are transformed into investments and it can be said that
financial sector play a significant role in economic growth of the country by
mobilizing surplus funds and utilizing them effectively for productive purpose. The
financial sector is characterized by the presence of integrated, organized and regulated
financial markets, institutions that meet the short term and long term financial needs
of both the household and corporate sector. Both financial markets and financial
institutions play an important role in the financial sector by rendering various
financial services to the community. They operate in close combination with each
other. This chapter deals with the meaning, functions and components of the financial
sector, evolution of commercial banking in India, role of financial sector and
commercial banks in economic development, rationale of banking sector reforms and
various banking sector reforms in India.
1.1 The Financial Sector
The financial sector is a set of complex and closely connected or interlined

institutions, agents, practices, markets, transactions, claims, and liabilities in the
economy that work together to provide funds for different economic activities.
Financial sector include complex institutional arrangements for mobilising financial
surplus from the people and transfer these to the deficit spenders. The institutional
arrangements includes all conditions and mechanism governing production,
distribution, exchange and holding of financial assets of various types and the
organisations as well as manner of operations of financial markets and institutions.
A financial sector helps to promote savings and appropriately allocate the available
funds. It is concerned about money, credit and finance, closely correlated yet different
from each other. Money refers to the means of payment or medium of exchange for
anything and it also serves as a store of value. Money consists of coins, notes and
1
deposits with banks withdrawal on demand. It is the liability of the banking system.
Credit/loan means a sum of money lend by one party to another to be returned with
interest. It is asset for the lender of the lending institution and liability for the holding
person. Finance is the monetary resources for funding the various activities. It
includes debt and owner funds of an economic entity.
1.2 Components of Indian Financial Sector
India‘s financial sector is diversified and expanding rapidly. It comprises commercial

banks, insurance companies, non-banking financial companies, cooperatives, pension
funds, mutual funds and other smaller financial entities (RBI, 2013). Ours is a bank
dominated financial sector and commercial banks account for over 60 per cent of the
total assets of the financial sector followed by the Insurance. Other bank
intermediaries include Regional Rural Banks and Cooperative Banks that target under
serviced rural and urban populations. Many Non Banking Finance Companies
(NBFC) operate in specialized segments (leasing, factoring, micro finance,
infrastructure finance), though some can accept deposits. Pension provision covers 12
percent of the working population and consists of civil service arrangements, a
compulsory scheme for formal private sector employees, and private scheme offered
through insurance companies (IMF, 2013).
Indian financial sector consists of financial institutions, financial markets, financial

instruments and financial services. The following are the four main components of
Indian Financial system:
1. Financial institutions
2. Financial Markets
3. Financial Instruments/Assets/Securities
4. Financial Services.
Financial institutions
Financial institutions are business organisations involved in the business of sale and
purchase of the financial assets and provide various financial services to the society.
These can be classified on the basis of functions, geographical coverage, sector, scope
of activity or type of ownership. An important classification is intermediaries and
non-intermediaries.
2
Financial institutions are the intermediaries who facilitate smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of
the surplus units and allocate them in productive activities by promising a better rate
of return. They buy primary securities and sell secondary securities that are in general,
more acceptable to the surplus units. By transforming primary into secondary
securities they embody innovations in financial technology where separate asset-debt
preferences of lenders and borrowers are reconciled to the satisfaction of both parties.
Lenders get access to the wide variety of secondary securities with lower risk, greater
liquidity, lower associated transaction and information costs and a host of other
services. Borrowers are benefitted by availability of large pool of funds with greater
certainty and relatively low rate of interests.
There arises one question that how these intermediaries are able to offer the low risk
secondary securities when they buy primary securities that are more risky. The answer
lies in the law of large number, portfolio diversification and services of professional
management; all this becomes realisable only when operating at a large scale.
Intermediary houses can be further classified as Bank and Non Bank Financial
Intermediaries (NBFI). Banking intermediaries are like Reserve Bank of India (RBI),
commercial bank, cooperative banks etc. The banking intermediaries are different
from the non banking intermediaries in the following manner:
 They participate in economies payment mechanism i.e., provide
transaction services.
 Their deposit liabilities constitute a major part of economy money
supply.
 They can create deposits or credits, which is money.
There are many non banking intermediaries like Life Insurance Corporation (LIC),
Unit Trust of India (UTI) etc. are known as NBFI‘s. An important distinction between
banks and NBFI‘s is that banks are subject to legal reserve requirements. They can
advance credit by creating claims against themselves, while NBFI‘s can only lend out
of resources put at their disposal by savers.
The non-intermediary institutions like Industrial Development Bank of India (IDBI),
National Bank for Agriculture and Rural Development (NABARD) are involve in
loan business but their funds are not directly obtained from the savers. These have
3
come into existence because of government efforts to provide assistance for specific
purposes, sectors and regions. They are therefore also called Non Banking Statutory
Financial Organisations (NBSFOs).
Financial institutions also provide services to entities seeking advice on various issues
ranging from restructuring to diversification plans. They provide whole range of
services to the entities who want to raise funds from the markets elsewhere. Financial
institutions act as financial intermediaries because they act as middlemen between
savers and borrowers.
Financial Markets
Finance is a prerequisite for modern business and financial institutions play a vital
role in economic system. It's through financial markets, the financial system of an
economy works. Financial markets are significant component of the financial sector.
These refer to the institutions or arrangements that facilitate the transactions in
financial assets and credit instruments of different type as currency, cheques, bonds
etc. The market may not have a precise location. The participants of these markets are
financial institutions, agents, brokers, dealers, borrowers, lenders, savers etc. These
markets can be classified in a variety of ways as follows:
 Based on maturity structure, there are money market and capital market.
Money market is a source of short term funds (one year or less). It facilitates
adjustment of liquidity among its participants like bill market, interbank call
money market, working capital advances from commercial banks etc. Capital
market deals in long term and medium term claims. For example stock
markets, government bond market, and financial institution credit. For long
and medium term claims the maturity period is more than one year but in a
well developed financial system secondary markets assists for most of such
claims thus making them fairly liquid.
 Based on type of securities traded, there are primary and secondary markets.
Primary market or new issue market deals in new financial claims. Secondary
market deals in securities already issued. Although secondary markets do not
contribute directly to the supply of additional capital, they do so indirectly by
increasing the liquidity of the primary securities.
4
 According to nature of instrument traded, these markets can be classified as
debt, equity or financial services market. Debt market is that market where
lenders provide funds to borrowers for some specified period at fixed interest
rate. In equity market, ownership of tangible assets (as houses and share of
stocks) is bought and sold. Financial services market deals in services that
enhance the working of debt and equity markets. For example safety deposit
boxes, Automated Teller Machine (ATM) transactions, brokerage services etc.
No secondary market exists for financial services.
 Organised and unorganised markets, when financial transactions take place out
of well established exchanges or without systematic and orderly structure, in
an informal way it constitutes the unorganised markets. It is largely made up
of indigenous banks, money lenders, and activities not coordinated by RBI, or
any other authority. The formal structure constitutes the organised segment. It
is subject to the different type of regulations from the authorities from time to
time.
The main functions of financial markets are to facilitate, creation and allocation of
credit and liquidity; to serve as intermediaries for mobilization of savings; to assist
process of balanced economic growth; to provide financial convenience.
Financial Instruments
Another important constituent of financial sector is financial instruments. They

represent a claim against the future income and wealth of others. It will be a claim
against a person or an institution, for the payment of the some of the money at a
specified future date.
Financial instruments are those instruments which are used for raising resources for
corporate entities. The financial instruments may be capital market instruments or
money market instruments. The financial instruments that are used for raising capital
through the capital market are known as capital market instruments. These are
preference shares, equity shares, warrants, debentures and bonds. The financial
instruments which are used for raising and supplying money in a short period not
exceeding one year through various securities are called money market instruments.
For example treasure bills, gilt-edged securities, state government and public sector
instruments, commercial paper, commercial bills etc. Financial instruments differ in
5
terms of marketability, liquidity, reversibility, type of options, return, risk and
transaction cost. Financial instruments help the financial markets and financial
intermediaries to perform the important role of channelizing funds from lenders to
borrowers.
Financial Services
Efficiency of emerging financial sector largely depends upon the quality and variety
of financial services provided by financial intermediaries. The term financial services
can be defined as "activities, benefits and satisfaction connected with sale of money
that offers to users and customers, financial related value".
Financial services cater to the needs of financial institutions, financial markets and
financial instruments. Financial institutions serve individuals and institutional
investors. The financial institutions and financial markets help the financial system
through financial instruments. They require a number of services of financial nature in
order to fulfil the tasks assigned. The functioning of the financial system very much
depends on the range of financial services provided by the providers and their
efficiency.
Following are some of the functions of financial service institutions:
 These institutions not only help to raise the required funds but also assure the
efficient distribution and deployment of funds.
 They assist in deciding the financial mix.
 They extend their services up to the stage of servicing of lenders.
 They provide services like bill discounting, factoring of debtors, parking of
short term funds in the money market, e-commerce, and securitisation of debts
and so on to ensure an efficient management of funds.
 These firms provide some specialised services like credit rating, venture
capital financing, lease financing, factoring, mutual funds, merchant banking,
stock lending, depository, credit cards, housing finance, merchant banking and
so on. These services are generally provided by the banking companies,
insurance companies, stock exchanges and non-banking finance companies.
Financial services rendered by the financial intermediaries bridge the gap between
lack of knowledge on the part of investors and increasing sophistication of financial
instruments and markets. These financial services are vital for creation of firms,
6
industrial expansion and economic growth. Before investors lend money, they need to
be reassured that it is safe to exchange securities for funds. This reassurance is
provided by the financial regulators who regulate the conduct of the market, and
intermediaries to protect the investors‘ interest. The Reserve Bank of India (RBI)
regulates the Money Market and Securities and Exchange Board of India (SEBI)
regulates the Capital Market.
1.3 Functions of Financial Sector
A financial sector performs the following functions:

 It serves as a link between savers and investors. It helps in utilizing the
mobilized savings of scattered savers in more efficient and effective manner. It
channelizes flow of saving into productive investment.
 It assists in the selection of the projects to be financed and also reviews the
performance of such projects periodically.
 It provides payment mechanism for exchange of goods and services.
 It provides a mechanism for the transfer of resources across geographic
boundaries.
 It provides a mechanism for managing and controlling the risk involved in
mobilizing savings and allocating credit.
 It promotes the process of capital formation by bringing together the supply of
saving and the demand for investible funds.
 It helps in lowering the cost of transaction and increase returns. It reduces cost
which motivates people to save more.
 It provides detailed information to the operators/ players in the market such as
individuals, business houses, Governments etc.
1.4 Role of Financial Sector in Economic Development
The relationship between finance and economic development is a long debated issue.
There is a long list of economists who stress the importance of a sound financial
sector for economic growth. Schumpeter (1911) was the first modern economist who
put the role of financial intermediation at the centre of economic development. It is
the first time that Schumpeter articulates statements about how financial transactions
take central stage in economic growth. Gerschenkron (1962) considers that banking
7
sector plays a key role at certain stages of industrialisation process. Goldsmith (1969)
finds a positive relationship between economic development and financial
development. The economists like Mckinnon, Shaw, Greenwood, Levine, Allen have
reiterated this view. These economists suggests a ‗supply leading‘ financial
development i.e., financial development precedes economic development; brought
about through a conscious, deliberate policy by the authorities. The basic idea behind
such promoted financial development is that it will help to accelerate the real rate of
growth. The available literature points to a number of channels through which finance
promotes growth:
 Increasing savings rate and therefore increasing the investment.
 Investment allocation
 Technical innovations.
 Easing external financial constraints.
 Improving corporate governance.
 Reducing credit rationing etc. and so on
These lead to higher investment and/or increased investment efficiency that ultimately
speed up the growth process. Thus one of the views on linkages between financial
development and economic growth is that the financial system plays an important role
in promoting economic development. It helps in production, capital accumulation and
growth by encouraging more savings, mobilising them to productive uses and
allocating them amongst alternative uses and users.
In every economy there are sectors with the surplus money and sectors with the need
of money (deficit sector). In the economy, household sector is the sector which has
extra or surplus funds to spend. There are many other sectors like production sector
who are deficit units that need much more money than their internal money. The
financial sector encourages the household or surplus sector to save more and put their
savings in the financial assets. These savings then is made to the other sectors to
enhance the productive activities.
The developments of the financial sector provide a wide range of financial assets and
services to suit the various needs of the different savers. Surplus funds flow more to
the financial sector rather than in the tangible physical assets. These funds can then be
made available to those who need them more for productive investments. A fully
8
developed financial sector helps in improving the allocation of the available funds in
the productive and socially desirable activities. The more supply of funds increase the
research and innovation activities. The need for external sources reduced. In the
developed financial sector the financial institutions provide suggestions and advice to
improve the functioning and efficiency of the production units. All of the services
enhance production, capital formation and growth.
There also exists an extremely contrasting view on the importance of the financial
sector. There are number of economists notably Robinson, Gurley, Lucas, Nicholas
Stern, Seers, who have other views on it. According to them well developed financial
sector is not essential for the economic growth, rather it is economic growth that helps
in the expansion of the financial sector and enterprises lead, finance follows
(Robinson, 1952). Thus they believe in demand –following or passive financial
development. Income increases with the development of the economy and create
demand for the various financial assets and services.
We have two views, first is supply-leading financial development where the sound
and developed financial sector assists in economic growth. Second is a demand-
following passive financial development that comes with economic growth. There is
third view also, that relationship between the financial development and economic
growth is direction of causality. In the beginning stage of growth and development
process, financial development may be promoted by authorities to increase capital
formation, innovations and growth. As growth proceeds, this supply-leading financial
development converted in demand-following development. The relationship between
financial development and economic growth is mutually reinforcing and complex.
Finance is an important part in the growth process, but only finance is not sufficient to
the growth. Financial sector can play effective role in the development process ,when
the government assure minimum conditions of both financial and political order and
refrain from random adhoc interference that increase uncertainty for long range
investment planning (Cameron,1972) .
This is not always true that financial sector will always work for the benefit of the
society; too many regulations will keep the deposits low and further reducing the
savings. Government regulations may favour more credit on favourable terms in those
areas and activities which may not necessarily be highly productive. It is often seen
9
that the weak borrowers are left behind even though they have more promising
projects. Thus the financial system must work in efficient, unbiased and effective way
to promote growth and development.
The banking system, the most dominant segment of financial sector, accounts for over
80% of the funds flowing through the financial sector (Sankar, 2003). A banking
sector performs three Primary functions in an economy: The operation of the payment
system, the mobilization of savings and the allocation of savings to investment
projects. By allocating capital to the highest value use while limiting the risk and cost
involved, the banking sector can exert a positive influence on the overall economy,
and thus of broad macro-economic importance (Bonin,1999).
Banking sector considered as the prime driver of the economic development.

According to Jha, (1985) the banks render vital services to the masses belonging to
the various sectors of the economy like agriculture, industry etc. The development of
the banking sector has been well acknowledged as the life support system for
accelerating the economic development of the nation. The banks perform the process
of financial intermediation through the institutionalisation of savings and investments
and foster economic growth. Stulz (2001) said that the growth potential of a country
can be hindered irrespective of adequate resources if the domestic financial
intermediation mechanism fails to allocate these savings to available investment
opportunities efficiently.
Banks are the reservoir of resources necessary for the economic development not just
the storehouse of the country‘s wealth. According to Schempeter (1934) the role of
banking sector was stressed as a financier of productive investments and thus an
accelerator of economic growth. Banking sector provide strength to monetary and
credit mechanism through its monetary authority and regulates the entire mechanism
to the requirements of economic system. The banking sector has shown remarkable
responsiveness to the needs of the planned economy and fostering economic growth
and development.
Within banking institutions, commercial banks play a catalytic role in rural

development, helping agriculture, industry and international trade in a significant
manner. They have very significant role in enriching the economic and social life of
the nation. Commercial banks mobilise resources to finance development programmes
10
which is an integral part of the development process and they have great advantage
because of their network of branches in the country. However if the banks fail to tap
the savings from the public , the money shall be lying idle in the hands of the people
and could not be of any use for the economic development of the country.
From the economic point of view, the major task of banks is to act as intermediaries,
channelling savings to investment and consumption. The investment requirements of
savers are reconciled with the credit needs of investors and consumers. The savings
placed at the disposal of the commercial banks are employed in numerous and large
transactions, adapted to the specific needs of the savers and borrowers. In this way
they are able to make substantial cost savings for both savers and borrowers, who
would otherwise have to make individual transactions with each other.
Banks social aspect has also become significant to reach the poorer sections of the
society. keeping in view the motto of social banking, banks have streamlined their
credit to meet up the priority sector lending norms. The commercial banks serving this
goal through expansion of their branch network in the rural areas. They finance
agriculture sector for modernisation, marketing of their produce, irrigational facilities
and for high yielding seeds and fertilizers. They also provide financial assistance to
the small and marginal farmers, landless agriculture workers, dairy farming, poultry
farming, animal husbandry and horticulture.
Commercial banks being the single most important source of credit provide short
term, medium term and long term finance to industry. Commercial banks provide
working capital finance and other kinds of loans to industry for expansion,
modernisation and renovation. They also play wider role in the revival of sick units by
way of preventing and detecting sickness in the early stages. Beyond this banks also
provide finance to retailers, traders and wholesalers in the form of purchasing
inventory, transferring goods from one place to other, discounting and accepting bills
of exchange, providing overdraft facilities and issuing drafts etc.
The commercial banks also finance exports and imports by providing foreign
exchange facilities to importers and exporters of goods. They arrange pre-shipment
credit in the form of loans, cash credit and overdraft facilities, while post-shipment
credit is provided in the form of discounting of export bills or granting loans against
these bills. This facilitates both internal and external trade of the country and in turn
11
flow of domestic and foreign receipt and payment is developed. The commercial
banks also provide funds to investors and customers who stimulate both aggregate
demand and supply for goods and services. The easy access to finance enhances the
demand for raw material and finished goods and ultimately boosts employment
opportunities. According to Shekar, (1974) the diversified services provided by the
banks help in the promotion of trade and industry.
Banks have diversified the range of their activities. The new services provided by the
banks include mutual funds, merchant banking activities, portfolio management, hire
purchase finance, venture capital and factoring services. All these activities of the
banks promote the development trade and industry. The banks also play a very
important role in the area of macro-economic policy concerns. They help in
controlling the inflation, deflation and keep the economy from the shocks of high
prices and low supply. Even the central banks depend upon the commercial banks for
the success of its monetary policy. According to Vashisht, (1991) the credit policy
with regard to volume and direction is subject to the control by central banking
authority, still commercial banks can devise new ways and means of mobilising
deposits and granting loans and thus can be innovative in deciding the monetary
policy.
Thus commercial banks have become an effective tool of social transformation and
rejuvenation. Apart from performing the key functions of providing liquidity,
payment services and managing bulk of intermediation processes, the banking sector
has been contributing to the process of economic development by serving as a major
source of credit to all sections of the economy. Banks have successfully created world
class financial products and services catering to the entire needs of the households and
businesses.
1.5 Evolution of commercial banks in India
According to the central Banking Enquiry Committee (1931) In India, the banking
system is as old as early Vedic period. The book of Manu contains reference
regarding deposits advances, pledge policy of loan, and rate of interest. From the
beginning of 20th century banking has been so developed that in fact, has come to be
called ―LIFE BLOOD‖ of trade and commerce (Munjal, 1990).
12
In India, banking has developed from the primitive stage to the modern system of
banking in a fashion that has no parallel in the world history. With the dawn of
independence, changes of vast magnitude have taken place in India. After
independence India launched a process of planned economic activity in order to
overcome the multitude of problems it faced as an underdeveloped nation. The
increasing tempo of economic activity leads to tremendous increase in the volume and
complexity of banking activity. Therefore, the role of banks has had to expand at a
fast pace (Narual, 1992). As engines of development and vehicle of silent socio-
economic revolution in the country, Indian banks have assumed new responsibilities
in the fields of geographical expansion, functional diversification and personal
portfolio. Indian banking transformed itself from ‗Class banking to Mass banking‘
(Chawla, Uppal and Malhotra, 1988).
The origin of the Indian banking industry may be traced to the establishment of bank
of Bengal in Calcutta (now Kolkata) in 1786. The growth of banking industry in India
may be studied in terms of two broad phases. Pre-independence(1786-1947) and Post-
independence (1947 till date). The Post-independence phase may be further divided
into three sub phases such as pre-nationalization period (1947-1969), Post
nationalization period (1969 to 1990) and Post-Reform period (1990 till date).
Pre-Independence Phase (1786-1947)
The pre-independence period was largely characterised by the existence of private

banks organised as joint stock companies. The western variety of joint stock banking
was brought to India by the English Agency Houses of Calcutta and Bombay. The
first bank of joint stock variety was Bank of Bombay, established in 1720 in Bombay.
This was followed by Bank of Hindustan in Calcutta which was established in 1770
by an agency house and which was closed down subsequently in 1882. The English
agency houses had established the bank of Bengal in Calcutta in 1786.
The first presidency bank was the Bank of Bengal established in Calcutta on 2nd June,
1806 with a capital of Rs. 50 lakh. The government subscribed to 20 percent of its
share capital and shared the privilege of appointing directors with voting rights. The
banks were given power to issue currency notes in 1823. The Bank of Bombay was
the second presidency bank established in 1840 with a capital of Rs. 52 lakh and the
Bank of Madras, the third presidency bank established in July, 1843 with capital of
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Rs. 30 lakh. They were known as presidency banks as they were set up in the three
presidencies that were the units of administrative jurisdiction in the country of the
East India Company.
The first formal regulation for banks was the enactment of the companies act, in 1850.
This act stipulated unlimited liability for banking and insurance companies until 1860.
In 1860, the concept of limited liability was introduced in banking. Thus by the end of
1900, there were three classes of banks in India: presidency banks numbering 3, joint
stock banks numbering 9 and exchange banks of foreign numbering 8.
The Swadeshi movement started in the early 1900s gave stimulus to growth of
indigenous joint stock banks. Some of the banks established during the period were:
The People‘s Bank of India, The Bank of India, The Bank of Baroda and The Central
bank of India. In 1921, three presidency banks were merged and formed The Imperial
Bank of India. On the eve of independence in 1947, there were 648 commercial banks
comprising 97 scheduled and 551 non-scheduled banks. The number of offices stood
at 2987 with total deposits at Rs. 1080crore and advances at Rs. 475 crores.
During pre independence period, the Indian joint stock banks specialised in providing
short term credit for trade in the forms of cash credit and overdraft facilities. Foreign
exchange business remained the monopoly of foreign banks. Between 1990 and 1925,
many banks failed due to insufficient capital, poor liquidity of assets, combination of
non banking activities, irrational credit policy, incompetent and inexperienced
directors. On the recommendation of the Central banking enquiry committee, the
Reserve Bank of India act was passed in 1934 and the Reserve Bank of India came
into existence in 1935 as the central banking authority of India.
At the end of late 18th Century, there was hardly any bank in India in the modern
sense of the term ‗Banks‘. Some banks were opened at that time which functions as
entities to finance industry, including speculative trade. With the large exposure to
speculative ventures, most of the banks opened in India during that period could not
survive and failed. The depositors lost money and lost interest in keeping deposits
with the bank. Subsequently, banking in India remains the exclusive domain of
Europeans for the next several decades until the beginning of 20th Century.
14
At the beginning of 20th Century, the Indian Economy was passing through a relative
period of stability. Around five decades have elapsed since the India‘s first war of
Indian independence and the social, industrial and other infrastructure have
developed. At that time there were very small banks operated by Indians and most of
them were owned and operated by particular community. The banking in India was
controlled and dominated by the presidency banks, namely, the Bank of Bombay, The
Bank of Bengal and the Bank of Madras-which later on merged to form the Imperial
bank of India.
The objectives of banks in the colonial era were mainly helping the colonial rulers in
raising the resources for their empire building activities and facilitating training
activities of the numerically small mercantile. 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 into the
markets. 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. Also that year,
India‘s Central Bank, The Reserve Bank of India began operation (Banerjee, Cole
and Duflo, 2004).
When India emerged as an independent nation, it inherited a war torn economy

bedevilled by shortage of food grains, unemployment and the pangs of partition. The
banking system, with shareholder orientation, was not well organized. The banks till
then were discharging the functions of a traditional financial intermediary. To reorient
them as instruments of economic change was indeed a stupendous task considering
the narrow objective adopted by the banks at the time of Indian independence
(Sarma, 1998).
Post-independence phase (1947 till date)
With the dawn of Independence changes of vast magnitude have taken place in India.
However soon after independence, the view that the banks from the colonial heritage
were biased in favour of working capital loans for trade and large firms and against
extending credit to small scale enterprises, agriculture and commoners, gained
15
prominence. The Post-independence phase may be further divided into three sub
phases as follows:
Pre-nationalization period (1947-1969)
In 1949, the Banking Regulation Act was passed which provided the framework for
the Reserve Bank of India‘s regulation and supervision of banks. The Act empowers
the Reserve Bank of India to regulate, supervise and develop the banking system.
Such powers encompass the establishment of new banks, merger and amalgamation of
existing banks, opening of new branches, closing of existing branches and shifting of
existing branches to other locations. The act also empowered the Reserve Bank of
India to effect on-site inspection of banks. During the period following 1949, Reserve
Bank of India attempted to institutionalise the savings of the public and to adapt a
credit system suitable to the emerging need of the economy.
During 1950 to 1969, two important developments took place. First, the All India
Rural Credit survey committee, which examined the issue of credit availability at the
rural areas, recommended the creation of state sponsored bank entrusted with the task
of opening branches in the rural areas. The State Bank of India Act, 1955 was passed,
under which Reserve Bank of India took control of the Imperial Bank of India and
renamed it as State Bank of India. Later in 1959, The State Bank of India (subsidiary
banks) act was passed enabling State bank of India to take over eight princely state
associated banks as its subsidiaries. They were: State Bank of Bikaner, State Bank of
Hyderabad, State Bank of Indore, State Bank of Jaipur, State Bank of Mysore, State
Bank of Patiala, State Bank of Saurashtra and State Bank of Travancore. Later on
State Bank of Bikaner and State Bank of Jaipur were merged into one bank namely
State Bank of Bikaner and Jaipur. This accelerated the pace of extending banking
facilities across country. Secondly, the relative priorities of developmental needs and
for ensuring an equitable and purposeful distribution of credit, the scheme of Social
Control over banks was announced in the parliament in December,1967.
The National Credit Council was set up in 1968 to assess the demand for bank credit
from various sectors of the economy and to determine their respective priorities in
allocation. At the launch of the first five year plan in 1951, there were 566
commercial banks consisting of 92 scheduled and 474 non-scheduled banks. In 1969,
total number of banks declined to 89 out of which 73 were scheduled and 16 were
16
non-scheduled. The banking scenario that prevailed in the early independence phase
had three distinct features. First, the bank failure has raised the concern regarding the
soundness and stability of the banking system. Secondly, there was large
concentration of resources from deposit mobilisation in a few hands of business
families. Third, agriculture was neglected in so far as bank credit was concerned. A
major development during this period was the enactment of the banking Regulation
Act empowering Reserve Bank of India to regulate and Supervise the banking sector.
Post nationalization period (1969 to 1990)
During this period several structural and functional changes took place. The spread of
Indian banking system was mainly concentrated in urban areas during 1950s and
1960s. It was felt that if bank funds had to be channelled for rapid economic growth
with social justice, there was no alternative but to nationalisation of at least the major
segment of the banking system. Hence in july1969, the Government of India
nationalised 14 major scheduled commercial banks, each having a minimum
aggregate of deposit of Rs. 50 crores. They were: the Central Bank of India, The Bank
of India, The Punjab National Bank, The Bank of Baroda, The United Commercial
Bank, The Canara Bank, The United Bank of India, The Dena Bank, The Syndicate
Bank, The Bank of Maharashtra and The Indian Overseas Bank. According to the
Bank Nationalisation Act, 1969, the objective and reasons for the nationalisation were
―an institution such as the banking system, which touches and should touch the lives
of the millions has to be inspired by a larger social purpose and has to sub-serve
national priorities and objectives such a rapid growth in agriculture, small industries
and export, raising employment levels, encouragement of new entrepreneurs and the
development of the backward areas. For this purpose it is necessary for the
government to take direct responsibility for expansion and diversification of banking
services and for the working of substantial part of the banking system.‖ Now the
banks can play the role of key agent more effectively in the economic growth by
extending banking facilities to the most deserving classes.
In 1980, the Government of India nationalised another six banks, each having deposit
of Rs.200 crores and above. They were: The Andhra Bank Ltd., The Punjab and Sind
Bank Ltd., The Corporation Bank Ltd. The Oriental Bank of Commerce Ltd., The
17
Vijaya Bank Ltd. And The New Bank if India Ltd. (The New Bank of India Ltd. Was
merged with Punjab National Bank in the Nineties).
In 1973, the Government of India had set up a Working group to study the credit
availability in the rural areas. The working group identified various weaknesses of the
cooperative credit agencies and commercial banks and came to the conclusion that
they may not be able to fill the regional and functional needs of the rural credit
system. Therefore the study group recommended a new type of institution, which
combined the rural touch and experience of cooperatives with the modernised outlook
and capacity to mobilise the deposits. The Government of India accepted this
recommendation and permitted the establishment of Regional Rural Banks (RRBs).
These banks are state sponsored; region based rural oriented commercial banks and
set up under the Regional Rural Banks (RRBs) Act, 1976. The ownership vests with
the sponsoring commercial bank, the central government and the government of the
state in which they are geographically located. Under this approach 196 Regional
Rural Banks (RRBs) were set up.
Post Reform period (1990 till date)
The government of India launched an extensive economic reform programme, in

1991. Reform measures were introduced in the financial sector as a part of general
reforms. The financial sector reforms were based on the recommendations of the
Committee on financial sector, 1991(Narsimham I) and the committee on the banking
sector reforms, 1997 (Narsimham II). The main objectives of the reforms were to
promote efficiency of the banking system through competitive forces. The strategy
adopted was to improve operational efficiency of the banking system and to impart
functional autonomy through reduced regulator‘s direct interventions in the working
of the institutions.
Reform measures not only imparted the greater transparency in dealing and reporting
by the entities but also integrated various segments of the financial sector such as
money market, debt market, foreign exchange market and capital market. The reforms
in the banking and the financial sector was guided by five principles: cautious and
sequencing of reforms measures, introductions of reforms that were mainly
reinforcing , introduction of complementary reforms across sectors, development of
financial institutions and development and integration of financial markets.
18
1.6 Rationale of banking Sector Reforms
Though the branches, deposits and credits of the commercial banks registered an
unprecedented quantitative growth in post nationalisation period yet, it was observed
that over a period of time certain inherent weaknesses have cropped up in the Indian
banking system.
In India, the banking and financial sector reforms were initiated during the last decade
of 20th century as a part of general economic reforms with a view to improving the
soundness of the public sector banks and other financial institutions. During the post
nationalisation public sector banks achieved spectacular success but such progress
was witnessed in mobilisation of savings, in creating employment opportunities and
spread of branch network of banks rather than in the improvement of the services to
the customers. The vast expansion and spread of the banking sector resulted in frauds,
corruption, misutilisation and several internal deficiencies in the system. Due to these
difficulties the customer services were affected badly, work technology remained
stagnant and the transaction cost kept on increasing over the years.
The overall business and earning capacity of commercial banks was adversely
affected and there were a number of reasons responsible for this financial chaos. The
high rate of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) reduced
the overall capacity of business to the large extent. The banks were required to keep
38.5 percent of their net demand and time liabilities as SLR in approved government
securities and 15 percent of their aggregate demand and time liabilities as CRR. They
were also required to invest 10 percent of their total demand and time liabilities
accumulating in the banking system during the specified period, as impound reserve.
This directed investment programme diverted 63.5 percent of banks total deposits in
meeting statutory obligations and banks were left with only 36.5 percent of aggregate
deposits to look into the interest of other competing sectors. All this eroded banks
profits to the considerable extent.
Over a period of time the proportion of public sector banks investment in government
and semi-government securities in the form of shares, debentures and bonds had
considerably gone up out of total deposits resulting into poor performance of these
banks. The poor performance of number of corporations and delay in the repayment
of loans had further affected the income generation capacity of the banks by way of
19
not meeting the credit requirements of the borrowers engaged in productive activities.
Misra and mishra (2001) the other major reasons for the poor performance of public
sector banks were uncompetitive environment, lack of operational flexibility,
managerial weakness and more importantly lack of autonomy in decision making. The
implementation of Directed Credit Programme (DCP) of the government assigned to
public sector banks is also held responsible for the inefficiencies of the banking
system. The banks were required o channelize 40 percent of their total credit in favour
of targeted priority sectors, to be attained by the year1985 made banks more
vulnerable. Banks were further directed to supply 16 percent to agriculture and allied
activities and 10 percent to small scale industries of total priority sectors credit.
The rate of interest is kept low to have easy access to bank credit and to make large
number of borrowers to avail loans. The losses in income on account of low rate of
interest for priority sector are compensated by charging higher rate of interest from
the borrowers belonging to non priority sectors. This cross subsidization of loans was
assumed to be helpful for banks in planning their credit allocation, but this practice
could not ensure higher and steady return for the banks.
This priority sector lending has become a major reason of financial strain for
commercial banks due to delay in repayment, poor recovery and becoming of these
loans bad assets. The poor recovery of loans, especially of agricultural loans has
seriously aggravated the problem of Non Performing Assets (NPAs). Likewise,
considerable amount of banks loans has been locked up in Small Scale industries
(SSI) because of chronic sickness of these units. Therefore, the banks are losing
considerable amount, by way of charging low rate of interest on the one hand and the
poor recovery of loans resulting in over-dues on the other hand. This is contributing to
poor income generation of banks.
On account of this government directed lending programme, banks have incurred

huge losses not on account of only low interest rate and poor recovery but there are
certain inherent deficiencies, problems and leakages in the system of priority sector
lending . the number of studies have revealed that , in certain cases, the selection of
beneficiaries are not appropriate and persons belonging to well off classes did manage
themselves to be included in the selection group. Further it was also noted that the
assets provided by the banks were not in accordance with the absorption capacity of
20
beneficiaries. Thus the effectiveness of the priority sector lending has continued to be
much below the desired level and loans provided to beneficiaries have failed to create
any tangible assets. The absence of tangible assets and poor recovery of loans has led
to reduction in banks income and poor capital formation.
Furthermore, Indian commercial banks have failed to come up to the desired level of
performance on account of poor productivity of employees. The lack of technical up-
gradation, competitiveness and efficiency in the banks has led to poor productivity of
banks even after nationalisation. The expenditure continued to grow but income not
increased in a significant manner. The growing establishment expenses, large
recruitment of staff and setting up of unviable branches made the financial condition
of the banks worst in the post liberalisation era.
The branches are opened in the rural and unbanked areas as per the target given by the
RBI had intensified the problem further existing in the form of viability of branches.
The customers in such areas belonged to poor sections with less income generating
capacity led to low deposits and advances. The loans dispersed in such rural areas did
not turn productive because of poor absorption capacity and lack of awareness. The
loans are remained unpaid for many years.
Over a period of time the capital position of the banks too eroded because of un-
productive branches. Sen and Vaidya (1997) the share of banks own funds and
reserves to risk weighted assets in the post nationalisation era continued to remain as
low as 3 to 4 percent identified the poor capital position of the banks.
The poor customer service due to frequent strikes and red tapism denting the social
image of the public sector banks resulted into inefficiencies. The customer services in
public sector banks have been adversely affected because of inadequate work space,
growing expectations of customers, handling of large number of small accounts, lack
of apathy to clients problems and increased work load due to handling of diversified
nature of loan operations.
The competitive spirit was also lacking among public sector banks in the post
nationalisation period. The numbers of restrictions were imposed by Government of
India and Reserve Bank of India in the form of sanctioning licenses for opening
branches. The private sector banks and foreign banks concentrated mainly in
21
metropolitan and port areas. These banks were restricted from undertaking certain
activities and only public sector banks were considered to undertake these
activities.According to Misra and mishra, (2001) the primary sector lending was
mainly concentrated in public sector banks and foreign banks enjoyed the privilege of
undertaking export credit which was not extended to all public sector banks. This
caused inefficiencies and income erosion of public sector banks.
The political interference and bureaucratic controls were also affected the
performance and operational efficiency, profitability of banks. Further class banking
was also transformed into mass banking because of phenomenal branch expansion
into rural and semi urban areas. Lack of proper disclosure norms led many banks to
keep their teething problems under cover. Narsimham (1994) the lack of
transparency among the public sector banks has not only affected the scope to
increase the income but also shrouded their actual position. The window dressing in
the financial statements of banks made it difficult to know the actual position of banks
and to drive certain policy conclusions.
Indian economy was in deep crisis in July 1991, when foreign currency reserves had
plummeted to almost $1 billion; Inflation had roared to an annual rate of 17 percent;
fiscal deficit was very high and had become unsustainable; foreign investors and NRIs
had lost confidence in Indian Economy. Capital was flying out of the country and we
were close to defaulting on loans. Along with these bottlenecks at home, many
unforeseeable changes swept the economies of nations in Western and Eastern
Europe, South East Asia, Latin America and elsewhere, around the same time. These
were the economic compulsions at home and abroad that called for a complete
overhauling of our economic policies and programs. Major measures initiated as a
part of the liberalization and globalization strategy in the early nineties.
Thus, at these backdrops the viability of a number of public sector banks became a
matter of grave concern. Some of them were incurring huge losses. The systematic
and effective supervision and regulation of the banking and non banking financial
system did not keep pace with the developments in these areas. In order to support the
major changes that took place in trade and industrial policies and to protect the
depositors and investors, a thorough review of the financial sector was felt necessary.
The overall performance with respect to efficiency, productivity and profitability
22
continued to be dismal, which require some immediate corrective measures. The
quality of services provided by the public sector banks has also not been considered
better, which also required immediate attention. In this background, the Government
of India appointed a high level committee under the chairmanship of M. Narasimham,
a former governor of RBI in August 1991 to go into all aspects relating to structure ,
organisation, functioning and procedures of the public sector banks and other
financial institutions.
1.7 Objectives of Financial Sector Reforms
For a long time, an alarming increase of sickness in the Indian financial system had
required urgent remedial measures or reforms which were introduced in 1991.
1. To develop a market-oriented, competitive, world-integrated, diversified,

autonomous, transparent financial sector.
2. To increase the allocative efficiency of available savings and to promote
accelerated growth of the real sector.
3. To increase or bring about the effectiveness, accountability, profitability,
viability, vibrancy, balanced growth, operational economy and flexibility,
professionalism and de-politicization in the financial sector.
4. To increase the rate of return on real investment.
5. To promote competition by creating level-playing fields and facilitating free
entry and exit for institutions and market players.
6. To ensure that the rationalization of interest rates structure occurs, that interest
rates are flexible, market-determined or market-related, and that the system
offers to its users a reasonable level of positive real interest rates. In other
words, the goal has been to dismantle the administered system of interest rates.
7. To reduce the levels of resource pre-emption and to improve the effectiveness
of directed credit programs.
8. To build a financial infrastructure relating to supervision, audit, technology,
and legal matters.
9. To modernize the instruments of monetary control so as to make them more
suitable for the conduct of monetary policy in a market economy i.e. to
increase the reliance on indirect or market-incentives based instruments rather
than direct or physical instruments of monetary control.
23
The key words describing reforms have been liberalization, deregulation,
marketisation, privatization, and globalization, all of which convey reforms objectives
in a clear manner. The basic premise underlying the reforms has been that the state
ownership and regulation have harmed the financial system, particularly the banks
and the investors, and that such regulation is no longer relevant and adequate. To use
the well-known academic terminology, the objective of financial reforms has been to
correct and eliminate financial repression; and to transform a financially repressed
system into a free system.
Financial sector reforms are said to be grounded in the belief that the competitive
efficiency in the real sectors of the economy cannot be realized to its full extent unless
the allocative efficiency of the private sector was improved. The main thrust of
financial sector reforms was on the creation of efficient and stable financial
institutions and markets, the removal of structural bottlenecks, introduction of new
players and instruments, introduction of free pricing of financial assets, relaxation of
quantitative restrictions, improvement in trading, clearing and settlement practices,
promotion of institutional infrastructure, refinement of market micro-structure,
creation of liquidity, depth, and the efficient price discovery process, and ensuring
technological up gradation.
1.8 Commercial Banking Reforms in India
Narasimham Committee – I (First Generation Reforms)
Banks, other financial institutions and financial markets were all operating in a highly
controlled regulated environment in the period before 1980s. Some steps towards
liberalisation were taken during 1980s. In 1991, wide ranging economy wide reforms
were undertaken. In August, 1991, the government of India appointed a committee on
the financial sector under the chairmanship of Shri. M. Narasimham, a former
Governor of RBI. The committee was to examine the existing structure of the
financial system and its various components and to make recommendations for
improving the efficiency and effectiveness of the system with particular reference to
the economy of operations, accountability and profitability of commercial banks and
financial institutions (Report of the committee on the financial system, 1992).
24
The committee approach to the issue of financial sector reforms was to ensure that the
financial services industry operates on the basis of the operational flexibility and
functional autonomy with a view to enhancing efficiency, productivity and
profitability. A vibrant and competent financial system was seen as necessary to
sustain the ongoing reforms in the structural aspects of real economy. The committee
was of the view that Indian banking and financial system had made commendable
progress in extending its geographical spread and functional reach and that there had
been considerable diversification of money and capital market. Despite this progress,
however certain serious problems had emerged reflected in decline in productivity
and efficiency and erosion of the profitability of the banking sector. The two major
factors were identified- directed investment and directed credit programmes. Both
earning much lower rate of interest than the market rate. Among the other important
factors noted were the deterioration in the quality of the loan portfolio, increasing
expenses due to massive branch expansion, many of which were un-remunerative
specially in rural areas, over manning, inadequate technical progress, weakness in
internal organisation structure, excessive political interference etc.
To restore the financial health of commercial banks and to make their functioning
efficient and profitable, the Government of India appointed a nine member committee
called 'The Committee on Financed System' under the chairmanship of M.
Narasimham, ex-Governor of Reserve Bank of India which made recommendations in
November 1991. The report of the committee was tabled in the Parliament on
December 17, 1991. The Committee laid down a blue print of financial sector
reforms, recognized that a vibrant and competitive financial system was central to the
wide ranging structural reforms. In order to ensure that the financial system operates
on the basis of operational flexibility and functional autonomy, with a view to
enhance efficiency, productivity and profitability, the Committee recommended a
series of measures aimed at changes according greater flexibility to bank operations,
especially in Pointing out statutory stipulations, directed credit program, improving
asset quality, institution of prudential norm, greater disclosures, better housekeeping,
in terms of accounting practices. In the words of Jalan, Bimal (2003), ex-Governor of
RBI, "the central plank is a set of prudential norm that are aimed at imparting strength
to the financial institutions, and inducing greater accountability and market discipline.
The norms include not only capital adequacy, asset classifications and provisioning
25
but also accounting standards, exposure and disclosure norms and guidelines for
investment, risk management and asset liability management." These
recommendations are a landmark in the evolution of banking system from a highly
regulated to more market-oriented system.
The reforms introduced since in 1991 breathed a fresh air in the banking sector.
Deregulation and liberalization encouraged banks to go in for innovative measures,
develop business and earn profits. These reforms, the Narasimham Committee-I felt,
will improve the solvency, health and efficiency of institutions. Dutt,Rudra and
Sundaram,(2004) the measures were aimed at
(i) ensuring a degree of operational flexibility,
(ii) internal 'autonomy for public sector banks in their decision-making process, and
(iii) greater degree of professionalism in banking operations
The Reserve Bank of India (2003) grouped the first phase of reform measures into
three main areas: Enabling measures, Strengthening measures and Institutional
measures. Joshi, (2002) these reforms can also be classified into five different groups
(A) Liberalization measures,
(B) Prudential norms,
(C) Competition directed measures,
(D) Supportive measures, and
(E) Other measures.
(A) Liberalization Measures
 Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR)
The SLR and CRR measures were originally designed to give the RBI two additional
measures of credit control, besides protecting the interests of depositors. A major
factor affecting the profitability and functioning of commercial banks was massive
pre-emption of bank resources in the form of higher Statutory Liquidity Ratio (SLR)
and Cash Reserve Ratio (CRR). The affecting Cash Reserve Ratio (CRR) has been
progressively reduced from 16.5% to 14.5 % in November 1995, 10 % in May 1999,
8.5 % in April 2000, 7.5 Percent in May 2001 and further to 4.75 % in November
2002. The Statutory Liquidity Ratio (SLR) on incremental net demand and time
liabilities has been reduced from 38.5 % in 1991 to 25 % at present. These reductions
26
have helped both in augmenting loanable resources of the banks and in improving
profitability of banks.
 Deregulation of interest rates
In the pre reform periods, interest rates on both deposits and advances of banks were
administered by Reserve Bank of India (RBI). These rates were usually unrelated to
market realities. As far as advances are concerned, there were as many as 20
administered rates in 1989-90. In regard to the regulated interest rate structure; the
basic thrust of the Narsimham Committee was that real rates of interest should be
positive and concessional interest rates are a vehicle for subversion. Following
reforms measures, the various rates of interests are now market determined.
Scheduled Commercial Banks have now the freedom to set interest rate on their
deposits subject to minimum floor rates and maximum ceiling rates. Banks are now
free to set interest rates with two concessive rates on all term deposits of maturity of
over 30 years. Prescription of rates of all term deposits and conditions for premature
withdrawal has been completely dismantled. The deregulation of interest rates has
given a high degree of freedom to banks in determining deposits and lending rates.
The committee recommended reduction of target for priority sector advances from 40
% to total credit to 10 %, the government did not agree to it. But it diluted the concept
of priority sector considerably by including housing loans, educational loans,
subscription to bonds and debentures of the infrastructure and development
organisation etc. The sub-targets in the priority sectors are 10 % for weaker sections
and 60 % credit-deposit ratio in the rural and semi urban areas have been conveniently
forgotten by banks and regulatory authorities. According to Joshi, (2002) selective
credit controls have been totally abolished, thus giving banks freedom to lend to even
the sensitive sectors.
(B) Prudential Norms
In April 1992, the RBI issued detailed guidelines on a phased introduction of

prudential norms to ensure safety and soundness of banks and impart greater
transparency and accounting operations. The main objective of prudential norms is the
strengthening financial stability of banks. Inadequacy of capital is a serious cause for
concern. Hence, as per Basle Committee norms, the RBI introduced capital: adequacy
27
norms. It was prescribed that banks should achieve a minimum of 4 per cent capital
adequacy ratio in relation to risk weighted assets by March 1993, of which Tier I
capital should not be less than 2 per cent. The Bank for International Settlements
(BIS) standard of 8 per cent capital to risk weighted asset ratio should be achieved
over a period of three years, that is, by March 1996, for banks with international
presence, it is necessary to reach the figure even earlier. The State Bank of India
(SBI) and other Nationalised banks had reached these norms in 1995-96. In line with
the recommendations of the committee ,commercial banks had been advised to raise
minimum capital to risk weighted assets ratio from 8% to 10% from the year ended
March,2000.Before arriving at the capital adequacy ratio of each bank, it is necessary
that assets of banks should be evaluated on the basis of their realizable value. Those
banks whose operations are profitable and which enjoy reputation in the markets are
all over to approach capital market for enhancement of capital. In respect of others,
the Government should meet the shortfall by direct subscription to capital by
providing loan. As per the recommendations of the Narasimham Committee banks
cannot recognize income (interest income on advances) on assets where income is not
received within two quarters after it is past due. The committee recommended
international norm of 90 days in phased manner by 2002. Measures have been taken
for reclassification of NPA and improvement of the soundness of commercial bank
functions. The assets are now classified on the basis, of their performance into 4
categories:
(a) standard,
(b) sub-standard,
(c) doubtful, and
(d) loss assets.
Adequate provision is required to be made for bad and doubtful debts (substandard
assets). Detailed instructions for provisioning have been laid down. In addition, a
credit exposure norm of 15 per cent to a single party and 40 per cent to a group has
been prescribed. Banks have been advised to make their balance sheets transparent
with maximum 'disclosure' on the financial health of institutions. The Committee
recommended provisioning norms for nonperforming assets. On outstanding
substandard assets 10 percent general provision should be made. On loss assets the
28
permission shall be 100 per cent. On secured portion of doubtful assets, the provision
should be 20 to 50 per cent.
(C) Competition Directed Measures
An element of competition has been ought to be fostered in financial sector by

permitting new private sector banks and more liberal entry of branches of foreign
banks. Local area branches have also been encouraged to foster competition in rural
and semi urban areas. Except in maturity pattern of assets and liabilities, movement in
provision accounts and NPAs, transparency and disclosure standards have been
enhanced to meet international standards. Transparent guidelines or norms of entry
and exit of private sector banks have been stipulated.
Since 1969, none bank had allowed to be opened in India. That policy changed in
January 1, 1993 when the RBI announced guidelines for opening of private sector
banks public limited companies. The criteria for setting up of new banks in private
sector were: (a) capital of Rs. 100 crores, (b) most modern technology, and (c) head
office at a non-metropolitan centre, In January 2001, paid-up capital of these banks
was increased to Rs. 200 crores which has to be raised to Rs. 300 crores within a
period of 3 years after the commencement of business. The promoters share in a bank
shall not be less than 40 per cent. After the issue of guidelines in 1993, 9 new banks
have been set up in the private sector. According to Shenoy, (2000) the new
generation private sector banks have brought about a paradigm shift in service
standards and set new benchmarks in terms of application of technology, speed in
delivery of services, channels, branch ambience and a higher order of marketing
orientation. These banks with their updated technology have been providing stiff
competition to public sector banks. Foreign banks have also been permitted to set-up
subsidiaries, joint ventures or branches, their number have increased from 24 in 1991
to 42 in 2000 and their branch network increased from 140 to 185 over the same
period. Banks have also been permitted to rationalize their existing branches, spinning
off business at other centres, opening of specialized branches, convert the existing
non-urban rural branches into satellite offices. Banks have also been permitted to
close down branches other than in rural areas. Banks attaining capital adequacy norms
and prudential accounting standards can set-up new branches without the prior
29
approval of RBI. Two recommendation of the Narasimham Committee was to abolish
the system of branch licensing and allow foreign banks free entry.
(D) Supportive Measures
Revised format for balance sheet and profit and loss account reflecting actual health
of scheduled banks were introduced from the accounting year 1991-92. There have
also been changes in the institutional framework. The RBI evolved a risk-based
supervision methodology with international best practices. New Board of Financial
Supervision was set-up in the RBI to tighten up the supervision of banks. The system
of external supervision has been revamped with the establishment in November 1994
of the Board of Financial Supervision with the operational support of the Department
of Banking supervision. In tune with international practices of supervision, a three-tier
supervisory model comprising outside inspection, off-site monitoring and periodical
external auditing based on CAMELS (Capital Adequacy, Asset quality, Management,
Earnings, Liquidity and System controls) had been put in place (Price Waterhouse
Coopers, 2004). Special Recovery Tribunals are set-up to expedite loan recovery
process. The recent Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interests (SARFAAESI) Act, 2002 enables the regulation of
securitization of and reconstruction of financial assets and enforcement of security
interests by secured creditors. The Act will enable banks to dispose of securities of
defaulting borrowers to recover debt.
(E) Other Measures
The Banking Companies (Acquisition and Transfer of Undertaking) Act, 1969 was
amended with effect from July 1994 permitting public sector banks to raise capital up
to 49 per cent from the public. There are number of other recommendations of the
Narasimham Committee such as reduction in priority sector landings, appointment of
special tribunals for speeding up the process of loan recoveries and reorganization of
the rural credit structure, all of which need detailed examination as these
recommendations have far-reaching implications both in terms of the structure of the
financial system and also the financing required to implement them.
30
The Committee proposed structural reorganization of the banking sector which
involves a substantial reduction of public sector banks through mergers and
acquisitions. It proposed a pattern of
a) 3 or 4 large banks of international character,
b) 8 to 10 national banks engaged in "general or universal banking
c) local banks whose operation be confined to a specific areas, and
d) RRBs financing permanently agriculture and allied activities.
Recommendations of Narasimham Committee – I
The main recommendations of the Committee were:-

1. Reduction of Statutory Liquidity Ratio (SLR) to 25 percent over a period of
five years.
2. Cash Reserve Ratio (CRR) should be progressively reduced. RBI should have
the flexibility to operate this instrument to serve its monetary policy objectives
rather than to control the secondary expansion of credit.
3. Directed credit programmes should be phased out and redefinition of the
priority sector to comprise the small and marginal farmers, the tinny sector of
the economy, small business and transport operators, village and cottage
industry, rural artisans and other weaker sections. The credit targets for this
redefined priority sector should be fixed at 10% of aggregate credit.
4. Deregulation of interest rates so as to reflect emerging market conditions and
concessional rates to be phased out. The structure of interest rates should bear
a broad relationship to the bank rate, which should be used as anchor to signal
the RBI‘s policy stance.
5. Banks and financial institutions should achieve a minimum capital adequacy
ratio of 4 percent in relation to risk weighted assets by March 1993, of which
Tier I capital should not be less than 2%. The BIS standard of 8 percent should
be achieved by March 1996, and 8 percent by those banks having international
operations by March 1994. In respect to those banks whose operations have
been profitable and enjoy a good reputation in the markets could straight away
approach to the capital market for enhancing capital. In respect of other banks,
the government could meet the shortfall by direct subscription to capital or by
providing a loan that could be treated as subordinate debt.
31
6. Banks and other financial institutions should adopt uniform accounting
practices in regard to income recognition, asset classification and provisioning
against bad and doubtful debts. Sound practices in regard to valuation of
investments on lines suggested by Ghosh committee on final accounts.
7. Balance sheet of banks and other financial institutions should be made
transparent and making full disclosures as recommended by the international
accounting standard committee.
8. Setting up of special tribunals on the pattern recommended by Tiwari
committee to speed up the process of recovery of loans
9. Setting up of Asset Reconstruction Funds (ARFs) to take over from banks a
portion of their bad and doubtful advances at a discount
10. Restructuring of the banking system, so as to have 3 or 4 large banks, which
could become international in character, 8 to 10 national banks with a network
of branches throughout the country engaged in universal banking and local
banks whose operations would be generally confined to specific regions. Rural
banks (including Regional Rural Banks), whose operations would be generally
confined to rural areas and whose business would be pre-dominantly engaged
in financing of agriculture and allied activities.
11. Setting up one or more rural banking subsidiaries by Public Sector Banks
12. Permitting RRBs to engage in all types of banking business
13. Abolition of branch licensing
14. Liberalizing the policy with regard to allowing foreign banks to open offices
in India.
15. Rationalisation of foreign operations of Indian banks
16. Giving freedom to individual banks to recruit officers
17. Inspection by supervisory authorities based essentially on the internal audit
and inspection reports.
18. Ending duality of control over banking system by RBI and ministry of finance.
RBI should be primary agency for regulations.
19. A separate authority for supervision of banks and financial institutions which
would be a semi-autonomous body under RBI
20. Revised procedure for selection of Chief Executives and Directors of Boards
of public sector banks. Banks should be free to make their own recruitments.
32
In the appointment of the chief executive, the recommendations of a group of
eminent people invited by the RBI governor should be considered.
21. Obtaining resources from the market on competitive terms by Developmental
Financial Institutions (DFIs). The approach of the committee was to ensure
operational flexibility, a measure of competition and adequate internal
autonomy in matters of loan sanctioning and internal administration. It was of
the view that commercial banks should be encouraged to provide term finance
to the industry, while at the same time, DFI‘s should increasingly engaged in
providing core working capital. This would help to enhance healthy
competition between banks and DFI‘s.
22. The committee was in strong favour of substantial and speedy liberalization of
capital market. It recommended that SEBI formulate a set of prudential
guidelines designed to protect the interest of the investors, to replace the
guidelines issued by the Controller of Capital Issues (CCI). It was of the view
that SEBI should not become the controlling authority like CCI, but should
function more as a market regulator to see that market is operated on the basis
of well laid down principles and conventions. The capital market should
gradually be opened up to foreign portfolio investment and simultaneously
efforts should be initiated to improve the depth of the market by facilitating
issue of new types of equities and innovative debt instruments.
23. The committee recommended that the Supervision of merchant banks, mutual
funds, leasing companies etc. that had appeared on the financial scene should
come within the purview of a separate agency to be set up by RBI and
enactment of a separate legislation providing appropriate legal framework for
mutual funds and laying down prudential norms for these institutions, etc.
24. Increased computerisation
There should not be any difference in treatment between public sector and private
sector (including foreign) banks and an indication of no further nationalisation. The
committee emphasised the need for a proper sequencing of the reforms and the need
for the government to undertake certain amendments in the existing laws that would
be required to carry out its recommendations.
33
Several recommendations have been accepted and are being implemented in a phased
manner. Among these are the reductions SLR/CRR, adoption of prudential norms for
asset classification and provisions, introduction of capital adequacy norms, and
deregulation of most of the interest rates, allowing entry to new entrants in private
sector banking sector, etc.
Review of the action taken on the recommendations of committee I on Banking

Sector reforms:
Many of the recommendations of the report have been accepted and implemented.
Some have not been accepted and some implemented in a manner somewhat different
from what was recommended. Reddy, Y.V. (1999) the visible impact of first
generation reforms may be summarized as follows:
 The banking system is well diversified with the establishment of new private
banks and about 20 new foreign banks after 1993. The entry of modern,
professional private sector banks and foreign banks has enhanced competition.
With the deregulation of interest rates both for advances as well as deposits,
competition between different bank groups and between banks in the same
group has become intense. What is more important is that apart from growth
of banks and commercial banking, various other financial intermediaries like
mutual funds, equipment leasing and hire purchase companies, housing
finance companies etc., which are sponsored by banks have cropped up.
 Finance regulation through statutory pre-emption has been lowered while
stepping up of the prudential regulations.
 Steps have been taken to strengthen PSBs through increasing their autonomy,
recapitalization, etc. Based on specified criteria nationalized banks were
given: autonomy in the matters of creation, abolition, up- gradation of posts
for their administrative officers up to the level of Deputy General Manager.
Rs. 10,987.12 crores for capitalization funds were pumped into banks during
1993-95. This indicates the extent of capital erosion faced by the nationalized
banks.
 A set of micro-prudential measures have been stipulated with regard to capital
adequacy, asset classification, provisioning, accounting rules, valuation norms,
etc. Capital to Risk Weighted Assets Ratio (CRAR) of banks stood at 8 per
34
cent. The percentage of Net non performing assets (NPAs) to net advances of
PSBs has declined from 14.4 per cent in 1993-94 to 8.5 per cent by 1997-98.
The prudential norms have been significantly contributed towards
improvement in pre-sanction appraisal and post-sanction appraisal and control,
the impact of which is clearly seen in the decrease in fresh addition of
performing accounts into the NPA category. As per RBI Report on Currency
and Finance (2001-02) consequent upon prudential norms, the most visible
structural change has been improvement in asset quality.
 Measures have been taken to broaden the ownership base of PSBs by allowing
them to approach the capital market. The Government of India, in a major
policy announcement, decided to reduce its stake in PSBs from 100 per cent to
51 per cent. The Government proposes to reduce further its stake to 33 per
cent. Moreover, there is a provision for foreign investments to the extent of 20
per cent. The net result of the dilution in ownership of PSBs is that these banks
are becoming slowly joint sector banks. A number of PSBs like State Bank of
India, Andhra Bank, Bank of Baroda, Canara Bank, Punjab National Bank
have gone up for public issue since 1994.
 Mergers and acquisitions have been taking place in the banking sector. In the
past, due to the existence of a large number of small non-viable banks, the RBI
encouraged larger of small banks with big banks. Now, market driven mergers
between private banks have been taking place.
 As intense competition becomes a way of doing, banks have to pay attention
to customer service. Product innovations and process engineering are the order
of the day. Since interest income has fallen with lowering of interest rates on
advances, banks have to look for enhancing fee-based income, to fill the gap
in interest income. Banks have therefore been moving towards providing value
added services to customers. Under the impact of technological up-gradation
and financial innovations, banks have now become super markets one stop
shop of varied financial services.
 SLR was brought down in phased manner to 25% over a period of about 5
years. CRR also was brought down gradually from 15% to 9.5 % in Nov,
1997.
35
 Contrary to the recommendations, RBI found priority sector accounts for a
little less than 30% of net bank credit. It was therefore decided to continue the
existing targets for priority sector lending.
 Recommendations for deregulation of interest rate except lending to small
borrowers and a part of export finance have been accepted. Interest rates on
deposits are now free except for saving deposits. The interest rate on the
government borrowings is also now market determined.
 All the reforms related to the capital adequacy, NPA‘s and provisioning of bad
loans have been accepted and implemented. Five nationalised banks
successfully raised capital from market since 1993 for a total of Rs. 6034.75
crores. Government has also directly subscribed to the capital of nationalised
banks to the extent of Rs. 20046.00 crores up to 1998.
 Recommendation for setting up of asset reconstruction fund was not
implemented, but the passage of the recovery of the debts due to bank and
financial institutions was paved by specific legislations in August, 1993. So
far 8 debt recovery tribunal and an appellate tribunal have also been
established in Mumbai.
 Four tier structures for banking system were not implemented. Except for
merger of weak public sector banks with another bank, there has been no
restructuring of public sector banks. Recommendations to allow new private
sector banks have been implemented and RBI announced entry norms for
them.
 Branch licensing policy has not been abolished ,but greater operational
freedom have been given to banks to open certain specialised branches, off
site ATMs and other non- branch offices.
 Regarding autonomy measures for banks, Government of India announced a
package in 1997 for banks fulfilling certain criteria, where they were allowed
to recruit specialised officers and also undertake campus recruitments for
probationary officers. The board of banks have been given powers to decide
their policies in respect of creation /abolition, up gradation of posts up to the
level of DGM .For appointment of CEO, Government of India has set up an
appointments board for board level appointments in public sector banks,
36
which is chaired by governor of RBI. The selection is based on the
professional experience and expertise in relevant fields.
 Recommendations regarding supervisions have been implemented in a
different manner. The Board for Financial Supervision (BFS) under aegis of
RBI with 4 members drawn from the RBI board and serviced by a separate
department of banking supervision has been constituted.
Jalan, Bimal (1998) the set of measures, coupled with many others, did have a
positive impact on the system. There has been considerable improvement in
profitability of the banking system. There has been improvement in key financial
indicators of all bank groups during the period 1992-98. For example, the net profits
of the scheduled commercial banks as a percentage of the total assets has been turned
around from a negative figure of 1.0 per cent on average during 1992-93 and 1993-94
to a positive of 0.5 per cent during 1994-95 to 1997-98. Simply, net profits as a
percentage of working funds which was 0.39 per cent in 1991-92 and (-) 1.08 per cent
in 1992-93 turned positive in 1994-95 and reached 0.81 per cent by 1997-98. In case
of most of the public sector banks business per employee and profit per employee
have shown improvement in the recent period, For e.g., in 1991-92 the average profit
per employee of PSBs, was Rs. 1.58 crores, it became positive in 1996-97 at Rs. 0.35
crores It further improved to Rs, 0.59 crores by 1999-2000 and Rs. 1.63 crores in
2002-03. By 1997, almost all public sector banks achieved the minimum capital
adequacy norms of 8 per cent. The gross and net NPAs of banking system as a
percentage of advances have dec1ined to 16 per cent and 8.2 per cent respectively by
March 1998, In terms of percentage of total assets; gross and net nonperforming
assets have declined to 7.0 per cent and 3.3 per cent respectively by March 1998. As
the second report of Narasimham Committee has observed, "this improvement has
arrested the deterioration in these parameters that had marked the functioning of the
system earlier. There is still a considerable distance to traverse. The process of
strengthening the banking system has to be viewed as a continuing process.
Narasimham Committee-II (1998) (Second Generation Reforms)
In the first phase of reforms as discussed above the focus had been on arresting the
qualitative deterioration in the functioning of the system. Most of the
recommendations were promptly implemented and a measure of success was
37
achieved. In the meanwhile, major changes had been taking place in the domestic
economic and institutional scene, coinciding with the movement towards global
integration of financial services. These developments reinforced the importance of
building a strong and efficient financial system. In 1998, therefore, the situation was
reviewed and there were the second generation reforms.
According to Rangarajan, (1998), the recommendations of Narasimham Committee-

I (1991) provided blueprint for first generation reforms of the financial sector. The
period 1992-97 witnessed laying of the foundations for reforms of the banking
system. It also saw the implementation of prudential norms relating to capital
adequacy, asset classification, and income recognition and provisioning, exposure
norms, etc. The difficult task of ushering in some of the structural changes
accomplished during this period provided the bedrock for future reforms. According
to Bhide, Prasad and Ghosh (2002) In fact, India withstood the contagion of 1997
(South-East Asia crisis) indicates the stability of the banking system Against such a
backdrop, the Report of the Narasimham Committee-II in 1998 provided the road map
for the second-generation reform process. According to Reddy (2000), two points are
worth noting at this juncture. First, the financial sector reforms were undertaken in the
early reform cycle, and secondly, the reforms in the financial sector were initiated in
well structured, sequenced and phased manner with cautious and proper sequencing,
mutually reinforcing measures; complementarily between reforms in the banking
sector and changes in the fiscal, external and monetary policies, developing financial
infrastructure; and developing financial markets. The Government appointed a second
high-level Committee on Banking Sector Reforms under the chairmanship' of Mr.
Narasimham to "review the progress of banking sector reforms to date and chart a
programme of financial sector reforms necessary to strengthen the Indian Financial
System and make it internationally competitive. The Committee in its report (April
1998) made wide-ranging recommendations covering entire gamut of issues ranging
from capital adequacy, asset quality, NPAs, prudential norms, asset-liability
management, earnings and profits, mergers and acquisitions, reduction in government
shareholdings to 33 per cent in public sector banks, the creation of global-sized banks,
recasting banks boards to revamping banking legislation.
38
The second generation reforms could be conveniently looked at in terms of three
broad inter-related issues:
 Actions that need to be taken to strengthen the foundations of the banking
system,
 Streamlining procedures, upgrading technology and human resource
development,
 Structural changes in the system. These would cover aspects of banking
policy, institutional, supervisory and legislative dimensions.
The important recommendation of the Committee may be stated as under:

Measures to Strengthen the Banking System
(i) Capital Adequacy
The Committee set new and higher norms of capital adequacy. It recommended that
the "minimum capital to risk assets ratio be increased to 10 per cent from its present
level of 8 per cent in a phased manner ,9 per cent to be achieved by the year 2000 and
the ratio of 10 per cent by 2002.Capital adequacy requirements should also take into
account market risk also. The risk weight for a Government guaranteed advances
should be the same as for other advances. The additional capital requirements will
have to come from either the market or the government. Those banks which are in a
position to access the capital market at home or abroad should therefore be
encouraged to do so.
(ii) Asset Quality, NPAs and Directed Credit
The Committee recommended that and asset be classified as doubtful if it is in the

substandard category for 18 months in the first instance and eventually 12 months and
loss of it has been identified but not written off. Advances guaranteed by the
government should also be treated as NPAs. Banks should avoid the practice of 'ever
greening' by making fresh advance to the troubled parties with a view to settle interest
dues and avoiding such loans treating as NPAs. The Committee believes that the
objective should be to reduce the average level of net NPAs for all banks to below 5
per cent by the year 2000 and to 3 per cent by 2002. For banks with international
presence, the minimum objective should be to reduce gross NPAs to 5 per cent and 3
per cent by 2000 and 2002 respectively and net NPA and to 3 per cent and 0 per cent
39
by these dates. For banks with a high NPA portfolio, the Committee suggested the
setting up of an Asset Reconstruction Company to take over bad debts. The
committee recognises that the small and marginal farmers and the tiny sectors of the
industry and small business have problem with regard to obtaining credit. The
committee recommends that given the special needs of this sector, the current 40% of
direct credit under priority sector should continue.
(iii) Prudential Norms and Disclosure Requirements
It recommended moving to international practice for income recognition and

recommended 90 days norm in a phased manner by the year 2002. In future income
recognition, asset classification and provisioning must apply even to government
guaranteed advances. Banks should pay greater attention to asset liability'
management to avoid mismatches.
Strengthening internal control Systems and Methods in Banks
The internal control systems which are internal inspection and audit should be
strengthened. The submission of controls returns by banks and controlling offices to
higher level offices, risk management system, etc. should be strengthened. There are
recommendations for inducting an additional whole time director on the board of the
banks, recruitment of skilled manpower, revising remuneration to persons at
managerial level, etc.
Structural Issues
(i) Mergers
The Committee is of the view that the convergences of activities between bank and
Development Financial Institutions (DFIs), the DFIs over a period of time convert
themselves into banks. There will be only two forms of financial intermediary‘s banks
and non-bank financial companies. Mergers between banks and between banks and
DFIs and NBFCs need to base on synergies and location and business specific
complementarities of the concerned institutions. Merger of public sector banks should
emanate from the management of banks, the government playing supportive role.
Mergers should not be seen as bailing out weak banks. Mergers between strong banks
would make for greater economic and commercial sense and would be a case where
the whole is greater than the sum of parts and have a 'force multiplied effect',
40
(ii) Weak Banks
A weak bank should be one who‘s accumulated losses and net NPAs exceed its net
worth or one who‘s operating profits less, its income on recapitalization bonds is
negative for three consecutive years. A case-by-case examination of weak banks
should be undertaken to identify those that are potentially viable with a programme of
financial and operational restructuring. Such banks should be nurtured into healthy
units by eschewing high cost funds, confinement of expenditure recovery initiatives,
etc. Mergers should be allowed only after they clean up their balance sheets.
(iii) Narrow Banks
Those banks, which have become weak because of high proportion of NPAs (20 per
cent of the total assets in some cases), the Committee recommended the concept of
'Narrow banking'. Raswalkar (1999) Narrow banking implies that the weak banks
place their funds in the short-term risk-free assets.
(iv) New Banks
The Committee also recommended the policy of permitting new private banks. It is
also of the view that foreign banks may be allowed to set-up subsidiaries or joint
ventures in India. They should be treated on par with private banks and subject to the
same conditions in the regard to branches and directed credit as other banks.
(v) Need for Stronger Banks
The Committee made out a strong case for stronger banking system in the country,
especially in the context of capital account convertibility, which would involve large
inflows, and outflows of capital and consequent complications for exchange rate
management and domestic stability. The Committee therefore recommended winding
up of unhealthy banks and merger of strong and weak banks.
(vi) Banking Structure
The Committee has argued for the creation of 2 or 3 banks of international standard
and 8 or 10 banks at the national level. It also suggested the setting up of small local
banks, which would be confined to a limited area to serve local trade, small industry
and agriculture at the same time these banks will have corresponding relationship with
the large national and international banks.
(vii) Local Area Banks
In the 1996-97 budget, the Government of India announced the setting up of new
Private Local Area Banks (LABs) with jurisdiction over three contiguous districts.
This banker will help in mobilizing rural saving and in channelling them into
41
investment in local areas. The RBI has issued guidelines for setting up such banks in
1996 and gave its approval 'in principle' to the sting up of seven LABs in the private
sector. Of these, RBI had issued licenses to 5 LABs, located in Andhra Pradesh,
Karnataka, Rajasthan, Punjab and Gujarat. These LABs have commenced business.
(viii) Public Ownership and Autonomy
The Committee argued that the government ownership and management of banks
does not enhance autonomy and flexibility in the working of public sector banks. In
this connection, the Committee recommended a review of functions of boards so that
they remain responsible to the shareholders. The management boards are to be
reorganized and they shall not be any government interference.
(ix) Review of Banking Laws
The Committee suggested the need to review and amend the provisions of RBI Act,
SBI Act, Banking Regulation Act, and Banking Nationalization Act, etc. so as to
bring them in line with the current needs of the industry. Ahluwalia (2001) Other
recommendations pertain to computerization process, permission to establish private
sector banks, setting up of Board of Financial Regulation and Supervision and
increasing the powers of debt recovery tribunals.
To summarize, the major recommendations were:
1. Capital adequacy requirements should take into account market risks.
2. In the next three years, entire portfolio of Govt. securities should be marked to
market. It should be appropriate that there should be a 5% weight for market
risk for Government and approved securities.
3. Risk weight for a Govt. guaranteed account must be 100%
4. CRAR to be raised to 10% from the present 8%; 9% by 2000 and 10% by
2002.
5. An asset should be classified as doubtful if it is in the sub-standard category
for 18 months instead of the present 24 months
6. Banks should avoid ever greening of their advances.
7. There should be no further re-capitalization by the Govt.
8. NPA level should be brought down to 5% by 2000 and 3% by 2002 (0% for
those banks with international presence).
9. Banks having high NPA should transfer their doubtful and loss categories to
Asset Reconstruction Company (ARC) which would issue Govt. Bonds
representing the realizable value of the assets.
42
10. We should move towards international practice of income recognition by
introduction of the 90 day norm instead of the present 180 days.
11. A provision of 1% on standard assets is required.
12. Govt. guaranteed accounts must also be categorized as NPAs under the usual
norms
13. Banks should update their operational manuals which should form the basic
document of internal control systems.
14. There is need to institute an independent loan review mechanism especially
for large borrower accounts to identify potential NPAs.
15. A system of Recruitment of skilled manpower directly from the market be
given urgent consideration
16. To rationalize staff strengths, redeployment of surplus staff, flexibility to
determine managerial remuneration and appropriate VRS must be introduced.
17. A weak bank should be one whose accumulated losses and net NPAs exceed
its net worth or one whose operating profits less its income on recap bonds is
negative for 3 consecutive years.
18. Elimination of subsidy element in priority sector( redefined) lending.
19. Full disclosure information.
The Narsimham Committee seeks to consolidate the gains made in the Indian
financial sectors while improving the quality of portfolio, providing greater
operational flexibility, autonomy in the internal operations of the banks and FIs so to
nurture in a healthy competitive and vibrant financial sector.
Review of the action taken on the recommendations of committee II on Banking

Sector reforms:
 Banks are now required to assign capital for market risk. A risk weight of
2.5% for market risk has been introduced on investments in Govt. and other
approved securities with effect from the year ending 31st March, 2000. For
investments in securities outside SLR, a risk weight of 2.5% for market risk
has been introduced with effect from the year ending 31 March, 2001.
 The percentage of banks‘ portfolio of Govt. and approved securities which is
required to be marked to market has progressively been increased. For the year
ending 31st March, 2000, banks were required to mark to market 75% of their
43
investments. In order to align the Indian accounting standards with the
international best practices and taking into consideration the evolving
international developments, the norms for classification and valuation of
investments have been modified with effect from September 30, 2000. The
entire investment portfolio of banks is required to be classified under three
categories, viz., Held to Maturity, Available for Sale and Held for Trading.
While the securities ‗Held for Trading‘ and ‗Available for Sale‘ should be
marked to market periodically, the securities ‗Held to Maturity‘, which should
not exceed 25% of total investments are carried at acquisition cost unless it is
more than the face value, in which case, the premium should be amortised
over a period of time.
 In cases of Govt. guaranteed advances, where the guarantee has been invoked
and the concerned State Govt. has remained in default as on March 31, 2000, a
risk weight of 20% on such advances, has been introduced. State Governments
who continue to be in default in respect of such invoked guarantees even after
March 31, 2001, a risk weight of 100% is being assigned.
 The minimum capital to risk asset ratio (CRAR) for banks has been enhanced
to 9% with effect from the year ending March 31, 2000.
 Banks are permitted to access the capital market. Till 2001, 12 banks have
already accessed capital market.
 Banks have been advised that an asset will be classified as ‗doubtful‘ if it has
remained in the substandard category for 18 months instead of 24 months as at
present, by March 31, 2001. Banks have been permitted to achieve these
norms for additional provisioning in phases, as under : As on 31.3.2001
Provisioning of not less than 50% on the assets which have become doubtful
on account of the new norm. As on 31.3.2002 Balance of the provisions not
made during the previous year, in addition to the provisions needed as on
31.3.2002.
 In the Monetary and Credit Policy announced in April 2001, the banks have
been advised to chalk out an appropriate transition path for smoothly moving
over to 90 days norm. As a facilitating measure, banks should move over to
charging of interest at monthly rests by
44
 April 1, 2002. Banks should commence making additional provisions for such
loans, starting from the year ending March 31, 2002, which would strengthen
their balance sheets and ensure smooth transition to the 90 days norm by
March 31, 2004.
 Prudential norms in respect of advances guaranteed by State Governments
where guarantee has been invoked and has remained in default for more than
two quarters has been introduced in respect of advances sanctioned against
State Government guarantee with effect from April 1, 2000. Banks have been
advised to make provisions for advances guaranteed by State Governments
which stood invoked as on March 31, 2000, in phases, during the financial
years ending March 31, 2000 to March 31, 2003 with a minimum of 25% each
year.
 number of measures have been taken to arrest the growth of NPAs: banks have
been advised to tone up their credit risk management systems; put in place a
loan review mechanism to ensure that advances, particularly large advances
are monitored on an on-going basis so that signals of weaknesses are detected
and corrective action taken early; enhance credit appraisal skills of their staff,
etc. In order to ensure recovery of the stock of NPAs, guidelines for one-time
settlement have been issued in July, 2000.
 Banks have been advised to put in place an independent Loan Review
Mechanism, as recommended by the Committee.
 The public sector banks have been permitted to recruit from the open market
or by way of campus recruitment, skilled personnel in areas like information
technology, risk management, treasury operations, etc. As regards the
recommendation in regard to discontinuing the practice of recruitment of
officers through Banking Services Recruitment Boards, Govt. may furnish
comments.
 Banks have been advised to review the training needs and give more focus to
emerging areas like Credit Management, Treasury Management, Risk
Management, Information Technology, etc.
 A Working Group was set up with representation from public sector banks,
technology experts, to operationalise and implement the programme of
computerisation for banks within a definite time frame. All the
45
recommendations of Group have been accepted for implementation. In
pursuance of the recommendations of the Working Group, the Indian
Financial Network (INFINET), a wide area Satellite based network using
VSAT technology has been commissioned on 24th June, 1999 at Institute for
Development and Research in Banking Technology (IDRBT), Hyderabad
which will connect bank branches and RBI Offices in a phased manner.
 A non-banking finance company has been permitted to merge with a bank.
Two banks in the private sector have also merged based on synergies and
business specific complementarities.
 It has been felt that branch presence by foreign banks would be better for the
reason that the parent bank would stand ready to support the branch in times of
distress. Since subsidiaries would be set up as a joint stock companies with
limited liability, the parent bank‘s liability to its subsidiary would be limited to
its shareholding. In the case of branches, the parent bank has responsibility
both towards capital and management whereas in the case of subsidiaries, the
parent bank‘s responsibility towards capital is limited.
 In respect of new NBFCs, which seek registration with the RBI and
commence the business on or after April 20, 1999 the criteria in regard to
minimum net worth has been increased to Rs.2 crores, vide the Monetary and
Credit Policy for the year 1999-2000.
 The minimum maturity of Certificate of Deposits (CDs) has been reduced to
15 days,
 FIIs have been permitted to invest in Treasury Bills, vide Monetary and Credit
Policy announced in April 1998.
 With effect from June 11, 1998 Foreign Institutional investors were permitted
to take forward cover from Authorised Dealers to the extent of 15 per cent of
their existing investment as on that date. Any incremental investment over the
level prevailing on June 11, 1998 was also made eligible for forward cover.
The Monetary and Credit Policy for 1999-2000 has further simplified the
procedure by linking the above mentioned limits to FIIs‘ outstanding
investments as on March 31, 1999. In other words, 15 per cent of outstanding
investment on March 31, 1999 as well as the entire amount – 100 per cent - of
any additional investment made after this date will be eligible for forward
46
cover. Further, any FII which has exhausted the limits mentioned above can
apply to RBI for additional forward cover for a further 15 per cent of their
outstanding investments in India at the end of March 1999.
 The recommendation of the Committee, which basically aims at ensuring that
the target for priority sector lending is achieved by each of the banks, has been
re-examined. As of March 2000, all public sector banks with the exception of
UCO Bank have achieved the priority sector lending target individually and
the public sector banks as a Group has exceeded the target at the macro level.
The UCO Bank is short of achievement only marginally. Furthermore, every
year the Govt. has been setting up a Rural Infrastructure Development Fund
(RIDF) in which all banks which do not achieve the priority sector target
contribute the amount of shortfall. Thus all banks, directly or indirectly are
able to fulfil the priority sector lending targets. Though the concept of debt
securitisation is a novel idea, it will not have any practical application since it
will not help in augmenting the flow of credit to the priority sector nor will it
help in addressing the question of regional imbalances. It has, therefore, been
decided that the recommendation need not be considered for the present.
 We are moving towards greater transparency and Statutory Auditors of banks
are now under the obligation to report on the deviations from adherence to the
prudential norms prescribed by RBI in their ‗Notes to Accounts‘. These
observations are followed up by the RBI with the concerned banks. In terms of
the provisions of Section 47A of the B.R. Act, 1949, as amended in 1994, the
RBI can impose a penalty not exceeding Rs. 5 lakhs or twice the amount
involved in such contravention or default where such amount is quantifiable
whichever is more and where such contravention or default is a continuing
one, a further penalty which may extent to Rs. 25,000 for every day after the
first day when the contravention or default continues.
Recent Banking Reforms
2010-11
 Domestic deposit rates of Scheduled Commercial Banks (SCBs) have moved

up during 2010-11. Following the RBI‘s raising of the repo and reverse repo
rates by 125 basis points (bps) and 175 bps respectively during March-
47
November 2010, the SCBs increased their deposit rates by 50 bps to 200 bps.
Interest rates offered by the PSBs, private-sector banks and foreign banks on
deposits of maturity of one to three years changed from the range of 6.00-7.25
per cent, 5.25-7.75 per cent, and 2.25-8.00 per cent respectively in March
2010 to the range of 7.00-8.50 per cent, 7.25-9.00 per cent, and 3.00-8.00 per
cent respectively in December 2010.
 The base rate system replaced the Basic Prime lending Rate (BPLR) system
with effect from 1 July 2010. The base rates of PSBs, private-sector banks,
and foreign banks were fixed in the range of 7.50- 8.25 per cent, 7.00-8.75 per
cent, and 5.50-9.00 per cent respectively. Subsequently, several banks
reviewed and increased their base rates. The base rate of PSBs and private-
sector banks changed to the range of 7.60-9.00 per cent and 7.00-9.00 per cent
respectively in December 2010.
 The interest rates on Non-Resident External Term Deposits (NRETM) and
Foreign Currency Non-Resident Bank Account (FCNR [B]) deposits are
regulated by RBI. At present, NRE ceiling deposit interest rate stands at
LIBOR plus 175 basis points and FCNR (B) ceiling deposit interest rate is at
London Interbank Offered Rate (LIBOR) plus 100 bps.
 The validity of the reduction in interest rate ceiling to 250 bps below the
BPLR on pre-shipment rupee export credit up to 270 days and post-shipment
rupee export credit up to 180 days was extended to 30 June 2010 from 30
April 2010.
 The Government of India decided to extend interest subvention of 2
percentage points with effect from 1 April 2010 to 31 March 2011 on pre- and
post-shipment rupee export credit for four export sectors, namely handicrafts,
carpets, handlooms, and Small and Medium Enterprises (SMEs) subject to the
condition that the interest rate after subvention will not fall below 7 per cent,
which is the rate applicable to a short-term crop loan under priority-sector
lending.
 A target of 40 per cent of Adjusted Net Bank Credit (ANBC) or credit
equivalent amount of Off Balance Sheet Exposures (OBE), whichever is
higher, as on 31 March of the previous year, has been stipulated for lending to
the priority sector by domestic SCBs, both in the public and private sectors.
48
Within this, sub-targets of 18 per cent and 10 per cent of ANBC or credit
equivalent amount of OBE, whichever is higher, have been stipulated for
lending to agriculture and the weaker sections respectively.
 All SCBs were advised to ensure that: (a) of the total advances to the MSE
sector, 40 per cent should go to micro (manufacturing) enterprises having
investment in plant and machinery up to 5 lakh and micro (service) enterprises
with investment in equipment up to 2 lakh; (b) of the total advances to the
Micro and Small Enterprises (MSE) sector, 20 per cent should go to micro
(manufacturing) enterprises with investment in plant and machinery above 5
lakh and up to 25 lakh, and micro (service) enterprises with investment in
equipment above 2 lakh and up to 10 lakh. (Thus 60 per cent of MSE
advances should go to micro enterprises).
 In terms of the recommendations of the Prime Minister‘s Task Force on
Micro, Small and Medium Enterprises (MSMEs) (Chairman: Shri T. K. A.
Nair) constituted by the Government of India, banks were advised as follows :
(a) to achieve a 20 per cent year-on-year growth in credit to MSEs to ensure
enhanced credit flow; (b) to achieve the allocation of 60 per cent of the MSE
advances to micro enterprises in stages, namely 50 per cent in the year 2010-
11, 55 per cent in the year 2011-12, and 60 per cent in the year 2012-13, and;
(c) to achieve a 10 per cent annual growth in number of micro-enterprise
accounts. (iii) banks were advised not to accept collateral security in the case
of loans up to 10 lakh extended to units in the MSE sector. (iv)The limit for
waiver of margin/ security requirements for agricultural loans was enhanced
from 50,000 to 1 lakh. Thus, at present, all agricultural loans up to 1 lakh do
not require any collateral.
 The Government of India set up the Rural Infrastructure Development Fund
(RIDF) in 1995 through contribution from commercial banks to the extent of
their shortfall in agricultural lending. Over the years, coverage under the RIDF
has been made more broad based in each tranche and, at present, a wide range
of 31 activities under various sectors is being financed.
 The Kisan Credit Cards (KCC) Scheme has become a widely accepted
mechanism for delivery of credit to farmers. The scheme now also covers
borrowers of the long-term cooperative credit structure. In order to safeguard
49
the interests of KCC holders, NABARD has allowed banks the discretion to
opt for ‗any insurance company of their choice‘. Recommendations of Task
Force ‗to look into the issue of a large number of farmers, who had taken loans
from private moneylenders, not being covered under the loan waiver scheme
are: i. Financial literacy and counselling campaigns be undertaken to increase
awareness among farmers on the KCC. ii. Banks be encouraged to educate
their rural branch staff about the KCC. iii. Banks use farmers‘ cooperatives
and Self Help Groups (SHG) federations as banking correspondents to
increase outreach. iv. The coverage of new farmers in the command areas of
bank branches and new areas be ensured through meaningful and purposeful
conduct of gram sabhas and kisan credit camps at regular intervals. v. Bankers
who have already been advised by the RBI to lend without any collateral, up
to Rs. 1 lakh per farmer, put such advice into more widespread practice
through Joint Liability Groups (JLGs) of tenant farmers, sharecroppers, and
oral lessees. vi. State governments exempt agricultural loan agreements from
stamp duty. vii. The KCC be technology enabled, including the conversion to
a smart card with withdrawals and remittances enabled at Automated Teller
Machines (ATMs), Points of Sale (PoS), and through hand-held machines;
banks need to have Core Banking Solutions (CBS) in place at the earliest, to
enable technology to benefit the farmer. viii. The KCC limit be fixed for five
years, based on the banker‘s assessment of total credit needs of the farmer for
a full year, and that the limit be operated by the borrower as and when needed,
with no sublimits for kharif and rabi, or for stages of cultivation. ix. Each
withdrawal under the KCC is allowed to be liquidated in twelve months
without the need to bring the debit balances in the account to zero at any point
of time. x. There be automatic renewal and annual increase on credit limit
linked to inflation rate.
 NBFCs were advised that there should be no discrimination in extending
products and facilities including loan facilities to physically/ visually
challenged applicants on grounds of disability.
2011-12
 During 2011-12 (up to end December 2011), deposit rates of SCBs have
increased across various maturities. Interest rates offered by SCBs on deposits
50
of one to three year maturity were placed in the 3.50-10.50 per cent range in
December 2011, as compared to 3.50-10.10 per cent in March 2011, while
those on deposits of maturity of above three years were placed in the 4.25-
10.10 per cent range as compared to 3.50-10.00 per cent in March 2011.
 The base rates of SCBs were placed in the 6.25-11.25 per cent range in
December 2011 as compared to 6.25-10.00 per cent in March 2011.
 Interest rates on Foreign Currency Non- Resident [FCNR (B)] deposits
continue to remain regulated by the RBI. At present, the prescribed ceiling
interest rate on FCNR (B) deposits stands at LIBOR plus 125 bps effective 23
November 2011.
 The median interest rates (at which more than 60 per cent of business is
contracted) on rupee export credit for pre-shipment credit (up to 180 days) of
SCBs were in the 10.40-12.63 per cent range in September 2011 (9.13-11.50
per cent in March 2011). Those on rupee export credit for post-shipment credit
(up to 180 days) were in the 8.88-12.75 per cent range in September 2011, as
compared to 8.75-12.25 per cent in March 2011.
 The RBI set up a committee to study issues and concerns in the micro-finance
sector (Chairman: Shri Y. H. Malegam). Based on its recommendation, all
SCBs have been advised by the RBI that bank credit to MFIs extended on, or
after, 1 April 2011 for on-lending to individuals and also to members of
SHGs/ Joint-Liability Groups (JLGs) will be eligible for categorization as
priority-sector advance under the categories agriculture, MSE, and micro
credit (for other purposes), as indirect finance, provided not less than 85 per
cent of total assets of the Micro Finance Institutions (other than cash balances
with banks and financial institutions, government securities, and money
market instruments) are in the nature of ‗qualifying assets‘. In addition, the
aggregate amount of loan, extended for income-generating activity, should not
be less than 75 per cent of the total loans given by MFIs. The above committee
recommended that the existing guidelines on bank lending to the priority
sectors be revisited. Accordingly, the Reserve Bank of India set up a
Committee, under the Chairmanship of Shri M. V. Nair, CMD, Union Bank of
India, to re-examine the existing classification and suggest revised guidelines
with regard to priority-sector lending classification and related issues.
51
 Consequent upon the announcement by the Union Finance Minister in Budget
Speech 2006-07, public-sector banks, regional rural banks and rural co-
operative credit institutions were advised that with effect from Kharif 2006-
07, Government would provide interest rate subvention of 2 per cent per
annum in respect of short-term production credit up to 3.0 lakh. This
subvention was available to public sector banks, regional rural banks and rural
co-operatives on the condition that they made short-term credit available at 7
per cent per annum. In case of RRBs and rural cooperatives, this was
applicable only to short-term production credit disbursed out of their own
funds and did not include such credit supported by NABARD refinance.
Pursuant to the Union Budget announcement of 2010-11, it was decided to
provide interest subvention of 1.5 per cent per annum for short-term
agriculture loans up to 3.0 lakh disbursed by public-sector Banks,
cooperatives, and RRBs. The additional subvention for prompt repayment has
been enhanced to 2 per cent per annum so that the effective interest rate
charged to such farmers is 5 per cent per annum up to 3.0 lakh.
 In the 2011-12 Budget, the Government of India proposed to provide interest
subvention of 1.5 per cent per annum for short term agriculture loans up to 3.0
lakh disbursed by Public Sector Banks, co-operatives and RRBs. The
additional subvention for prompt paying farmers is proposed to be enhanced to
3 per cent per annum so that the effective interest rate charged to these farmers
is 4 per cent per annum up to 3.0 lakh.
 RBI has been encouraging banks to leverage upon the latest available
technology to expand and handle their business in a cost effective manner.
Computerization as well as the adoption of core banking solutions has been a
major step in improving the efficiency of banking services. Presently almost
98 per cent of the branches of public sector banks are fully computerized, of
which almost 90 per cent are on the core banking platform. Introduction of
automated teller machines (ATMs) has enabled customers to do banking
without visiting the bank branch. In 2010-11 the number of ATMs witnessed a
growth of 24 per cent over the previous year. More than 65 per cent of the
total ATMs belonged to public sector banks at end March 2011. During 2010-
11, the number of debit cards grew at the rate of 25 per cent over the previous
52
year. In sync with the trend observed in case of ATMs, nearly three-fourths of
the total debit cards were issued by public sector banks at end March 2011.
 A sum of 12,000 crores has been provided for capital infusion in Public Sector
Banks to enable them to maintain a minimum Tier I CRAR at 8 percent as on
31 March, 2012 and also to increase shareholding of the Government of India
in the PSBs to 58 per cent. Further, the Government has appointed a High
Level Committee headed by Finance Secretary, to assess the need for
capitalisation of various PSBs for the next 10 years keeping in view various
challenges the PSBs have to face due to the impending implementation of
Basel III norms and the credit needs of the fast growing economy; and to
explore various options to raise resources to capitalize the PSBs and analyse
various suggested / preferred modes of capitalisation.
 Government is signing Memorandum of Understandings (MoUs) with the
Public Sector Banks (PSB) whereby capital infusion will be linked to
achieving the targets by PSBs on various key parameters on productivity,
including Return on Assets, Net Profit Per employee and Cost to Income
Ratio. MOUs spanning over a period of four years, 2011-12 to 2014-15, have
since been finalized with all the PSBs excluding SBI Associate Banks. SBI
will be entering into MOU with its Associate Banks on similar parameters.
Government has put in place a mechanism of Statement of Intent on Annual
Goals (SOI) to monitor the performance of the PSBs on various performance
parameters. In order to have greater focus on efficiency parameters and also to
have a more realistic view of the quality of assets of PSBs, SOI parameters
have been revised during 2011-12.
 Detailed Strategy and Guidelines on Financial Inclusion have been issued by
the Government to banks on 21 October 2011 which inter-alia provide
emphasis on: (i) setting up more brick and mortar branches with the objective
to have a bank branch within a radial distance of 5 km; (ii) to open bank
branches by Sept 2012 in all habitations of 5,000 or more population in under
banked districts and 10,000 or more population in other districts; (iii) to
provide a Business Correspondent within a radial distance of 2 km; (iv) to
cover villages of 1,000 and more population in 10 smaller States/UTs by
53
September 2012; (v) to consider Gram Panchayat as a unit for allocation of
area under Service Area Approach to bank branch etc.
 A Pilot Project on Financial Inclusion (FI) in Mewat district was also
undertaken by all the public sector banks and the Gurgaon Gramin Bank
functioning in the district. Banking facilities are now available in all the 95 FI
villages, either through a brick and mortar branch or a business correspondent.
77 Ultra Small Branches are being set up by various banks. Training on e-
payment was imparted to all the bank officials. Campaign to issue Kisan
Credit Cards (KCC) to all eligible non defaulter farmers and General Credit
Cards (GCC) to non-farmers was organized. Wide publicity and financial
literacy measures were initiated through broadcasting financial inclusion
messages in the local Mewati language on the community radio, display of
graffiti at prominent places, organization of Kisan Goshtis, mobilization of
progressive farmers to form farmers clubs etc. A proof of concept in inter-
operability between the Business Correspondents of different banks was also
done. Syndicate Bank has tied up with SBI Life for providing micro insurance
cover of 25,000 with a nominal premium of 32/- per annum. Solar Home
Lighting Systems were popularized and 1500 loans have been given to
establish Solar Home Lighting System.
 To align the minimum capital ratio of all deposit taking NBFCs with that of
systemically important non-deposit—taking NBFCs, all deposit-taking NBFCs
were advised to maintain a minimum capital ratio consisting of Tier I and Tier
II capital at 15 per cent of their aggregate risk-weighted assets on balance
sheet and risk adjusted value of off-balance sheet items with effect from 31
March 2012.
 It was clarified that the term ‗infrastructure loan‘ would now include ‗telecom
towers‘ also as an infrastructure facility for availing of credit facility. Further,
NBFCs were also advised that only Credit-Rating Agencies (CRAs) approved
by the RBI can assign rating to Infrastructure Finance Companies (IFCs).
 A Sub-Committee of the Central Board of the RBI (Chairman: Shri Y. H.
Malegam) was constituted to study issues and concerns in the MFI sector. It
was announced that the broad framework of regulations recommended by the
Committee had been accepted by the Bank and it had been decided to create a
54
separate category of NBFCs, viz; Non Banking Financial Company-Micro
Finance Institution (NBFC-MFI). Consequently there would be seven
categories of NBFCs namely Asset Finance Company (AFC), Investment
Company (IC), Loan Company (LC), Infrastructure Finance Company (IFC),
Core Investment Company (CIC), Infrastructure Debt Fund- Non- Banking
Financial Company (IDFNBFC) and Non-Banking Financial Company -Micro
Finance Institution (NBFC-MFIs). Directions to such companies were issued
on 2 December 2011. An NBFC-MFI is defined as a non-deposit taking NBFC
(other than a company licensed under Section 25 of the Companies Act, 1956)
that fulfils the conditions like (i) Minimum Net Owned Funds of 5 crore, (For
NBFC-MFIs registered in the North Eastern Region of the country, the
minimum NOF requirement shall stand at 2 crore), (ii) not less than 85 per
cent of its net assets are in the nature of ‗qualifying assets‘.
 Entry-point norms, prudential norms for capital requirement, and asset
classification and provisioning norms have been prescribed for NBFCs-MFI.
NBFCs-MFI was also advised about pricing of credit, i.e. to maintain an
aggregate margin cap of not more than 12 percent. The interest cost will be
calculated on average fortnightly balances of outstanding borrowings and
interest income is to be calculated on average fortnightly balances of
outstanding loan portfolio of qualifying assets. Interest on individual loans
will not exceed 26 per cent per annum and will be calculated on reducing
balance basis. Processing charges shall not be more than 1 per cent of gross
loan amount. Processing charges need not be included in the margin cap or
interest cap.
 Multiple-lending, over-borrowing and ghost borrowers have been prohibited.
NBFCs-MFI has been advised to follow non-coercive methods of recovery of
loan. Further, corporate governance related instructions have also been issued.
NBFC-MFIs have been advised to review their back office operations and
make the necessary investments in information technology and systems to
achieve better control, simplify procedures, and reduce costs.
 Broad guidelines have been issued vide a press release dated 23 September
2011 for setting up of IDFs to facilitate flow of funds into infrastructure
projects. The IDF will be set up either as a trust or as a company. A trust-
55
based IDF would normally be a mutual fund (MF), while a company-based
IDF would normally be an NBFC. An IDF- NBFC would raise resources
through issue of either rupee- or dollar-denominated bonds of minimum five-
year maturity. The investors would be primarily domestic and off-shore
institutional investors, especially insurance and pension funds which would
have long term resources. An IDF-MF would be regulated by the Securities
and Exchange Board of India (SEBI) while an IDF-NBFC would be regulated
by the RBI. Eligibility parameters for NBFCs as sponsors of IDF-MFs include
a minimum NOF of 300 crore; CRAR of 15 per cent; net NPAs less than 3 per
cent; the NBFC to have been in existence for at least five years and earning
profits for the last three years in addition to those prescribed by SEBI in the
newly inserted Chapter VI B to the MF Regulations. Only NBFC-IFCs can
sponsor IDF-NBFCs with prior approval of the RBI and subject to the
following conditions: the sponsor IFC would be allowed to contribute a
maximum of 49 per cent to the equity of the IDF-NBFC with a minimum
equity holding of 30 per cent of the equity of IDF-NBFC, post investment, in
the IDF-NBFC; the sponsor NBFC-IFC must maintain minimum CRAR and
NOF prescribed for IFCs; there are no supervisory concerns with respect to the
IFC. The IDF is granted relaxation in credit concentration norms and in risk
weights.
2012-13
 The policy rates were cut during 2012-13, including a reduction of 75 basis
points (bps) in the repo rate in two steps (50 bps in April 2012 and 25 bps in
January 2013), a reduction of 100 bps in the SLR in August 2012, and a 75
bps cut in the cash reserve ratio (CRR) in three steps (25 bps effective 22
September 2012, 25 bps effective 3 November 2012 and 25 bps effective 9
February 2013).
 The modal term deposit rates for banks across all maturities declined by 15
bps to 7.27 per cent during 2012-13 (as on 15 December 2012). The decline
was noted across all bank groups and mostly for maturities up to one year.
 The modal interest rate on non-resident (external) rupee (NRE) deposits of
banks declined by 37 bps during 2012-13 (up to December 15) to 8.71 per
cent, reflecting subdued demand for export credit in the economy. Interest
56
rates on foreign currency non-resident (bank) account (FCNR [B]) deposits
continue to be regulated by the RBI. With a view to augmenting foreign
currency inflows into the economy, effective 5 May, 2012 the interest rate
ceiling on FCNR (B) deposits was raised to LIBOR/ Swap rates plus 200 bps
for 1-3 year maturity and LIBOR/Swap rates plus 300 bps for 3-5 year.
 Following the reduction in the repo rate in April 2012 and the calibrated
liquidity easing measures announced by the RBI during 2012-13, the modal
base rate of banks declined by 25 bps to 10.50 per cent during the current
fiscal.
 The interest rate on export credit in foreign currency was deregulated effective
5 May 2012 to increase foreign currency loans to exporters. The modal
lending rate (at which 60 per cent or more business was contracted) for the
reporting banks on pre-shipment credit in foreign currency declined by 20 bps
to 4.03 per cent between November 2012 and June 2012 in line with decline in
LIBOR rate during the period.
 Revised guidelines issued by the RBI on priority sector lending (PSL) on 20
July 2012, mandates commercial banks and foreign banks with 20 or more
branches to allocate 40 per cent of their Adjusted Net Bank Credit (ANBC) or
credit equivalent amount of off-balance sheet exposures (OBE), whichever is
higher, to the priority sector.
 The Finance Minister in his Budget Speech of 2012-13 had announced that
Swabhimaan would be extended to habitations with population more than
1,000 in the north-eastern and hilly states and population more than 1,600 in
the plains areas as per Census 2001.
 Considering the need for close supervision and mentoring of the Business
Correspondent Agents (BCAs) by the respective banks and in order to ensure
that a range of banking services are available to the residents of such villages,
Ultra Small Branches (USBs) are being set up in all villages covered through
BCAs under financial inclusion.
 A decision was taken in the meeting of the National Committee on Direct
Cash Transfer held by Hon'ble Prime Minister that Direct Benefit Transfer
(DBT) will be rolled out from 1 January, 2013 in 43 identified districts. The
purpose of Direct Benefits Transfer is to ensure that benefits go to individuals'
57
bank accounts electronically, minimising tiers involved in fund flow thereby
reducing delay in payment, ensuring accurate targeting of the beneficiary and
curbing pilferage and duplication. 28 schemes were identified for DBT rollout
in 43 identified districts from 1.1.2013. It was further decided that future
benefits under all the 28 schemes would be transferred in the following phased
manner - (a) in 20 of the 43 districts, from 1.1.2013 (b) in 11 of the 43 districts
after 1.2.2013, and (c) in the remaining 12 of the 43 districts after 1.3.2013.
The Interest Subvention Scheme is being implemented by the Government of
India since 2006-07 to make short-term crop loans up to 3 lakh for a period of
one year available to farmers at the interest rate of 7 per cent per annum. The
additional subvention which was 1per cent in 2009-10 was gradually increased
to 2 percent in 2010-11 and 3 per cent in 2011-12 and 2012-13.
 In 2012-13 also, the Government has infused capital in PSBs to augment their
Tier-I capital so that they maintain their Tier-I CRAR at a comfortable level
and remain compliant with the stricter capital adequacy norms under BASEL-
III.
 Some recent initiatives taken by the government to address the rising NPAs
include (a) appointment of nodal officers in banks for recovery at their head
offices/ zonal offices/ for each Debts Recovery Tribunal (DRT); (b) thrust on
recovery of loss assets by banks; (c) close watch on NPAs by picking up early
warning signals and ensuring timely corrective steps by banks; (d) directing
the state-level Bankers' Committee to be proactive in resolving issues with the
state governments; and (e) designating Asset Reconstruction Companies
(ARCs) resolution agents of banks.
 Pursuant to the second review of the Monetary Policy, the RBI has also
announced the following remedial measures: the provision for restructured
standard accounts is to be raised from the existing 2 per cent to 2.75 per cent;
the sanction of fresh loans/ad-hoc loans from 1st Jan 2013 will be made on the
basis of sharing of information among banks; banks will conduct sector-
activity-wise analysis of NPAs; banks will put in place a robust mechanism for
early detection of sign of distress, amendments in recovery laws, and
strengthening of credit appraisal and post credit monitoring.
58
 The regulatory and supervisory framework of NBFCs continued to focus on
prudential regulations. NBFCs that are predominantly engaged in lending
against the collateral of gold jewellery have inherent concentration risk and
are exposed to adverse movement of gold prices, as a prudential measure it
was decided that all such NBFCs shall: hereafter maintain a Loan-To-Value
(LTV) ratio not exceeding 60 per cent for loans granted against the collateral
of gold jewellery and disclose in their balance sheet the percentage of such
loans to their total assets; maintain a minimum Tier l capital of 12 per cent by
1 April 2014; not grant any advance against bullion / primary gold and gold
coins.
 Systemically important Core Investment Companies (CIC) with total assets
not less than 100 crores, either individually or in aggregate along with other
CICs in the group, and that raise or hold public funds, shall apply to the RBI
for grant of Certificate of Registration (CoR).
 The RBI on 21 November 2012 issued detailed guidelines with regard to the
regulation of IDF-NBFCs. In terms of the guidelines, for the purpose of
computing capital adequacy, IDF-NBFCs are permitted to assign a risk weight
of 50 per cent on bonds covering Public Private Partnership (PPP) and post
commercial operations date (COD) projects in existence over a year of
commercial operation.
 A new category of NBFCs, viz. non-banking financial company factors, has
been introduced and separate directions have been issued in this regard by the
RBI. These directions include a mention that every company intending to
undertake factoring business shall make an application for grant of CoR as
NBFC-factor to the RBI. Existing NBFCs that satisfy all the conditions
enumerated in these directions can also apply for change in their classification.
An NBFC-factor, will need to commence business within six months from the
date of grant of CoR. Net Owned Funds (NOF) for every company seeking
registration as NBFC-factor has been fixed at a minimum of 5 crores.
2013-14
 Scheduled commercial banks (SCBs) responded to the policy measures by

adjusting their deposit and lending rates. The transmission of monetary easing
during 2012-13 and Q1 2013-14 enabled the Weighted Average Lending Rate
59
(WALR) on the outstanding rupee loans extended by banks to decline by 37
bps during 2012-13 and further by 7 bps in Q1 2013-14 whereas the median
term deposit rate increased by 32 bps.
 The RBI increased interest rates on FCNR (B) deposits of 3-5-year maturity
by 100 bps to 400 bps above the London Interbank Offered Rate (LIBOR) in
August 2013 in light of prevailing exchange rate pressures. These moves were
reversed in March 2014.
 Some recent initiatives taken by the government to address the rising NPAs
include: Appointment of nodal officers in banks for recovery at their head off
ices/zonal off ices/for each Debts Recovery Tribunal (DRT), Thrust on
recovery of loss assets by banks and designating asset reconstruction
companies (ARC) resolution agents of banks, Sanction of fresh loans on the
basis of information sharing amongst banks.
 The RBI‘s recently released study ‗Early Recognition of Financial Distress,
Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for
Revitalizing Distressed Assets in the Economy‘ has suggested various steps
for quicker recognition and resolution of stressed assets. The other main
proposals in the framework are: Centralized reporting and dissemination of
information on large credit.
 The RBI set up the Committee on Comprehensive Financial Services (CCFS)
for Small Businesses and Low-Income Households in September 2013 under
the Chairmanship of Dr Nachiket Mor. The Committee‘s Report was released
on 7 January 2014. At its core, the Committee‘s recommendations are that in
order to achieve the task of financial inclusion in a manner that enhances both
financial inclusion and stability, there is need to move away from an exclusive
focus on any one model to an approach where multiple models and
partnerships are allowed to thrive, particularly between national full-service
banks, regional banks of various types, NBFCs, and financial markets. The
common theme of all the recommendations made by the Committee is that
instead of focusing only on large generalist institutions, specialization and
partnerships between specialists must be encouraged. Such an approach, in its
view,would be far more effective at delivering high quality financial inclusion,
without compromising financial stability or responsibility towards customers.
60
 The RBI released ‗Guidelines for Licenses of New Banks in the Private
Sector‘ on 22 February 2013, wherein applications for setting up new banks in
the private sector were invited, for which 25 applications were received. A
High Level Advisory Committee under the Chairmanship of Dr Bimal Jalan,
former Governor RBI, was set up for screening these applications. The
Committee submitted its Report along with its recommendations on 25
February 2014. Based on this, an internal scrutiny of the applications was done
and the RBI, on 2 April 2014, granted ‗in-principle‘ approval to two
applicants, namely IDFC Limited and Bandhan Financial Services Private
Limited, to set up banks under the Guidelines.
Apart from these some other reforms are as follows:
Basel III norms: These are rules written by the Bank of International Settlement's
Committee on Banking Supervision (BCBS) whose mandate is to define the reform
agenda for the global banking community as a whole. Basel Committee was formed in
1974 by a group of central bank governors from 10 countries. Earlier guidelines
were known as Basel I and Basel II accords. Later on the committee was expanded to
include members from nearly 30 countries, including India. Inspite of implementation
of Basel I and II guidelines, the financial world saw the worst crisis in early 2008 and
whole financial markets tumbled. One of the major debacles was the fall of Lehman
Brothers. One of the interesting comments on the Balance Sheet of Lehman
Brothers read: ―Whatever was on the left-hand side (liabilities) was not right and
whatever was on the right-hand side (assets) was not left.‖ Thus, it became necessary
to re-visit Basel II and plug the loopholes and make Basel norms more stringent and
wider in scope.
BCBS, through Basel III, put forward norms aimed at strengthening both sides of
balance sheets of banks viz. (a) enhancing the quantum of common equity; (b)
improving the quality of capital base (c) creation of capital buffers to absorb shocks;
(d) improving liquidity of assets (e) optimizing the leverage through Leverage
Ratio (f) creating more space for banking supervision by regulators under Pillar II and
(g) bringing further transparency and market discipline under Pillar III. Thus,
Basel III norms were released by BCBS and individual central banks were asked to
61
implement these in a phased manner. RBI (India's central bank) too issued draft
guidelines in the initial stage and then came up with the final guidelines.
The final guidelines have been issued by Reserve Bank of India for implementation of
Basel 3 guidelines on 2nd May, 2012.
(a) These guidelines would become effective from January 1, 2013 in a phased
manner. This means that as at the close of business on January 1, 2013, banks must be
able to declare or disclose capital ratios computed under the amended guidelines. The
Basel III capital ratios will be fully implemented as on March 31, 2018.
(b) The capital requirements for the implementation of Basel III guidelines may be
lower during the initial periods and higher during the later years. Banks needs to keep
this in view while Capital Planning;
(c) Guidelines on operational aspects of implementation of the Countercyclical
Capital Buffer. Guidance to banks on this will be issued in due course as RBI is still
working on these. Moreover, some other proposals viz. ‗Definition of Capital
Disclosure Requirements‘, ‗Capitalisation of Bank Exposures to Central
Counterparties‘ etc., are also engaging the attention of the Basel Committee at
present. Therefore, the final proposals of the Basel Committee on these aspects will
be considered for implementation, to the extent applicable, in future.
(d) For the financial year ending March 31, 2013, banks will have to disclose the
capital ratios computed under the existing guidelines (Basel II) on capital adequacy as
well as those computed under the Basel III capital adequacy framework.
(e) The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9%
against 8% (international) prescribed by the Basel Committee of Total Risk weighted
assets (RWA). This has been decided by Indian regulator as a matter of
prudence. Thus, it requirement in this regard remained at the same level. However,
banks will need to raise more money than under Basel II as several items are excluded
under the new definition.
(f) of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of
RWAs;
(g) In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs,
(international standards require these to be only at 4.5%) banks are also required to
maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of
62
Common Equity Tier 1 capital. CCB is designed to ensure that banks build up capital
buffers during normal times (i.e. outside periods of stress) which can be drawn down
as losses are incurred during a stressed period. In case such buffers have been drawn
down, the banks have to rebuild them through reduced discretionary distribution of
earnings. This could include reducing dividend payments, share buybacks and staff
bonus.
(h) Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which
has been raised to 7% under Basel III. Moreover, certain instruments, including some
with the characteristics of debts, will not be now included for arriving at Tier 1
capital;
(i) The new norms do not allow banks to use the consolidated capital of any insurance
or non financial subsidiaries for calculating capital adequacy.
(j) Leverage Ratio: Under the new set of guidelines, RBI has set the leverage ratio at
4.5% (3% under Basel III). Leverage ratio has been introduced in Basel 3 to regulate
banks which have huge trading book and off balance sheet derivative positions.
However, In India, most of banks do not have large derivative activities so as to
arrange enhanced cover for counterparty credit risk. Hence, the pressure on banks
should be minimal on this count.
(k) Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires
banks to hold enough unencumbered liquid assets to cover expected net outflows
during a 30-day stress period. In India, the burden from LCR stipulation will depend
on how much of CRR and SLR can be offset against LCR. Under present guidelines,
Indian banks already follow the norms set by RBI for the statutory liquidity ratio
(SLR) – and cash reserve ratio (CRR), which are liquidity buffers. The SLR is mainly
government securities while the CRR is mainly cash. Thus, for this aspect also Indian
banks are better placed over many of their overseas counterparts.
(l) Countercyclical Buffer: Economic activity moves in cycles and banking system is
inherently pro-cyclic. During upswings, carried away by the boom, banks end up in
excessive lending and unchecked risk build-up, which carry the seeds of a disastrous
downturn. The regulation to create additional capital buffers to lend further would act
as a break on unbridled bank-lending. The detailed guidelines for these are likely to
be issued by RBI only at a later stage.
63
Pradhan Mantri Jan-Dhan Yojana (PMJDY): It is a scheme for comprehensive
financial inclusion launched by the Prime Minister of India, Narendra Modi on 28
August, 2014. PMJDY is a National Mission on Financial Inclusion encompassing an
integrated approach to bring about comprehensive financial inclusion of all the
households in the country. The plan envisages universal access to banking facilities
with at least one basic banking account for every household, financial literacy, access
to credit, insurance and pension facility. In addition, the beneficiaries would get
RuPay Debit card having inbuilt accident insurance cover of र 1 lakh. The plan also
envisages channeling all Government benefits (from Centre / State / Local Body) to
the beneficiaries‘ accounts and pushing the Direct Benefits Transfer (DBT) scheme of
the Union Government. The technological issues like poor connectivity, on-line
transactions will be addressed. Mobile transactions through telecom operators and
their established centres as Cash Out Points are also planned to be used for Financial
Inclusion under the Scheme. Also an effort is being made to reach out to the youth of
this country to participate in this Mission Mode Programme.
Special Benefits under PMJDY Scheme
 Interest on deposit.
 Accidental insurance cover of Rs.1.00 lacs.
 No minimum balance required.
 Life insurance cover of Rs.30,000/-
 Easy Transfer of money across India
 Beneficiaries of Government Schemes will get Direct Benefit Transfer in these
accounts.
 After satisfactory operation of the account for 6 months, an overdraft facility
will be permitted
 Access to Pension, insurance products.
 Accidental Insurance Cover, RuPay Debit Card must be used at least once in
45 days.
 Overdraft facility upto Rs.5000/- is available in only one account per
household, preferably lady of the household.
64
Swabhimaan: It is a financial security programme was launched by the Central
Government to ensure banking facilities in habitation with a population in excess of
2000 by March 2012. This nationwide programme on financial inclusion was
launched in February, 2011 with its focus on bringing the deprived sections of the
society in the banking network to ensure that the benefits of economic growth reach
everyone at all levels. ―Swabhimaan‖ is a path-breaking initiative by the Union
Government and the Indian Banks‘ Association to bridge economic gap between rural
and urban India. This campaign is a big step towards socio-economic equality by
bringing the underprivileged segments of Indian population into the formal banking
fold for the first time. The vision for this programme is social application of modern
technology.
In a big nation like India, providing banking facilities across the length and breadth of
the country, especially in rural areas, has always been a great challenge for the
successive governments since Independence. Even though nationalisation gave a big
boost to expansion of banks in rural areas with Public Sector Banks becoming
important instruments for advancement of rural banking and changing lives of rural
populace.
The key idea is that there is need for village level presence – a customer-facing
channel that is close to the customer preferably at a walking distance of not more than
three to four kilometers. For this, it is important to have entities which are good at
delivering outreach while operating in very difficult remote conditions. Besides
giving access to banking, it also enables government subsidies and social security
benefits to be directly credited to the accounts of the beneficiaries, enabling them to
draw the money from the bank saathi or business correspondents in their village itself.
This initiative enables small and marginal farmers to obtain credit at lower rates from
banks and other financial institutions. This would insulate them from exploitation of
the money lenders. Government‘s emphasis on bankers is to take up this task with a
sense of responsibility and understanding and exercise courtesy and respect,
especially to small borrowers.
The initiative is also important to protect the customers, especially the most
vulnerable ones, from harsh financial practices and prevent them from being
65
overburdened by debt. All in all, the end objective should be to empower people to
achieve their own goals through enhancing their financial capabilities.
―This campaign ensures to provide the following services to the Rural India:
 Promises to bring basic banking services to unbanked villages with a

population of 2000 and above.
 The movement facilitates opening of banks accounts, provide need-based
credit and remittance facilities besides helping in promoting financial literacy
in rural India.
 The programme is aimed at increasing the demand for credit among the
millions of small and marginal farmers and rural artisans who will benefit by
having access to banking facilities.
 This financial inclusion campaign aims at providing branchless banking
services through the use of technology.
 Banks provide basic services like deposits, withdrawals and remittances using
the services of Business Correspondents (BCs) also known as Bank Saathi.
 The initiative also enables Government subsidies and social security benefits
to now be directly credited to the accounts of the beneficiaries so that they
could draw the money from the Business Correspondents (BCs) in their
village itself.
 The Government hopes that the benefits of micro insurance and micro pension
products reach the masses through this banking linkage.
 This programme now makes it possible for the large number of migrant
workers in urban areas to remit money to their relatives in distant villages
quickly and safely.
 The facilities provided through banking outlets will enhance social security by
facilitating the availability of allied services in course of time like micro
insurance, access to mutual funds, pensions, etc.
 Banking facilities like Savings Bank, recurring Deposits, Fixed deposits,
Remittances, Overdraft facility, Kisan Credit Card (KCCs), General Credit
Cards (GCC) and collection of cheques will be provided.
66
 The Banks are also working together with the Unique Identification Authority
of India (UIDAI) for enrolment, opening bank accounts and also to facilitate
transfer of government subsidies and other payments.
1.9 Structure of Indian commercial banks
Figure 1.1 Schedule Banking Structure in India as on March, 2013
Scheduled Commercial Banks Scheduled Co-operative Banks
Private Sector Foreign Bank (43)

Banks (20)
Public Sector Banks Regional Rural

(26) Banks (64)
Old Private Sector Banks (13) New Private Sector Banks (07)
Nationalised Banks (19) Other Public Sector Banks (01)
SBI and its Associates (06)
Scheduled Urban Co-operative Scheduled State Co-operative

Banks (51) Banks (16)
Note: Scheduled Banking Structure as indicated in the Second Schedule of the

Reserve Bank of India. Figures in brackets indicate number of banks in each group.
67
Banking sector in India has a wide mix, comprising of scheduled and non-scheduled
banks, nationalised commercial banks, post office saving s bank, cooperative sector
banks and foreign sector banks. Scheduled banks consist of scheduled commercial
banks and scheduled cooperative banks. Indian banking industry consist of 220
scheduled commercial banks, out of which Regional Rural banks constitute 64 banks
as on March,2013 (as shown in the figure 1.1). Regional Rural banks play an
important role in the development of privileged sections of the society. These banks
have been set up to meet the credit requirements of rural agricultural labourers, small
and marginal farmers and small entrepreneurs etc. Apart from regional rural banks,
other commercial banks are 89 in number, comprising of 26 public sector banks, 20
private sector banks and 43 foreign banks as on March, 2013. Public sector category
includes nationalised banks (19), SBI and its associates (6) and 1 other public sector
bank.
In the financial set up of the country, public sector banks hold major share in the total
assets of scheduled commercial banks. Despite some of the operational constraints,
public sector banks are still in the possession of certain core strengths like wide
branch network, large customer base and geographical coverage. The major changes
occurred in the institutional set up of commercial banks after Reserve bank of India
made free the entry of private sector and foreign banks to function side by side with
the public sector banks. Hanson and kathuria (1999) however foreign banks were
allowed to continue in the new milieu, but their expansion was stringently regulated.
The entry of private and foreign banks put stiff competition and led to paradigm shift
in banking space. Apart from this scheduled cooperative banks comprised of
scheduled urban and state cooperative banks. As on March2013, there were 51 urban
and 16 state scheduled co-operative banks. These banks have been set-up on unit
banking principle.
Indian commercial banking sector had witnessed a structural transformation due to

change in economic ideology over a period of time. This has resulted into change in
growth of banking indicators. Some of the banking indictors have slowed down and
some are speeding up. Similarly, the entry of private sector banks in the commercial
banking space, the respective share of different indicators with respect to different
bank groups has changed.
68
1.10 Conclusion
Financial sector reforms in India introduced as a part of the structural adjustment and
economic reforms programme in the early 1990s have had a profound impact on the
functioning of the financial institutions, especially banks. The principal objective of
financial sector reforms was to improve the allocative efficiency of resources, ensure
financial stability and maintain confidence in the financial system by enhancing its
soundness and efficiency. At the same time, reforms were also undertaken in various
segments of financial markets, to enable the banking sector to perform its
intermediation role in an efficient manner. With a view to making the reform
measures mutually reinforcing, the reform process was carried forward through
analysis and recommendations by various Committees/Working Groups and extensive
consultations with experts and market participants.
The banking sector reforms, which were implemented as a part of overall economic
reforms, witnessed the most effective and impressive changes, resulting in significant
improvements within a short span. The distinctive features of the reform process may
be stated thus:
I. The process of reforms has all along been pre-designed with a long term
vision. The two Committees on financial sector reforms (Narasimham
Committee-I and II) have outlined a clear long-term vision for the banking
segment particularly in terms of ownership of PSBs, level of competition, etc.
II. Reform measures have been all pervasive in terms of coverage of almost all
problem areas. In fact, it can be said that, it is difficult to find an area of
concern in the banking sector on which there has not been a Committee or a
group.
III. Most of the reform measures before finalization or implementation were
passed through a process of extensive consultation and discussion with the
concerned parties.
IV. Most of the reform measures have targeted and achieved international best
practices and standards in a systematic and phased manner. .
V. All the reform measures and changes have been systematically recorded and
are found in the annual reports as well as in the annual publications of RBI on
"Trend and Progress of Banking in India".
69
Before nationalisation, the commercial banks were mainly concentrated in the urban
areas or few selected areas. The profitability of the financial sector was very low. On
the back of poor profitability step towards the economic growth; equity and justice
was taken in the form of nationalisation of banks in the year 1969. The commercial
banks made an unprecedented growth during 1980‘s and 1990‘s. But a shift from
‗class banking‘ to ‗mass banking‘ coupled with certain statutory conditions in the post
nationalisation period lead to low profitability. Therefore, deteriorating financial
health of the banks becomes a major concern for the policy makers.
On the back of ill health of banks and certain inherent problems within the system
lead to the introduction of banking sector reforms as a part of financial sector reforms.
The steps like reduction in statutory liquidity ratio and cash reserve ratio were
initiated. In this line, number of reforms in the form of transparency, prudential norms
and capital adequacy norms equal to that of international standards were introduced.
In order to enhance competitive efficiency, norms for domestic private sector banks
and foreign banks were also changed to revive the financial health of commercial
banks.
The banking system, which was over-regulated and over administered, was freed from
all restrictions and entered into an era of competition since 1992. The entry of modern
private banks and foreign banks enhanced competition. Deregulation of interest rates
had also intensified competition. Prudential norms relating to income recognition,
asset classification, provisioning and capital adequacy have led to the improvement of
financial health of banks. Consequent upon prudential norms the most visible
structural change has been improvement in the quality of assets. Further, there has
been considerable improvement in the profitability of banking system. The net profits
of SCBs, which were negative in 1992-93, become positive in 1994-95 and stood at
Rs. 17,077.07 Crores by March 2003. The profitability of the Indian Banking System
was reasonably in line with International experience. It may be pointed out that the
banking sector reform is certainly not a one-time affair. It has evolutionary elements
and follows a progression of being and becoming. Form this point, Indian experience
of restructuring banking sector has been reasonably a successful one. There was no
major banking crisis and the reform measures were implemented successfully since
1992. Some expressed the fear that the reforms will sound a blow to social banking.
The Government did not accept the Narasimham Committee-I recommendation that
70
advances to priority sector should be brought down from 40 per cent to 10 per cent.
The Banks continued to be directed to lend a minimum of 18 per cent of total banks
credit to agriculture sector.
The major recommendation include increase in the CRAR to 10% by 2002,new

guidelines for asset classification, reduction in net NPAs to below 3%( 0% for those
banks with international presence) , elimination of subsidy element in priority sector
lending, full disclosure information, revised and regularly updated operational manual
by banks and Consolidation and convergence of the financial system, a system of
recruiting skilled manpower from the open market, redeployment of the surplus staff
,flexibility to determine managerial remuneration, achieving rapid induction of IT,
allowing foreign banks to set up subsidiaries or joint ventures in India, evolution of
risk management system, greater internal control, transparency and market discipline,
legislative steps etc.
The government‘s responsibility as per the committee would then be to create and
nurture a diversified and functionally efficient financial sector through an appropriate
incentive framework and a legal system rather than through direct interventionalist
policies. The commercial banks have aided the economic development in an effective
way in the post independence periods. They mobilise savings, lending, investing and
related activities and facilitate the economic process of production, distribution and
consumption.
71
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Future of India‘s Economy‖. Univeristy of California, Nov.20, RBI Bulletin,
January, pp.33-65.
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Delhi, 2003.
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Reforms‘, The Journal of the India Institute of Bankers, Vol-2, April 1998.
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Schumpeter, J.A. ( 1934). The Theory of Economic Development. Cambridge,
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Distributors, New Delhi, pp. 3.
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CHAPTER 2
REVIEW OF LITERATURE
2.1 Introduction
The earlier chapter had been devoted to an introduction to the financial sector and an
outline of the major reforms undertaken in the financial sector. Before analysing the
impact of these reforms on financial development in India and the growth of Indian
economy, it is important to review the existing literature from the viewpoint of
techniques and indicators used and the existing results in this area. Review of
literature has vital relevance with any research work. With the help of literature
review, the possibility of repetition of study can be eliminated and another dimension
can be selected for the study. A number of studies have been carried out in India and
around the world covering various aspects of banking and financial sector. This
chapter presents a review of the relevant existing theoretical and empirical literature
related with the present topic as under:
Chakravartee committee (1985) was set up to review the working of the monetary
system in India. The committee was of the view that there should be a controlled
competition among the banks. It recommended for rationalisation of concessional
interest rates.
Levine (1996) argued that the preponderance of theoretical reasoning and empirical
evidence suggests a positive relationship between financial development and
economic growth. There is evidence that the financial development level is a good
predictor of future rates of economic growth, capital accumulation, and technological
change. Moreover, cross-country, case-style, industry level and firm-level analysis
document extensive periods when financial development crucially affects the speed
and pattern of economic development. The author explains what the financial system
does and how it affects, and is affected by economic growth. Theory suggests that
financial instruments, markets and institutions arise to mitigate the effects of
information and transaction costs. A growing literature shows that differences in how
well financial systems reduce information and transaction costs influence savings
rates, investment decisions, technological innovation, and long-run growth rates. A
less developed theoretical literature shows how changes in economic activity can
76
influence financial systems. The author advocates a functional approach to understand
the role of financial systems in economic growth. This approach focuses on the ties
between growth and the quality of the functions provided by the financial systems.
The author discourages a narrow focus on one financial instrument or a particular
institution.
Levine and Zervos (1996) using data on 49 countries from 1976 to 1993, the authors
investigated whether measures of stock market liquidity, size, volatility, and
integration in world capital markets predict future rates of economic growth, capital
accumulation, productivity improvements, and private savings. They found that stock
market liquidity-as measured by stock trading relative to the size of the market and
economy is positively and significantly correlated with current and future rates of
economic growth, capital accumulation, and productivity growth, even after
controlling for economic and political factors. Stock market size, volatility and
integration are not robustly linked with growth, nor are financial indicators closely
associated with private savings rates. The authors determined that these results are
consistent with views that (1) financial markets and institutions provide important
services for long-run growth and (2) stock markets and banks provide different
financial services.
Fry (1997) studied the real interest rate as the key to a higher level of investment and
a rationing device leading to greater investment efficiency. However, Fry suggested
five pre-requisites for the success of financial liberalisation: The first is adequate
prudential regulation and supervision of commercial banks, both of which imply some
minimal levels of accounting and legal infrastructure. The second is a reasonable
degree of price stability. The third is the fiscal discipline to avoid inflationary
expansion of reserve money by the Central Bank, seen through direct domestic
borrowing by the government or through the indirect effect of government borrowing,
which produces surges of capital inflows and requires a large purchase of foreign
exchange by the Central Bank to prevent exchange rate depreciation. The fourth is a
tax system that does not impose discriminatory or implicit taxes on the financial
sector. The fifth is a profit-maximising policy by the commercial banks.
Beck, Levine and Loayza (1999) evaluated whether the level of development in the
banking sector exerts a causal impact on economic growth and its sources-total factor
77
productivity growth, physical capital accumulation, and private saving. They used (1)
a pure cross-country instrumental variable estimator to extract the exogenous
component of banking development and (2) a new panel technique that controls for
country-specific effects and endogeneity. They found that: banks do exert a large,
causal impact on total factor productivity growth, which feeds through to overall GDP
(Gross Domestic Product) growth. The long-run links between banking development
and both capital growth and private savings are more tenuous.
Levine, Loayza and Beck (1999) studied: a) whether the level of development of
financial intermediaries exerts a casual influence on economic growth and b) whether
cross-country differences in legal and accounting systems (such as creditor rights,
contract enforcement, and accounting standards) explain differences in the level of
financial development. Using traditional cross-section, instrumental-variable
procedures and recent dynamic panel techniques, they found that development of
financial intermediaries exerts a large causal impact on growth. The data also showed
that cross-country differences in legal and accounting systems help determine
differences in financial development. Together, these findings suggest that legal and
accounting reform that strengthens creditor rights, contract enforcement, and
accounting practices boosts financial development and accelerates economic growth.
RBI (1999) provides the central banks perspectives on how deregulation has impacted
on banks performance. This review of the RBI covers all categories of the banks, not
just public sector banks but also the private sector banks. The principal findings of
this review are worth highlighting:
1) There has been a decline in spread and tendency towards convergence across
all banks groups, except foreign banks.
2) Intermediation cost as percentage of total assets had also declined, especially
for public sector banks and new private sector banks.
3) Median profit per employee of public sector banks witnessed a significant rise
between 1996-1997 and 1999-2000.
4) Non-interest income to working funds rose moderately for the median of
public sector banks.
5) The ratio of wage bill to total expenses remained at a high level for public
sector banks.
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6) The cost to income ratio declined both at the SBI Group and the Nationalised
banks.
Verma committee (1999) identified and examined the problems of weak banks and
suggested a strategic plan of financial, organisational and operational restructuring for
them. The committee on the basis of seven parameters covering solvency, earning
capacity and profitability evaluated the public sector banks. These parameters were:
capital adequacy ratio at 8 %, coverage ratio at 0.50 %, return on assets at median
level, net interest margin at median level, profit to average working funds at median
level, ratio of cost to income at median level and ratio of staff cost to income at
median level for the years 1997-98 and 1998-99. All the public sector banks were
further categorised into five groups. The committee recommended recapitalisation of
weak banks subject to strict conditionality relating to operational restructuring.
Agarwal (2000) investigated the relationship between stock markets and financial
intermediaries‘ development and the link between stock market development and
long-term growth in India. The study suggests that well-developed stock markets offer
different types of financial services than those of the banking system and therefore
provide an extra impetus to economic activity. Hence, banking sector and capital
markets are complementary and not substitutes. He also found that various parameters
of stock market development such as size and liquidity are statistically significant in
explaining economic activity.
Arestis, et al (2001) examined the relationship between stock market development

and economic growth in five developed countries after controlling for the effects of
banking system and stock market volatility. The results support the view that,
although both banks and stock markets are able to promote growth, the effect of the
former is more powerful. They also suggested that the contribution of stock markets
to economic growth has been exaggerated by studies that use cross -country growth
regressions.
Ikhide and Alawode (2001) highlighted that financial sector reforms began in
Nigeria with the deregulation of interest rates in August 1987. Since then, far-
reaching policy measures including the chartering of new banks, reform of the capital
market and a move from direct to indirect monetary controls have been undertaken.
The results from the implementation of the reforms have been disappointing,
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however, bank insolvency, high inflation and excessively high interest rates have
become common phenomena in the economy. This study uses discriminant analysis to
demonstrate that the health of banks deteriorated following reforms in Nigeria. The
study cautiously identified a wrong sequencing process as a major factor in the poor
performance of the financial sector reforms, but agrees that a lot more research needs
to be done in this area.
Laurenceson (2002) studied that the impact of stock market on economic

development is limited in China. Especially, the corporate governance effect has been
ineffectual and stock markets are insignificant sources of financing for non-state
owned firms. Besides, on a macro level, their impact on the overall level of savings
mobilisation and allocation efficiency of capital also has found to be negligible.
Singh and Srinivasan (2002) examined several dimensions of economic reform in

India, in the context of the country‘s federal system and of globalization, they
explicitly recognized that the national government has sub national governments
below it, and that all these layers of government simultaneously interact with foreign
governments and corporations in a global economy. They examined two groups of
reforms, the first involving redrawing of state-market boundaries, and the second
concerned with reconfiguring federal institutions themselves. The first group includes
financial sector reforms, assignment of regulatory powers, infrastructure reform and
development, and privatization. They noted the progress made in financial sector
reform but also the problems caused for the financial sector as a whole by state and
central fiscal deficits. They discussed the extreme problems of the power sector, and
the important federal dimensions that make reform more difficult there. They also
highlighted the regional concentration of Foreign Direct Investment (FDI) in India‘s
more liberalized economy. The second group of reforms includes tax reforms, reform
of centre-state fiscal transfer mechanisms, and local government reforms. To some
degree, these reforms in federal governance hold the key to open the door for further
reform elsewhere, by reducing the fiscal burden placed on the private sector by
government deficits. They acknowledged the political economy aspects of reform of
governance, and discussed possibilities for politically acceptable packages of fiscal
reforms, such as combinations of changes in tax assignment that would be acceptable
to the centre as well as the state governments. They also discussed the possibility that
80
growing regional inequalities might require the intergovernmental transfer system to
be more efficient and effective in its objectives.
Al-Yousif (2002) examined the nature and the direction of the relationship between
financial development and economic growth using both time-series and panel data
from 30 developing countries for the period 1970-2000, and reported a negative
correlation between financial development and economic growth. These results can be
attributed to the weakness of these countries' financial environments, which have
encouraged the inefficient allocation of savings and led in turn to the negative growth
of the GDP.
Koivu (2002) studied the relationship between financial sector and economic growth
in transition countries had been largely ignored in the earlier empirical literature. In
this paper, they analysed the finance- growth nexus using a fixed-effects panel model
and unbalanced panel data from 25 transition countries during the period 1993-2000.
They measured the qualitative development in the banking sectors using the margin
between lending and deposit interest rates. Their second variable for the level of
financial sector development is the amount of bank credit allocated to the private
sector as a share of GDP. According to the results, the interest rate margin is
significantly and negatively related to economic growth. This outcome is in line with
theoretical models and has important policy implications. On the other hand, a rise in
the amount of credit does not seem to accelerate economic growth. The main reasons
behind this result could be the numerous banking crises the transition countries have
experienced and the soft budget constraints that are still prevalent in many transition
countries. Due to these specific characteristics the growth in credit has not always
been sustainable and in some cases it may have led to a decline in growth rates.
Neimke (2003) used a theoretical and empirical approach to explain the dynamic link
between financial development and economic growth in the transition countries. He
found that both the theoretical explanations and the empirical results, point to
financial institutions having significant effects for investment and the development of
factor productivity as the foundation for long-term positive growth. This is
particularly true for Central and Eastern Europe as well as for the former Soviet
Union economies that have inherited widely obsolete capital stock, and are suffering
from sharp decline in their growth rates.
81
Calderon and Liu (2003) examined the direction of causality between financial
development and economic growth on data from 109 developing countries and
industrialised countries from 1960 to 1994. They found that financial development
generally leads to economic growth and that there is a positive interaction between
financial and economic growth. They also reported that financial deepening
contributes more to the causal relationship in the developing countries. Financial
deepening propels economic growth through both a more rapid capital accumulation
and productivity growth.
Loayza and Ranciere (2004) studied the apparent contradiction between two strands
of the literature on the effects of financial intermediation on economic activity. On the
one hand, the empirical growth literature finds a positive effect of financial depth as
measured by, for instance, private domestic credit and liquid liabilities (for example,
Levine, Loayza, and Beck 2000). On the other hand, the banking and currency crisis
literature finds that monetary aggregates, such as domestic credit, are among the best
predictors of crisis and their related economic downturns (for example, Kaminski and
Reinhart 1999). The authors account for these contrasting effects based on the
distinction between the short- and long-run impacts of financial intermediation.
Working with a panel of cross-country and time-series observations, they estimated an
encompassing model of short- and long-run effects using the Pooled Mean Group
estimator developed by Pesaran, Shin, and Smith (1999). Their conclusion from this
analysis is that a positive long-run relationship between financial intermediation and
output growth coexists with a mostly negative short-run relationship. The authors
further developed an explanation for these contrasting effects by relating them to
recent theoretical models, by linking the estimated short-run effects to measures of
financial fragility (namely, banking crises and financial volatility) and by jointly
analyzing the effects of financial depth and fragility in classic panel growth
regressions.
Fatima (2004) explored the causality issue between financial development and
economic growth in the Moroccan context over the period 1970-2000 based on
Granger causality tests. The evidence presented in this paper suggested a spasmodic
short-term, rather than long-term causality relationship between finance and growth.
These findings may be attributed to the newness of financial sector reforms in
Morocco, along with the absence of an appropriate investment climate required to
82
foster significant private investment and promote growth in the long run. In addition,
aggregate data suggested that financial deepening in Morocco benefited household
and government consumption more than private sector investment. An empirical
investigation of the impact of credit to the private sector on consumption is therefore
provided and confirmed the hypothesis that the expansion of credit to the private
sector witnessed in Morocco since the reforms have helped maintain consumption
patterns, even during times of hardship.
Rani (2005) studied that the Narasimham Committee I‘s recommendations came out
with a system of registration introduced in April 1993 for NBFCs with NOFs of Rs.50
lakhs and above including prudential norms pertaining to income recognition, asset
classification and provisioning which were prescribed in June 1994. The Khanna
Committee mainly dealt with redesigning the supervisory framework and also
CAMEL model was prescribed for on-site inspection. The RBI Amendment Act 1997
introduced compulsory registration with the RBI. Narasimham Committee II, a
comprehensive legislation for the first time which empowered RBI with sweeping
powers in all respects of control over the performance and existence of NBFCs. The
number of reporting NBFCs and the growth rate of deposits continued to rise till the
year 1997, but declined after 1998 as the regulatory framework 1998 which came as a
source of excessive control to the real and genuine players in the market. The main
source of NBFCs has always been the fixed deposits. The gross NPAs to the total
advances were 11.4 per cent in March 1998 and it declined to 9.7 per cent in
September 2002. The Directions 1998 are amended from time to time based on the
recommendations of Vasudev Committee.
Hondroyiannis et al (2005) assessed empirically the relationship between the

development of the banking system and the stock market and economic performance
for the case of Greece over the period 1986-1999. The empirical results gained from
using VAR models, suggest a bi-directional relationship between finance and growth
in the long run. Also, both bank and stock market financing can promote growth and
furthermore the contribution of stock market finance to economic growth appears to
be substantially smaller compared to bank finance.
Jeanneney, Hua and Liang (2006) studied that financial development might lead to
productivity improvement in developing countries. In the present study, based on the
83
Data Envelopment Analysis approach, they used the Malmquist index to measure
China‘s total factor productivity change and its two components (i.e., efficiency
change and technical progress). They found that China has recorded an increase in
total factor productivity from 1993 to 2001, and that productivity growth was mostly
attributed to technical progress, rather than to improvement in efficiency. Moreover,
using panel dataset covering 29 Chinese provinces over the period from 1993 to 2001
and applying the Generalized Method of Moment (GMM) system estimation, they
investigated the impact of financial development on productivity growth in China.
Empirical results showed that, during this period, financial development has
significantly contributed to China‘s productivity growth, mainly through its
favourable effect on efficiency.
Bayraktar and Wang (2006) studied that Banking sector openness may directly
affect growth by improving the access to financial services and indirectly by
improving the efficiency of financial intermediaries, both of which reduce the cost of
financing and in turn, stimulate capital accumulation and economic growth. The
objective of the paper is to empirically reinvestigate these direct and indirect links,
using a more advanced econometric technique (GMM dynamic panel estimators). An
illustrative model is presented to link financial market development with investment.
The empirical results confirm the presence of direct and indirect links and thus
provide support for countries planning to open their banking sector for international
competition.
Balakrishnan and Parameswaran (2007) adopted recent development in the

econometrics of estimating and testing for multiple structural breaks in the linear
models to identify phases of growth in India since 1950. The noteworthy feature of
the methodology is that it allows the data to parameterise the model, thus yielding
results that are immune to the prior beliefs of the researcher. Mostly, the authors have
identified significant changes in economic policy and tested for whether they have
succeeded in bringing about the growth shift, even though there is no agreement on
the precise policies that did so. The authors followed a methodology that identifies
growth regimes endogenously rather than one based on exogenous information such
as the date of initiation of a policy change. The resulting estimates revealed that there
are two growth regimes in India since 1950. The authors then decomposed by sector
the contribution to the change in the growth rate across these regimes. Finally, by
84
means of a simple econometric model, the authors tested a hypothesis that emerges
from their estimation and testing for structural break in the main sectors of the
economy to provide an explanation of the growth transition in India. In conclusion,
the authors considered the bearing of their results on extant explanations of the same
transition. Further, the results showed that services have led growth in India for at
least two decades by now, which is acknowledged to be a prerequisite to understand
economic growth in India.
Hassan and Jung (2007) analyzed the impact of financial sector reforms from the
early 1990s on promoting economic growth in Morocco. To derive feasible policy
implications, they estimated not only pooled regressions, but also variance
decompositions of GDP growth rates to examine what proxy measures of financial
development are most important in economic growth over time and how much they
contribute to economic growth across geographic regions and income groups. They
found strong linkages between financial development and economic growth in high-
income OECD countries, but not in East Asian & Pacific, South Asian, and Sub-
Saharan African regions, in the short run. Therefore, it may be necessary for Morocco
to make different policy efforts to achieve steady economic growth in the long run.
Mohan (2007) analysed the various aspects of banking sector reforms carried out in
India and examined the impact of reforms using various parameters and explores the
factors underlying the improvement in performance. The Public Sector Banks (PSB)
have shown a remarkable transformation in the post-reform period. Profitability is
comparable to international banks, efficiency and stability have improved and there is
a convergence between Public Sector Banks and private banks. But the PSBs will be
severely tested as disintermediation proceeds apace on both the asset and liability
sides. Their survival depends on their ability to rise to the challenges ahead. Both
unions as well as government in its capacity as owner have an important role to play
in ensuring that PSBs are well prepared to meet these challenges. One lesson that
emerges from the Indian experience with bank reforms is that there is virtue in
organizational diversity and it pays to have different business models in a given
setting. The paper suggests that the system gains when there is diversity in ownership-
public, private, foreign. Hence, it would be tragic if the gains we have made by
charting a unique course in bank reforms were sacrificed at the altar of ideology.
85
Dastidar (2007) focused on the potential impact of adoption of Basel II norms on the
goal of financial inclusion in India. It is argued that the Basel II norms, which will
cover all banks by March, 2009, will introduce tightly controlled and comprehensive
coverage of risks that could undermine financial inclusion. The research methodology
is based on statistical data analysis using financial data, including data on money
markets, foreign exchange markets and debt and securities markets from the RBI and
other media sources. The authors concluded that the norms may not be against the
spread of bank lending to those who are now excluded. However, given the inherent
biases inherent within the banking system, the norms may provide a convenient
excuse for a half hearted approach of banks towards financial inclusion. In fact, it is
emphasised that the serious inter-regional, inter-class and inter-sectoral disparities in
banking services in India call for a calibrated balancing of prudential norms and the
provision of genuinely inclusive and regionally well-spread services.
Das and Ghosh (2007) attempted to make a theoretical analysis of the linkages
between bank deregulation and solvency. Many developing countries have adopted
the programme directed or regulated credit to achieve the socially optimum allocation
of credit. Dismantling of this directed credit programmes is being as one of the major
aspect of financial sector liberalisation that many of these countries are pursuing. The
advocates of this liberalisation regime argue that the directed credit programme
generates inefficiency and low rates of saving which makes the banking services
unprofitable and if the banks continue with such a state , they eventually becomes
bankrupt or insolvent. This paper borrows theoretical traditions from the structuralist
and new Keynesian schools to construct a theoretical example to show that, if
allocation of bank credit conforms to the pattern of social profitability, a part of the
additional gain to the society may accrue to the banks as well in the form of additional
profit to the society as a whole. The authors have developed a model of small open
economy with typical features of developing economies and make a comparison of
bank profits under free market conditions and under directed credit programme. Based
on these analyses, the paper argued that under certain macro-economic conditions the
programme of directed credit that seeks to maximize social welfare might also raise
aggregate bank profit substantially above the level that it attains in free market
equilibrium.
86
Edirisuriya (2007) has clearly stated that Sri Lanka went ahead with its financial
sector reforms about three decades ago. As the banking sector is the leading sector in
most of the financial systems, the reforms were mainly directed towards the banking
sector. Among these reforms were recommendations to improve private sector
participation significantly in the financial sector, removal of restrictions on banking
products such as interest rate and loans, exchange rate relaxation, opening up of
financial markets for foreign and domestic competition and to encourage efficient
functioning of financial market with less government interferences. Though, the
programme of reforms is still not completed, substantial benefits appear to be
spreading in Sri Lanka as well as many countries in the region. The objective of this
study is to examine what types of reforms are being implemented in the country and
whether there are any significant benefits to the general public using examples mainly
from the banking sector. The analysis shows that Sri Lankan banks have evolved to a
more efficient and competitive market. However, financial market in Sri Lanka needs
to go further to improve their efficiencies to bring them up to the standard of
international financial markets. Lack of financial literacy among market participants,
dominance of state owned banks and lack of clear directives for the government
appear to be major issues in the banking sector. Findings of the study also suggest that
though there are substantial gains from financial sector reforms however, further
reforms are necessary to improve efficiency in the financial sector.
Shah (2007) presented a paper to assess the credit flows through the co-operative
across all the districts and regions of Maharashtra and their sustainability, viability
and operational efficiency. The data is collected from various secondary and official
records for the period (1980-2000). The effect of various factors affecting changes in
loan advances through Primary Agricultural Cooperative Credit Societies(PACS) in
Maharashtra is estimated through R² using only linear specification while the viability
of credit institutions are evaluated through estimation of breakeven levels of their loan
advances and deposits and various financial ratios. The finding revealed that slow
growth in institutional finance through credit cooperation during the decade of
economic reforms (1991-2000) as compared to the decade preceding it. Slower
growth has also been observed in the membership of credit cooperatives in
Maharashtra during reform period. On the contrary, outstanding loans are growing at
a much faster rate as compared to loan advances during both pre and post economic
87
reform period .The empirical evidence shows the languid attitude of PACS towards
SC/ST. Another issue which needs to be taken care of is escalating over dues and Non
Performing Assets (NPAs) of the cooperatives operating in both forward and
backward regions of Maharashtra. The author articulated that in order to pump up the
rural credit flow through cooperatives, the major problem faced by the system can be
shouldered with more fiscal jurisprudence.
Bayraktar and Wang (2008) have made a successful attempt in establishing the
direct and indirect linkage between the two variables i.e., financial openness and
economic growth by using a more advanced econometric technique, the Generalised
Method of Moments (GMM) instrumental variable estimation method. The dataset
comprises of 28 countries, both developing and developed countries, all of which
have completed their financial liberalization process. The main data source for the
bank level variables like net interest margin, overhead costs, total assets etc is
BANKSCOPE for the period 1994-2003. Though this cross - country and overtime
analysis gives a picture of the continuous changes that took with financial openness
over the nine year period, but it does not allow to conduct a longer term growth
analysis. This is the limitation of the paper which has been duly acknowledged by the
authors of the paper. Two different sets of regressions equations are run to study the
direct and indirect link between the economic growth rate and the share of foreign
bank assets after other determinants of growth like macroeconomic and efficiency
level of the banking sector variables have been controlled for. The empirical result
obtained after running the regression on the panel data gives a positive relationship
between the two variables and thus supports the presence of both types of links. This
study would help policy makers who are wary of financial openness to get a picture of
its impact on economic growth rate and might encourage them to remove
liberalisation restrictions on foreign banks.
Mahesh and Bhide (2008) in their paper made a successful attempt to examine the
effect of India‘s financial sector reforms, introduced in 1992 on the efficiency level of
Indian commercial banks for the period 1985-2004, which covers some pre- reform
and post- reform years. Three different measures of efficiency namely the cost, profit
and loan advance efficiency have been introduced. These have been estimated using
the Battese and Coelli (1995) approach. The panel dataset of 94 banks for 20 years is
obtained from the Performance Highlights of Banks, Annual Accounts of Scheduled
88
Commercial Banks, and balance sheet and expenditure statements of respective banks.
Stochastic frontier analysis employed to study the impact of reforms gives an
unambiguous results. It shows that financial reforms have had a significant impact on
the all three types of efficiency measures. While loan advance efficiency has declined
marginally for the entire industry in the period under consideration, cost efficiency
has improved and profit efficiency shows a varying trend. The paper comes up with a
strong result negating the wide held perception that public sector banks are inefficient.
The analysis showed that public sector banks rank first in two out of the three
efficiency measures, indicating that these banks do not lag their private counterparts
in efficiency. It also showed that competition has a significant impact on the
efficiency levels of commercial banks across all the three measures. Therefore, this
study clearly indicated that the financial sector reforms bring changes in the banking
sector and these changes have influenced the efficiency level of the services provided
by the banking sector. This paper is very relevant in guiding the finance related policy
makers as it suggests that the rapid changes in the financial sector that are underway
will keep influencing the performance of the banking sector.
Mahadeva (2008) examined the inclusive nature of financial growth and suggested
some alternatives to ensure effective financial inclusion in India. Financial inclusion,
in any economy, is a precondition for achieving industrial growth and overall
development. In India, banking sector and other financial institutions have not
succeeded in providing financial services to rural sector and also to marginalized
section of society like scheduled caste and tribes, women, landless labourers etc.
Financial exclusion thus helped in enhancing the social and economic segregation in
India. Both supply and demand side factors are responsible for this malfunction. On
the demand side, lack of awareness, illiteracy, unemployment, low income status,
social exclusion of people etc are some of the major hindrances for financial
inclusion. On the supply side, procedural rigidity, attitude problem of the bankers,
ineffective government interventions etc. are some of the main obstacles. But the most
depressing fact about financial exclusion is probably associated with the inadequate
and low coverage of banking sector in rural India. While the national data showed that
only 43% of total branches are working in rural areas, some regions even are doing
worse than this national average. Also the rural-urban divide within a particular
region should not be ignored. The role of Rural Co-operative societies is also not
89
satisfactory at all. Even though mere physical expansion of bank branches may not
lead to financial inclusion, still this is a necessary condition for overall economic
development. Although government has taken several initiatives to ensure increased
access of under-served people, the situation would not change unless the bankers
change their attitude towards these marginalized people. Also some alternative
measures may come in terms of re-examining credit needs of people, maintaining a
good relation between financial institutions and rural inhabitants, building strong links
between financial institutions and rural-based institutions, creating a Financial
Inclusion Fund under the NABARD and initiating a special motivational training to
the workforce.
Beck (2008) showed that financial development accelerates aggregate economic

growth, economists have not resolved conflicting theoretical predictions and ongoing
policy disputes about the cross-firm distributional effects of financial development.
Using cross-industry, cross-country data, the results are consistent with the view that
financial development exerts a disproportionately positive effect on small firms.
These results have implications for understanding the political economy of financial
sector reform.
Rena (2008) the study has clearly stated that Indian economy has been recording
impressive growth rates since 1991. This can be partly attributed to the multi-sector
structural reforms aimed at enhancing productivity, efficiency and international
competitiveness of the economy. The reforms have been undertaken gradually with
mutual consent and wider debate amongst the participants and in a sequential pattern
that is reinforcing to the overall economy. The financial markets have developed and
are more integrated after the reforms, and regulatory and supervisory institutions have
been set-up. The reforms, though slow paced initially but well synchronized, have
begun to yield results. The economy has recorded consistently high growth rates,
avoided any adverse impact from the South East Asian crises, built substantial foreign
exchange reserves, pre-paid some of its external debt and restructured its domestic
debt. An attempt was made in this paper to figure out the challenges and threats that
lie ahead in Indian economy. The study also raised a number of questions that need
further analysis to understand better the continuing and likely impact of the economic
reforms in India.
90
Biswas (2008) investigated the quantitative evidence on the existence and
characterisation of the causality between finance and economic growth and the role of
‗market- based‘ and ‗ bank- based‘ financial system in the economic development. To
examine the direction of causality, the paper used the dataset comprising of twelve
Asian countries for the period 1981-2005. The sample of countries chosen provided a
variety of experiences with regard to financial systems, financial policies followed
and level of institutional development. The data has been collected from various
sources like Emerging Stock Market Fact Book (Standard & Poor‘s), Database of
International Financial Statistics (IFC), World Economic Outlook and World
Development Indicators. In assessing the intricate relationship between the stock
market, banking sector development and economic growth, the paper used proxy
variables like Value Traded Ratio (VTR) for stock market indicator, Bank Credit to
Private Sector (BCPS) for Banking sector indicator and the real per capita GDP
growth rate for economic growth. By invoking co-integration and causality tests for
the data, historical evidence showed that the financial- growth relationship varies
across Asian countries and may also change over time. Therefore, this study
concluded that economic growth does not merely depend upon the stock market and/
or the banking sector but also on other factors such as policy measures for
infrastructure development. This paper acts as a motivation for research scholars to
explore areas like government securities market, private debt markets, venture capital
and new issues market, which are also important factors influencing economic
growth.
Song and Sheng (2008) the study decomposed the sources of Chinese growth by first
making a distinction between technological progress and technical efficiency in the
growth accounting framework, and then identifying a series of reform programmes,
such as urbanization, structural change, privatization, liberalization, banking and
fiscal system reforms as the key components in institutional innovation which
facilitate the improvement of technical efficiency and through which economic
growth. These components were then incorporated into the model specification, which
was estimated based on a panel dataset by applying the Principal Component Analysis
(PCA) to eliminate the multicolinearity problem. The results showed that
urbanization, liberalization and structural change in the form of industrialization are
the most important components in contributing to the improvement of technical
91
efficiency and hence growth, highlighting the importance of government policies
aimed at enhancing further urbanization, openness to trade and industrial structural
adjustments to sustain the growth momentum in China. The study also found that the
potential for further enhancing growth through technical efficiency in China is
considerable, which can be realized by deepening State-Owned Enterprises (SOEs)
restructuring, and banking and fiscal system reform.
Ayadi, Adegbite and Ayadi (2008) has investigated that the importance of the
financial system to economic development is not quite clear cut. Some researchers
such as Hicks (1969) hold the view that the financial system plays a crucial role in the
mobilization of capital for industrialization. On the other hand, there are those, who
hold a contrary view. In the 1980s, several African governments embarked on
structural adjustments programs in order to correct the disruptions in their economies.
As Geo-Jaja and Mangum (2001) note, structural adjustment programs seldom
delivered on their intended objectives. This paper evaluated the structural adjustment
program in Nigeria with a view to finding out if it resulted in an enhanced level of
financial development. Moreover, the relationship between financial development and
economic growth during post-SAP period is examined using the Spearman rank
correlation. The expected outcome of the structural adjustment program in Nigeria
was marred by policy reversals of government. This is a possible reason for the poor
performance of the financial sector of the economy. Therefore, financial development
and economic growth have no consistent relationship in post-SAP Nigeria.
Chistiansen, Schindler and Tressel (2009) this paper has attempted to find out a
simultaneous assessment of the relationship between economic performance and three
groups of economic reforms: domestic finance, trade, and the capital account. Among
these, domestic financial reforms, and trade reforms, are robustly associated with
economic growth, but only in middle-income countries. In contrast, they do not found
any systematic positive relationship between capital account liberalization and
economic growth. Moreover, the effect of domestic financial reforms on economic
growth in middle-income countries is explained by improvements in measured
aggregate Total Factor Productivity (TFP) growth, not by higher aggregate
investment. They presented evidence that variation in the quality of property rights
helps explain the heterogeneity of the effectiveness of financial and trade reforms in
developing countries. The evidence suggested that sufficiently developed property
92
rights were a precondition for reaping the benefits of economic reform. Results were
robust to endogeneity bias and a number of alternative specifications.
Obstfeld (2009) conducted a study and has analysed that despite an abundance of
cross-section, panel, and event studies, there is strikingly little convincing
documentation of direct positive impacts of financial opening on the economic
welfare levels or growth rates of developing countries. The econometric difficulties
are similar to those that bedevil the literature on trade openness and growth, though if
anything, they are more severe in the context of finance. There is also little systematic
evidence that financial opening raises welfare indirectly by promoting collateral
reforms of economic institutions or policies. At the same time, opening the financial
account does appear to raise the frequency and severity of economic crises.
Nonetheless, developing countries have moved over time in the direction of further
financial openness. A plausible explanation is that financial development is a
concomitant of economic growth, and a growing financial sector in an economy open
to trade cannot long be insulated from cross-border financial flows. This survey
discusses the policy framework in which financial globalization is most likely to
prove beneficial. The reforms developing countries need to institute to make their
economies safe for international asset trade are the same ones they need so as to
curtail the power of entrenched economic interests and liberate the economy‘s
productive potential.
Rousseau and Wachtel (2009) the paper has clearly stated that although the finance-
growth relationship is now firmly entrenched in the empirical literature, they showed
that it is not as strong in more recent data as it was in the original studies with data for
the period from 1960 to 1989. They considered several explanations. First, they find
that the incidence of financial crises is related to the dampening of the effect of
financial deepening on growth. Excessive financial deepening or too rapid a growth of
credit may have led to both inflation and weakened banking systems which in turn
gave rise to growth-inhibiting financial crises. Excessive financial deepening may
also be a result of widespread financial liberalizations in the late 1980s and early
1990s in countries that lacked the legal or regulatory infrastructure to exploit financial
development successfully. However, they found little indication that liberalizations
played an important direct role in reducing the effect of finance. Similarly, there is
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little evidence that the growth of equity markets in recent years has substituted for
debt financing and led to a reduced role of financial deepening on growth.
Ahmad and Malik (2009) has used a panel data set for 35 developing countries over
the period 1970-2003, this study analysis the role of financial sector development in
economic growth and domestic and foreign capital accumulation. A major finding of
the study is that financial sector development affects per capita GDP mainly through
its role in efficient resource allocation, rather than its affects on capital accumulation.
Furthermore, it is the domestic rather than foreign capital accumulation that is
instrumental in increasing per worker output and hence promoting economic growth
in the long run. Furthermore, foreign capital also does not stimulate domestic capital
accumulation, while domestic capital plays a significant role as a complementary
factor for attracting foreign capital.
Orok-Duke, Edu and Ekot (2009) assessed the impact of financial sector
reforms/liberalizations on savings mobilization in Nigeria. Financial liberalization
involves the elimination of credit controls, deregulation of interest rates, easing of
entry into the financial services industry, development of capital markets, increased
prudential regulation and supervision, and liberalization of international capital flows.
Reforms are expected to increase competitive efficiency within the financial market in
at least three ways. Firstly, the elimination of regulations and price distortions, which
allows savings to be directed into highest-yielding (risk-adjusted) form of investment
(improved allocative efficiency). Secondly, increased competition reduces the cost of
financial intermediation (higher operational efficiency). Thirdly, the reform measures,
generates and improved range of financial products and services adaptable to
changing consumer need (dynamic efficiency). Although financial reforms can
increase the efficiency by channelling resources into productive use, its impact on the
quantity of savings is theoretically ambiguous. Accordingly, this paper dwells on
theoretical issues and critical review of financial sector reforms/financial
liberalization in Nigeria. Attempt was also made to assess the impact of the
reforms/liberalization. The paper analyzed the roles of the recent literature. Ten
indicators that encompass all the qualities of a well developed financial sector reforms
were selected to measure the impact of financial sector deregulation on the economy.
94
Acharya, Amanulla and Joy (2009) investigated the relationship between financial
development and economic growth in the Indian states. In pursuit of this objective,
the tests of Panel Cointegration and Fully Modified Ordinary Least Squares (FMOLS)
are conducted by using three panel data sets viz., (i) data on BIMAARU states,
(consisting of five states); (ii) data on nine other Indian States and (iii) data on full
sample of fourteen states (BIMAARU states as well as nine other Indian states). The
data used in this study consists of the annual data on Net State Domestic Product and
Total Commercial Bank Credit Outstanding in various sectors during period 1981-
2002, collected from various publications of Reserve Bank of India and Central
Statistical Organisation. The panel cointegration results confirm a long-run
relationship between financial development and growth across Indian states.
Burzynska (2009) in his thesis aimed to determine the impact of different banking
institutions on economic growth and assess the compatibility of state financial
policies with country‘s economic performance. The empirical analysis is performed
using annual data for the period 1978 to 2005. Using the Granger-causality test
procedure under vector autoregressive model I examine the relationship between
economic growth and, respectively, different types of banks and different types of
loans. The procedure provides evidence that presence and direction of causality is
affected by the type of bank as well as type of loan. There is two-way causality
between economic growth and policy banks as well as rural credit cooperatives. The
development of state-owned commercial banks and other commercial banks merely
follows economic growth. Furthermore, loans to construction sector Granger cause
growth and there is a one-way causality between growth and loans to commercial
sector. The fact that policy banks manage to positively influence China‘s development
might indicate that state policies concerning financial sector and economic growth are
successful. However to sustain the growth it is important to further develop financial
services, ensure better credit allocation and improve access to financing for private as
well as small and medium-sized enterprises.
Fadare (2010) investigated the effect of banking sector reforms on economic growth
in Nigeria over the period 1999 - 2009. Using the ordinary least square regression
technique, he established that interest rate margins, parallel market premiums, total
banking sector credit to the private sector, inflation rate, inflation rate lagged by one
year, size of banking sector capital and cash reserve ratios account for a very high
95
proportion of the variation in economic growth in Nigeria; and although there is a
strong and positive relationship between economic growth and the total banking
sector capital, the relationship between economic growth and other exogenous
variables of interest rate margins, parallel market premiums, total banking sector
credit to the private sector, inflation rate and cash reserve ratio reveal the wrong signs.
The implication which emerges from our empirical results with regards to the wrong
signs of these parameters is that theoretical expectations would only be valid when all
conditions are normal. This outcome has important policy implications as market
realities resulting from factors such as market inefficiencies, policy conflicts,
information asymmetry and government interference in the interaction of market
forces may produce results in direct contradiction to theoretical expectations.
Greenwood, Sanchez and Wang (2010) in their study a costly state verification
model of financial intermediation is presented to address this question that how
important is financial development for economic development?. The model is
calibrated to match facts about the U.S. economy, such as intermediation spreads and
the firm-size distribution for the years 1974 and 2004. It is then used to study the
international data, using cross-country interest-rate spreads and per-capita GDP. The
analysis suggests a country like Uganda could increase its output by 140 to 180% if it
could adopt the world‘s best practice in the financial sector. Still, this amounts to only
34 to 40% of the gap between Uganda‘s potential and actual output.
Das (2010) studied that the Indian financial sector has undergone a significant
structural transformation since the initiation of the financial liberalization in 1990‘s. It
brought significant changes in the Indian economy in general and financial sector in
particular. Against this backdrop, the present paper intended to analyze the
performance of the Indian banking sector after the initiation of financial liberalization
and also aims to measure the cost efficiency of the Indian banking sector during the
post reform period. The study found, after deregulation, the concentration has
declined which resulted in increasing competition. The share of private and foreign
banks in banking asset, deposit and credit has gone up. The profitability of all bank
groups has gone up, but the foreign banks are more profitable. Using Stochastic
Frontier Approach (cost frontier) and RBI data for 60 Indian commercial banks and
on the basis of empirical investigation (panel estimation), the paper concludes that
after financial liberalization there has been no significant change in the cost efficiency
96
of the public sector banks. The finding showed a marginal decline in the cost
efficiency of the public sector banks in the post reform period. A comparison among
various bank groups in the post reform period showed, the domestic private banks are
becoming more efficient in comparison to the public sector and the foreign banks.
However, the study found the public sector banks to be more cost efficient than the
private and the foreign banks.
Rehman (2011) has clearly stated that banks indulge in catering the needs of
government, public sector organization and private businesses. Government of
Pakistan introduced several reforms for the improvement of banking sector. State
Bank of Pakistan (SBP) has taken many influential steps in order to increase
performance of banks in Pakistan. The study aimed to explore impact of financial
reforms on economic growth of Pakistan and correlation among economic growth,
deposits, lending, real interest rate, savings, and inflation, taking data of thirty six
years. Regression analysis using E-Views was applied and explored a positive impact
of financial reforms on economic growth. It is recommended to the government to
remove the interest rate ceiling and overcome the problem of inflation.
Berthouy (2011) highlighted macroeconomic models of endogenous growth and

cross-countries studies have demonstrated that financial development enhances
investments and economic growth. To understand the mechanisms at stake, they
investigated the microeconomic effects of banking reforms on one of the determinants
of firm efficiency: capital investments. The empirical study is based on Indian firm
level data and the identification strategy relies on the deregulation of the banking
system in India over the 90s. Findings shed new light on the relationship between
financial development, capital accumulation and economic growth. Banking reforms
have a positive effect on firms' capital investments. Disentangling the channels of
transmission suggests that these results are driven by the expansion of private and
foreign banks over the period. Moreover, the impact of financial development is
stronger for initially more productive, liquid and profitable firms. These empirical
findings are robust to alternative specifications that control for industry and firm
characteristics and that address directly potential reverse causality concerns.
Mwenda and Mutoti (2011) in their paper investigated the effects of market-based
financial sector reforms on the competitiveness and efficiency of commercial banks,
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and economic growth, in Zambia. The results showed that reforms adopted in Phase II
(strengthening of regulatory and supervisory, payments and settlements, and financial
operations frameworks) and Phase III (implementation of a comprehensive financial
sector development plan) had significant positive effects on bank cost efficiency.
Macroeconomic variables such as per capita GDP and inflation were insignificant.
Further, using an endogenous growth model in which industrial production is a proxy
for GDP growth, it was found that bank cost efficiency, financial depth, Phase II and
III financial sector reforms, the degree of economic openness, and rate of inflation
were significant determinants of economic growth. Phase II policies and the inflation
rate have negative effects while the rest of the variables have positive effects on
economic growth.
Johannes, Njong and Cletus (2011) in this work they investigated the relationship
between financial development and economic growth in Cameroon using time series
data for the period 1970-2005. Using the Johansen method of cointegration analysis
and various measures of financial development, they found that financial development
has a positive effect on economic growth in the long run through efficient collection
and allocation of financial resources. They also found a long term causality
relationship running from financial development to economic growth. Therefore they
proposed that the ongoing financial reforms in the country should be pushed forward
so as to boost the development of this sector and by that increase its role in economic
development.
Poshakwale and Qian (2011) investigated the impact of financial reforms on

competitiveness and production efficiency of the banking sector, as well as the short-
term and long-term impact on economic growth, in Egypt during 1992–2007. The
results suggest that the reforms have a positive and significant effect on
competitiveness and production efficiency. Also, the evidence shows that state-owned
banks are generally less competitive than private banks and foreign banks are less
competitive than domestic banks. The average x-inefficiency of Egyptian banks is
around 30 per cent, which is comparable to those reported for other African countries.
Finally, there is evidence to suggest a significant relationship between financial bank
productive efficiency and economic growth in the short run but not in the long run.
Overall, the results support the argument for continuing the financial sector reform
programme in Egypt.
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Zhao and Murinde (2011) investigated the interrelationships among bank
competition, risk taking and efficiency during banking sector reforms in Nigeria
(1993–2008). Their modelling procedure involves three stages: measure bank
productive efficiency, using data envelopment analysis, and the evolution of bank
competition, using Conjectural Variations (CV) methods; then, used the CV estimates
to test whether regulatory reforms influence bank competition; finally investigate the
impact of the reforms on bank behaviour. The evidence suggests that deregulation and
prudential re-regulation influence bank risk taking and bank productive efficiency
directly (direct impact) and via competition (indirect impact). Further, it is found that
as competition increases, excessive risk taking decreases and efficiency increases.
Overall, the evidence on Nigeria affirms policies that foster bank competition.
Biekpe (2011) empirically investigated the degree of bank competition and

intermediation efficiency in Ghana. The evidence obtained suggests a non-
competitive market structure in the Ghanaian banking system, which hampers
financial intermediation. The study also found that Ghanaian banks are
monopolistically competitive. It is argued that the structure, as well as the other
markets characteristics, constitutes an indirect barrier to entry thereby shielding the
large profits in the Ghanaian banking system. Further, it is argued that policies that
encourage and stimulate greater consolidation in the financial sector would go a long
way to enhance competition among banks and improve efficiency and profitability.
This paper seeks to examine the nature and extent of competition in Ghana‘s banking
sector from 2000 to 2007 and compares that with earlier study by Buchs and Mathisen
(2005) which covers the period from 1998 to 2003. The main essence of the study is
to establish whether competition in the Ghanaian banking sector has changed
significantly during the study period following the country‘s extensive financial sector
reforms including the recently introduced Financial Sector Strategic Plan (FINSSIP).
The study contributes to policy and existing knowledge on competition in the
Ghanaian banking sector in several ways. Firstly, the competitive nature of banking
business in Ghana helps them to strengthen their positions and, in the process, help to
stabilize the Ghanaian economy. Secondly, the study offers useful lessons to
regulators on the kind of regulatory framework and other policy measures required to
stimulate efficiency in the operations of financial institutions in the country. In terms
of contribution to knowledge and methodological innovations, this study adds value to
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the study by Buch and Mathisen (2005) by considering the relative impact of
aggregate local demand for bank services and differences in risk preferences across
banks on output pricing of loans and revenue generation by banks in the Panzar–
Rosse methodology. Three other alternative approaches to analysis, namely the
persistence of profitability (POP) approach, the conjectural variations (CV) method
and the estimation of the Lerner Index are applied in the study to assess competition
in the Ghanaian banking industry.
Gupta, Kochhar and Panth (2011) examined whether that financial sector reforms
necessarily result in expansion of credit to the private sector and how does bank
ownership affect the availability of credit to the private sector? Empirical evidence is
somewhat mixed on these issues. They used the Indian experience with liberalization
of the financial sector to inform this debate. Using bank-level data from 1991- 2007,
they ask whether public and private banks deployed resources freed up by reduced
state pre-emption to increase credit to the private sector. They found that even after
liberalization, public banks allocated a larger share of their assets to government
securities than did private banks. Crucially, they also found that public banks were
more responsive in allocating relatively more resources to finance the fiscal deficit
even during periods when state pre-emption (measured in terms of the requirement to
hold government securities as a share of assets) formally declined. These findings
suggested that in developing countries, where alternative channels of financing may
be limited, government ownership of banks, combined with high fiscal deficits, may
limit the gains from financial liberalization.
Ogujiuba and Obiechina(2011) stated that one of the most challenging debates of
modern history is whether financial development causes economic growth or a
consequence of economic activity. There are on-going reforms in the sector in
Nigeria, thus the importance of a review of the various reforms. Evidence as to
whether and how reforms are remedying the traditional weaknesses of the Financial
Sector is so far limited in Nigeria. Ongoing reforms to improve banks‘ corporate
governance and internal systems suggest that the prospects for the financial sector to
perform profitably and prudently, while reducing volatility in the system exist. The
paper adopts an empirical review approach for its analysis. Paper suggested that the
present reforms be reviewed and sustained in an orderly manner, for appropriate
channelling of resources for investment and productive purposes. Efforts should be
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concentrated on the linkages of the sector with macro accounts and where financial
development appears to have been the weakest. Furthermore, advancement of the
financial sector vis-a-vis instruments should be the primary focus for the authorities.
A counterfactual feedback mechanism should also be integrated within the financial
sector for an appropriate signalling for the economic productive base.
Khadraoui and Smida (2012) have examined the relationship between financial
development and economic growth and have received a lot of attention in the
economic literature in recent years. This study aimed to revisit different econometric
approaches used in panel data in relation of financial sector development and growth.
They extend their previous study by employing updated data and also exploring more
questions related to the empirical link between financial development and growth.
More specifically, they investigate the issues relevant to static and dynamic panel data
effect. They investigated the role of financial development (as measured by the credits
to the private sector to GDP) in enhancing growth for different groups of countries.
Estimations are conducted with a panel data of 70 countries over the period 1970-
2009 using both LS (fixed effect) and GMM-Difference and GMM-System estimators
for dynamic panel data. While the finding of a positive correlation between indicators
of financial development and economic growth cannot settle this debate, advances in
computational capacity and availability of large cross-country data sets with relatively
large time dimensions have enabled researchers to rigorously explore the relationship
between financial development and economic growth. Empirical results reinforced the
idea that financial development promotes economic growth in all econometric
approaches used in this paper.
Sahoo (2013) empirically evaluated the role of financial structures in economic

development of India. An assessment of various indicators of financial development
revealed that both the bank-based and market-based intermediation processes have
undergone remarkable improvements in the last six decades. While credit
disbursement by Indian banks has increased sharply in the past decades, it is still far
below the world average level and even below the level in its EDEs peers. However,
in the recent years, the market capitalization of Indian stock market has increased
sharply reflecting more reliance on market-based sources of funding. One-way
Granger causality running from private sector credit to real GDP confirms the supply-
leading process of bank intermediation, while the ARDL cointegration test suggested
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that both the bank-based and market-based financial deepening have positive roles in
driving India‘s economic development. The findings indicated that in a relatively
bank-centric financial sector, Indian banks have the potential of further channelization
of credit to the productive sectors of the economy.
Samargandi, N., Fidrmuc, J. and Ghosh, S (2013) investigated the effect of

financial development on economic growth in the context of an oil-rich economy. In
doing so, they allow for the effect of financial development to be different for the oil
and non-oil sectors of the economy in the long–run. Using the Autoregressive
Distributed Lag (ARDL) bounds test technique; they found that financial development
has a positive impact on the growth of the non-oil sector in Saudi Arabia. In contrast,
its impact on total GDP growth is negative but insignificant.
George and James (2013) investigated the market structure of Ghana‘s banking
industry and determined whether the market structure has been changed after the
financial restructuring. This study specifically measured the degree of competition of
the banking system in Ghana by using the H-statistics. Various studies on the degree
of competition were reviewed. This study employed a widely used non structural
methodology put forward by Panzar and Ross (1987) the H-statistic and drawn upon a
comprehensive average annual data from the various issues of the Bank of Ghana
annual reports from 1988 to 2011. Based on the reported H-statistic, it can be
concluded that Ghana‘s banks are operating under perfect condition. However, the
test for a change in competition status at the time of liberalization was not significant,
indicating no evidence of a change in competition as a result of liberalization.
Arumugam and Selvalakshmi (2014) studied that the major banking sector reforms
in India have started about two decades earlier, but their outcome is visible now. With
the adoption of liberalization, privatization and globalization measures helped to
attain major changes in Indian banking sector. The banking sector being the life line
of the economy and assumed with utmost importance in the financial sector reforms.
The reforms were aimed at to make the banking sector more competitive, versatile,
efficient, and productive to follow international standards and to free from the
directions and control of Government. In order to check the impact of banking sector
reforms in economic development, ten years data from 2001-02 to 2010-11 have been
analyzed. Augmented Dickey-Fuller test, Co-integration test, financial data analysis,
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CRAR, and Bank Efficiency Scores are the statistical tools employed for the study.
The empirical result shows the presence of long-run relationship among the dependent
and independent variables. The overall findings inform that banking reforms in India
has adequately and positively impacted on the performance of economy. Performance
of all bank groups during the sample period is found satisfactory. Efficiency of banks
and credit disbursement has been systematized since the implementation of banking
reforms in India.
Gaurav , Shardha and Swamy, Namratha and Singh, Charan(2014) examined the
impact of foreign banks on Indian economy. Further, it discussed the various opinions
towards the foreign bank operations in the host country, with India as the example.
The paper looked at the regulatory framework in India to understand the attitude of
RBI towards foreign banks. It also discussed what several foreign banks feel about the
Indian regulatory setup and how these banks have adapted themselves to deal with the
changes. To look at the impact of foreign banks the paper analysed various parameters
like the rural presence, contribution towards priority sector, technological
development and financial ratios like return on asset and equity. Two case studies
have been discussed – one, about The Hong Kong and Shanghai Banking
Corporation‘s (HSBC) journey in India and the other, about BCCI in India. The paper
ends by discussing various challenges which are faced by foreign banks when they
set-up their shop in the country.
Patel (2014) studied that the recent past financial sector reform especially in Sub
Saharan Africa (SSA) has become a challenging task for policy maker, academician
and practitioner. In this paper, he attempted to trace the relationship between financial
deepening and growth for the period of 10 year (i.e. 2001-2010). He takes Data source
from Bank of Zambia and World Bank. The paper analysed the trends of GDP growth
rate and financial deepening in Zambia during the reform period. The paper founds
that Zambian economy has not been able to improve the level of financial deepening.
However, Zambian record of economic performance during the recent past remains
very impressive. He concluded that the financial system has not been able to increase
an effective financial intermediation, which is reflected in terms of rising M2/GDP
ratio.
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Mahajan and Verma (2014) studied that long run high growth of an economy
requires mobilization of large amount of savings and then its allocation to the highest
return assets/projects. For such efficiency, a well-developed financial system has
always been a requirement. An Attempt in the present study has been made to
examine if the financial sector development in Indian economy since 1981 has
contributed to long run economic growth of the economy. For this purpose, a financial
development index has been formulated using principal component analysis, using the
variables from banking sector as well as the stock market, capturing almost the entire
financial system. The study made use of the data spanning from 1981-2011 including
the break during 1991 when Indian financial system went through crucial financial
reforms. GDP at constant US dollars has been used as a proxy variable for economic
growth of the country. Two variable Engle-Granger approach has been used to find
out long run equilibrium relationship between financial development and economic
growth in the context of the Indian economy. Study confirmed the long run co-
movements between financial development and economic growth in India. However,
Error Correction Model (ECM) does not support short run relation.
2.2 Conclusion
On the whole, mass of studies (cross sectional, panel and time series) suggests that
better functioning of financial sector support faster economic growth. The country
case studies document critical interactions among financial sector reforms, financial
intermediaries, financial markets, government policies and economic growth.
Disagreement exists over some individual cases. Nonetheless, the body of available
country studies suggests that while the financial system responds to the demands of
non- financial sector, well functioning financial system have, in some cases during
some time periods, importantly spurred economic growth.
The available studies on India suggest:
 Financial repression prior to the reforms had negative effect on the

development of the financial system and therefore on economic growth
through finance-growth nexus.
 Subsequent to reforms, growth of both financial institutions and financial
markets is noted, based on some selected indicators.
 Financial development has positively contributed to economic growth.
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After this review of literature it is found that, in order to evaluate the performance of
different bank groups, different banking indictors have been taken keeping in view the
requirement of the study. To analyse the performance, some studies were based on
ratio analysis and to find the impact of banking sector reforms various econometric
techniques like correlation analysis, multiple regression, data envelopment analysis
and discriminant analysis have been used.
Though there are several studies conducted on the subject, most of the studies are
conducted on performance appraisal studies or impact studies of financial reforms and
its impact on individual banks. There are very few studies have been conducted on the
financial reforms and its impact on Indian public sector and private sector banks.
There has been no systematic attempt to compare the pre-post reforms period. Most
of the studies evaluating the performance of commercial banks were based on few
indicators and for a limited number of years .None of the studies cited above is
comprehensive enough in terms of indicators and techniques used to give a complete
picture of financial development in India subsequent o reforms, and its association
with economic growth. Thus there was a gap of the study on the subject. Therefore
after finding the gap of research, the present study has been undertaken on the above
mentioned subject and modest attempt has been made to cover the gaps lying in the
past studies.
105
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CHAPTER 3
RESEARCH METHODOLOGY
Research methodology is a systematic way to solve a problem. It is a science of

studying how research is to be carried out. Essentially, the procedures by which
researchers go about their work of describing, explaining and predicting phenomena
are called research methodology. It is also defined as the study of methods by which
knowledge is gained. Its aim is to give the work plan of research. It is necessary for a
researcher to design a methodology for the problem chosen. One should note that
even if the methods considered in two problems are same the methodology may be
different. It is important for the researcher to know not only the research methods
necessary for the research undertaken but also the methodology. In this chapter need,
scope, objectives and econometric methodology is discussed.
3.1 Need of the Study
Before nationalisation, the commercial banks in India were privately owned and the
main motive of their functioning is profit maximisation. Urban areas are developing
very fast and these areas are more profitable so banks open their branches more in the
urban areas as compared to the rural areas. More than 80% branches are in urban
areas and credit was available to the traders, commerce and industry. But after
nationalisation, the basic objective of profit maximisation has been completely
changed. Now the focus has been shifted from profit maximisation to social banking.
Due to this and newly introduced norms in the form of certain statutory obligations,
the profit of the banks fall considerably. Narasimham, (1994) states that the
substantial percentage of banks resources being locked up in the form of statutory
obligations, their income earned in the form of interest has remained very low.
The profitability of the commercial banks continued to remain low due to the poor
recovery of loans particularly of agriculture loans and locking up of their funds in the
sick small scale industries. Other than this target oriented branch expansion policy of
serving the unbanked areas has also been responsible for coming up of non-viable
branches and consequently poor profits. According to the branch licensing policy
1969-70 the banks were given licenses for opening one office in urban areas for every
three offices opened in rural and semi-urban areas. This has also caused low
profitability. But with the introduction of the banking sector reforms in 1991 branch
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licensing policy was abolished and banks were made free to open or close branches
except the rural branches. Patel and Khankkjoje (1991) state that the financial sector
reform committee made it clear that the progress made in rural branches expansion
should not be reversed and closure of rural branches shall require prior approval.
There are some sectors which are very important in term of their contribution to the
national income and economic development of the country. The government policy
since nationalisation has been to extend credit not only to the important sectors but
also to those sectors which were neglected. There are some sectors which were
accorded priority status for credit allocation like agriculture, Small Scale Industry
(SSI) and self employment. Since priority sectors are critical to high and sustained
growth of GDP, the business of banks had been to focus priority sectors irrespective
of whether there are credit targets or not. In the recent years, the government policy of
credit access has also focussed on credit to consumer durables, credit to corporate
elite and credit to capital market related activities.
In the banking space liberalisation has also resulted in to the entry of new private
sector banks in the last two decades. The RBI has for the first time brought the norms
regarding the entry of new banks or issuing of licenses to the corporate houses or
industrialists. This is surely expected to affect the profitability of the public sector
banks. The accounts of many corporate houses are likely to be transferred from public
sector banks to their own private sector banks. It has also been debated that the
chances are there to have more and more flow of credit to the associated company
from their own bank.
One another impact of the banking sector reforms that has caught the attention is the
substantial expansion of foreign banks in the country. In the year 1987 there were 42
foreign banks operating in India with the branch network of 32, which has risen to
138 branches in the year 1990-91 and has touched 306 branches network at the end
March31, 2010. Batcha (2002) states that it is committed under W.T.O. (World Trade
Organisation) agreement that minimum 12 licenses every year have to be issued to
foreign banks or their branches. These banks are spreading their branches to urban
and commercial significant areas. Such policies are likely to have long term
implications on Indian banking. More and more foreign banks and domestic private
114
sector banks are entering into the banking sector, which is expected to erode the
profits of the public sector banks.
According to Santhanakrishan (2005) in India, the globalisation process took off

after 1991 in the shape of banking sector reforms, which can rightly be called a
watershed event in our march towards globalisation. Bhide (2001) said that
globalisation is both a challenge and an opportunity for Indian banks to gain strength
in the domestic market and increase their presence in the global market.
The Narasimham Committee has attributed the poor performance of the commercial
banks in the post liberalisation period not to public ownership but points mainly to the
managerial and policy environment within which banks had operated. The committee
report has sought to improve the efficiency of the banking system by introducing
transparency in operations and ensuring that banking sector should operate on a sound
financial footing. For this, controls on interest rates were removed, regulatory and
supervisory standards strengthened. New norms of asset classification, income
recognition and capital adequacy requirements were introduced. In a further step
saving interest rates have been deregulated.
Due to liberalisation, globalisation and growing competition, customer centric

approach has become the order of the day in the banking industry. In the reasonable
duration of time after the reforms, there has been a meaningful evaluation of
commercial banks, how they have performed in the changed policy environment.
Therefore, the operational efficiency has become the primary goal of all the banking
organisations.
It is necessary to have a financial system whereby both financial institutions and

financial markets play an important role from the financial stability perspective. Stock
market is an important and growing ingredient of the financial market, more so in
developing countries. Well developed stock markets may be able to offer different
kinds of the financial services from financial institutions and a different kind of
impetus to investment and growth (Levine and Zervos, 1998). Increasing Stock
Market Capitalisation (SMC) may improve an economies ability to mobilise capital
and diversify risk. On one hand ,there are models that emphasis the tension between
bank based and market based systems (Levine,2002), on the other there exists a
115
number of studies on financial development and economic growth focussing on
complementarity hypothesis (Demirguc-Kunt and Levine, 2001).
On these front many questions has been raised. Has the performance of commercial
banks in India improved since the financial sector reforms? The question is relevant
because the entry and expansion of private sector banks and foreign banks, it was
expected that the Indian banks would reorganise their operations and improve their
efficiency to meet the increased competition. The efficiency of the commercial banks
to a large extent is going to affect the stability of the financial system , therefore it is
essential to know that how on the back of financial sector reforms , the performance
of the commercial banks have been affected.
The number of studies using econometric techniques for evaluating the performance
of commercial banks and stock markets in the reform period has been made. But still
certain aspects have been remained untouched. In most of the studies analyses has
been based upon limited number of banking parameters, stock market parameters,
limited time period and limited number of banks. Therefore it is required that one
study analysing the performance of the banks on economic parameters should be
carried out. All the divergent dimensions of the performance of the banks have been
taken up for evaluating their performance. In the past no such comprehensive study
has been made looking the financial development in the pre and post- financial sector
reforms, performance of all commercial banks and financial development-economic
growth nexus.
The bank group wise performance has been analysed taking various indicators. The
time span for the study has been kept very long almost all the years have been taken
for which data information is available in order to find the interbank disparities in the
performance of a particular indicator. Therefore not even a single study seems to
cover a sufficiently large span of time so that an objective picture of bank‘s
performance could emerge. Thus keeping in view the above mentioned limitations it
is important that a comprehensive study evaluating the banking sector development,
comparing the performance of different bank groups, stock market development and
financial development-economic growth nexus should have taken up.
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3.2 Scope of the study
The present study aims at analyzing the performance of the different commercial bank
groups, banking sector development, stock market development and financial
development-economic growth nexus in the helm of financial sector reforms. In order
to study the actual impact of financial sector reforms, the performance has been
compared in the pre and post- reform periods.
Since banking sector and stock markets represent majority of the financial sector in
India. Therefore the study has been confined to these two sectors. The study includes
all the public sector banks (State Bank of India & Its Associates and Nationalised
Banks), Private Sector Banks (new and old), Foreign Banks and Regional Rural
Banks. The study also includes the aggregate data of All Scheduled Commercial
Banks (including and excluding RRBs).
Data on public sector banks is available from 1980 to 2012-13. For the rest data up to
1988-89 is not available. This however does not seriously constraint the analysis in
view of the fact that public sector banks constituted more than 90% of the total
banking assets in the pre-reforms period. So the trend of public sector banks can be
taken as representative of the entire banking system.
It also needs to be noted that the data up to 1987 is available for calendar years i.e.,
January to December. The data for 1988-89 covers 15 months i.e., January to
December 1988 and January to march 1989. So wherever a flow variable is involved
it has been deflated by a factor 12/15 =0.8, so that it reflects magnitude appropriate to
12 months duration on an average basis. 1989-1990 onwards, data is available on the
basis of conventional financial years as followed in India i.e., 1st April to 31 March.
While analysis pre and post-reform data, certain factors need to be kept in mind. First
of all reforms is an ongoing process, so one should not expect a sudden jump on a
particular date but a gradual change, possibly with a lag, and spread over a time
period. So if one finds an improvement even in mid or late 1990‘s, it can be attributed
to the reforms undertaken in the early 1990s. Secondly subsequent to the reforms all
banks have adopted new accounting standards (with effect from 1992-93) prescribed
by RBI. Therefore the comparison of pre and post-reforms data cannot be made
without qualifications. With the adoption of new norms the bank‘s balance sheet and
117
profit and loss position was bound to deteriorate. So, any deterioration in the observed
values can substantially be due to the changes in the norms rather than other factors.
For such an analysis, the appropriate technique would be one that clearly expresses
each data value rather than some average changes over a given time period. The best
way of analysis in this case is to look at year to year data assisted by a visual
representation of data by means of appropriate graphs.
For the purpose of determining the impact of reforms on the banking sector, the
period has been divided into three parts. The public sector banks cover the time period
1968-1991(Pre-reform period), 1992-2013 (post-reform period) and 1968-2013 the
whole study period.
In order to study the impact of the financial sector reforms on financial development
and to assess the impact of reforms on the financial performance of financial
institutions, the following indicators have been selected.
 Gross domestic Savings: Gross domestic Savings include savings of

household sector, private corporate sector and public sector.
 Gross domestic Capital Formation: Gross Domestic Capital Formation
includes the public sector, private sector. Adjusted total capital formation is
also included in the study.
 Deposits: Deposits are the sum of demand deposits and time deposits of the
schedule commercial banks. Total bank deposits includes deposit of scheduled
commercial banks , deposits of non- scheduled commercial banks and deposits
of state cooperatives maintaining account with RBI. Area wise deposits are
also analysed in the study.
 Institutional finance to the private sector (Credit): Financial assistance
from the banking system to the private sector includes bank credit and the
investments made by the banking sector in other than government and
approved securities. Total bank credit that goes to the banking sector has been
obtained as the sum of non-food credit advanced by the scheduled commercial
banks and the credit provided by the non SCB and cooperative banks. For the
financial assistance provided by the financial institutions, state level
institutions like State financial Corporations (SFCs) and State Industrial
Development Corporation (SIDCs) are not included because in respect of
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these data is available only up to 2004. Six all India financial institutions
Small Industries Development Bank of India (SIDBI), Life Insurance
Corporation (LIC), General Insurance Corporation (GIC), Tourism Finance
corporation of India (TFCI), IFCI Venture Capital Funds (IVCF) and
Industrial Finance Corporation of India (IFCI) are included for which the data
is available till 2013. The others have not been included in the analysis to
maintain the comparability of data. Area wise credit is also analysed in the
study.
 Density of the financial system: the ratio of population per bank office gives
Cameron‘s measure of density.
 Branch expansion: The geographical distribution of bank branches is an
important variable for analyzing the attitudes of banks towards the
development of the society. In places where bank branches are more, better
and increased banking facilities can be ensured in the society and a good
system of banking culture can be developed among people, which is a prime
requirement in the development of an economy.
 Total Advances: Total Advances are the sum of type wise advances, security
wise advances and sector wise advances. The type wise advances are the sum
of bills purchased and discounted, cash credits, overdrafts and loans and term
loans. The security wise advances are the total of advances secured by tangible
assets, covered by bank or government guarantees and unsecured advances.
The sector wise advances include advances in India and outside India.
Advances in India include advances to priority sectors, public sector banks and
others.
 Total business: Total business is the sum of total deposits and total advances.
 Total assets: It is defined as the sum of cash in hand and balances with RBI,
balances with banks, money at call and short notice, investments, advances,
fixed assets, other assets and balance of loss.
 Total income: It is defined as the sum of interest earned and other income of
banks.
 Operating profit: Profits represent the difference between income and
expenditure. The difference between total income and expenditure of any
119
concern gives its net profit. Net profit plus provisions and contingencies give
operating profit.
 Non-performing assets: It includes the non performing assets of the
scheduled commercial banks as percentage of net advances.
 Capital to Risk Weighted Asset Ratio (CRAR): it is confined to the
minimum capital requirements for banks.
 Ratio of intermediation cost to total assets (ICR): Basic function of the
commercial banks is to act as intermediary between surplus and deficit units of
the economy. This ratio gives how efficiently banks are carrying the function
of intermediation of funds in the economy. Intermediation costs are identical
to operating expenses i.e., all expenses minus interest that is paid on deposits
etc. by banks.
 Operating profit to wage bill (in terms of Rs. 1000 spent on employees):
The ratio of operating profit to wage bill gives what is similar to labour
productivity in conventional accounting. It tells per thousand rupees spent on
employees what the extent of profit for each bank groups and all scheduled
commercial banks in the aggregate.
 Business per employee/ labour inputs (in monetary terms): Bank‘s basic
function is accepting deposits and making credit. So the sum of deposits and
loans and advances has been taken to represent business. Employee measure is
taken in monetary terms (i.e., per rupee spent on payment and provisions to
employees) for two reasons. First, consistent data is not available on the
number of employees. Second wage rate increases may not always be
accompanied by an increase in productivity. So it will be the amount spent on
hiring of labour force rather than the number of employees that will reflect a
truer measure of productivity.
 Competition: This is calculated by dividing net interest margin by the total
assets of the banks.
 Size of the stock markets: Size of the stock exchange generally expressed in
terms of number of listed companies and the market capitalisation ratio i.e.,
the ratio of Stock Market Capitalisation to Gross Domestic Product (GDP).
 Liquidity of the market: This measure the frequency of trading. Two
commonly used measures of liquidity are turnover ratio which is total value of
120
shares traded on a country‘s stock exchange divided by stock market
capitalisation. The other is value traded ratio which is total value of domestic
stock traded on a country‘s exchanges relative to GDP.
 Volatility of stock markets: This is measured by the standard deviation of
daily returns.
3.3 Objectives of the study
The major objective of the present thesis is to study that how the financial sector
reform affect the economic growth in India. The work is a comparative study of pre
and post- reform period. It aims to achieve the following objectives:
 To study the impact of the financial sector reforms on banking sector

development.
 To assess the impact of reforms on the financial performance of financial
institutions.
 To assess the impact of financial sector reforms on size, liquidity and volatility
of the stock market.
 To examine the relationship among banking sector development, stock market
development and economic growth in India.
 To identify the direction of causality between financial development and
3.4 Hypotheses
On the basis of the above mentioned objectives, the following null hypotheses (H0)
are tested in relation to the period prior and after the financial sector reforms of 1991:
 There is no significant impact of the financial sector reforms on banking sector

development.
 There is no significant impact of reforms on the financial performance of
financial institutions.
 There is no significant impact of financial sector reforms on size, liquidity and
volatility of the stock market.
 There is no significant change in the relationship among banking sector
development, stock market development and economic growth in India.
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 There is no change in the direction of causal relationship between financial
development and economic growth of India.
3.5 Limitations of the Study

Taking into consideration the objectives of the study and its coverage in terms of time
span and different types of banks the study is prone to many limitations. Some of the
important limitations of the study are:
 The study is based on the financial data reported by various banks. In such a
case the limitations of financial accounting are likely to remain inherent in the
study. One such limitation is change in price level which is a major problem.
If various financial variables such as total business, deposits, credit etc. are
deflated to the base year, the conclusions drawn by the study may change.
However, this does not seem to be a major limitation in the present study, as
the figures of the particular year of different banks will be deflated by the
same index number. Therefore the relative position of the banks will remain
more or less the same. But the growth rates based upon current prices are
definitely going to be misleading to some extent.
 There has been a lot of window dressing in presenting the final accounts by
the commercial banks in order to hide the actual position. The data relating to
deposits and advances with respect to banks, shoot up at the end of the
accounting year because of unscrupulous practices followed by branch
managers. This fact becomes clear when data at the end of the year is
compared with the data on other dates of the year. The data relating to
advances and credit deployment is knowingly inflated to meet the targets.
Therefore, the performance of the related banks cannot be assessed truly in
such a situation.
 Another limitation is concerning the sources of data. Different reports and
books show different data of the same time.
 The impact of reforms on the level of non-performing assets could not be
made in view of no reporting of data relating to non-performing assets in the
pre-reform periods. Therefore, the growth of the non-performing assets has
only been ascertained in the post-reform period. Similarly, the position of
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different bank groups relating to capital to risk weighted assets ratio have been
analysed in the post -reform period.
 Since the objectives, policies and practices of the banks were different in the
pre and post reform period. Therefore, an objective comparison between two
periods cannot be made.
 In the present study, only the quantitative aspects of productivity and
profitability have been examined. Qualitative aspects such as motivation of
employees, customer satisfaction, image of the bank have not been considered
which play definite role in performance of a bank.
3.6 Data sources
The various indicators of financial development have been examined with respect to
any structural break corresponding to the reforms in the financial sector. Time period
and methodology differ in variables depending on the availability of the data and
nature of analysis. The analysis is based on secondary data obtained from the
following resources:
 Report on Trends & Progress of Banking in India (Different issues), RBI.

 Hand Book of Statistics on Indian Economy (2012-2013), RBI.
 Economic survey of Govt. of India (2012-2013) issued by ministry of finance,
Government of India.
 Statistical tables relating to banks in India (1979-2009).
 Flow of funds accounts of the Indian economy, RBI.
 Handbook of statistics on Indian securities market ,2013.
3.7 Methodology
A sound and a scientific methodology is a basic foundation of investigation. The

accuracy and availability of the findings hinges on the methodology followed to
conduct the study. The review of studied guide in developing better methods and
techniques to accomplish objectives of an investigation. This section is therefore,
devoted to explain methodological framework adopted to accomplish objectives of the
study.
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First of all the data is plotted against the time series of all the indicators. This gives
very clear picture of the trend. If a jump or a change of slope occurs at any particular
time period it will indicate a structural change with respect to the concerned variables.
A more rigorous approach is to obtain the rate of growth using the regression analysis
and then examine for a structural break corresponding to the reforms using standard
tests available. This is possible only if adequate data is available and it does not show
wide fluctuations.
Adequate and consistent data is available for both pre and post- reform periods for the
indicators, so regression analysis is used. In the cases where consistent and adequate
data is not available or the magnitudes have been sharply fluctuating, simple data
analysis is done because regression analysis in such cases will not give meaningful
results.
Regression analysis: This is applied for knowing the banking sector development in
India during the pre and post- financial sector reforms. The average annual rate of
growth for the indicators where possible is obtained using regression equation of the
following form:
Where, the variable is represented by y; T denotes the time period; and b i.e., the
coefficient of T represents the average annual rate of growth of the variable y. ‗e U‘ is
the error term/disturbances/unobserved factors.
Chow Test: This test is commonly used in time series analysis to test for the presence
of a structural break, Bhattacharya and Sivasubramanian (2003). It is a statistical
and econometric test of whether the co-efficient estimated over one group of the data
are equal to the co-efficient estimated over another. The average annual rate of growth
are obtained for the two sub periods (break taken in the year 1990-1991) and for the
entire time period for which data is available. Subsequently chow test (Gujarati, 2007)
for structural break is performed to test for the impact of reforms
F
RSS R  RSSUR ) / K
RSSUR /  N1  N 2  2 K 
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Where, RSS R = Restricted Residual sum of squares for combined regression.
RSS UR = RSS1 + RSS 2
RSS1 = Residual sum of squares for pre reform period regression.
RSS 2 = Residual sum of squares for post reform period regression.

K= No. of parameters to be estimated (=2)
N1 = Observations in the pre-reform period.
N 2 = Observations in the post-reform period.
Decision rule: if the value of calculate F using the above statistics is greater than the
value of F obtained from the table i.e., F cal >F critical , it implies the rejection of null
hypothesis of various growth rates being same in the pre-post reform periods. In other
words, if value of calculated ‗F‘ greater than the Critical Value of ‗F‘ implies that the
growth rates in the post-reforms sub periods are higher.
Exponential Growth Rate (EGR): This test is applied to know the progress with
respect to different banking indicators among different bank groups. The rate is
ascertained with the help of exponential growth rate (EGR). The exponential growth
rate has been computed by the function as follows:
Y=a.bt
Where ‗a‘ is Y- intercept and ‗b‘ is the slope of the curve at the origin of X.
Y is dependent variable, ‗t‘ is number of years, ‗a‘ and ‗b‘ are regression parameters.
Exponential growth rate = (b-1)*100
‘t’ – Test : This test is applied for checking the level of significance for various
regression coefficients. ‗t‘ value is computed as follows:
Coefficient of simple determination (r2): It is applied to represent the proportion of

the total variability around ‗Y‘ that is explained by the linear relationship of Y and X.
r2
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3.8 Econometric Methodology
Econometrics is the unification of economic theory, statistics and mathematics where
the statistical data are used to measure the economic relationships. Three major
econometric techniques are usually used in applied studies; cross-sectional approach,
panel-data approach and time-series approach. The econometric methodology used to
examine the relationships between financial development and economic growth is
based on a time-series approach because the main objective is to study economic
relationships in one country over time (Brooks, 2002).
3.8.1 The determinants of growth
There is no consensus on the role of financial development in the economic growth.

There is also lack of unanimity on the key determinants of growth. In the case of
finance-growth relationship, differences exist between different countries and at
different times. Particular variable say government expenditure can be a drag on
growth in one country and a key factor in stimulating economic growth in the other
country. In the same country it may vary across time periods.
Traditional growth models have focussed on capital accumulation as the prime

determinant of growth. The concept of incremental capital output ratio is very
important. Harrod –Domar model single out investment as the only factor affecting
growth and contend that output grows in a fixed proportion in relation to the
incremental capital stock. The financial intermediation or any other variable would
have no place in determining economic growth. Such rigid relationship between
capital and output growth have been proven to be far from truth. Economic growth
depends on other factors also than just capital. But, these other factors vary from time
to time and place to place.
The differences in the rates of growth of various economies were in the past attributed
to differences in rates of physical capital accumulation. Government expenditure and
governance in the economy were considered of prime importance in explaining
differing rates of growth across economies. Finance or availability of funds for
production activities and overall development of the financial sector has also been
considered as explaining differences in economic growths. Then lately, it has been
argued that it is not only physical capital formation but also human capital formation
that is crucial to the growth process. The above discussion is important as it points to
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various determinants of economic growth being discussed in literature from time to
time. Economic growth depends on a number of qualitative and quantitative factors.
The important ones are as follows:
Physical capital accumulation: Traditionally capital has occupied important place in

economic growth in literature. Accumulation of physical capital is often considered as
synonyms with growth. Capital formation takes place in the private sector and
government sector. The trends in public and private capital formation can often be
different. These two can influence economic growth in different manner. In such a
case they need to be separately accounted for.
Labour: In economies with low density of population, labour is a scarce input and
shortage of labour at times can hinder the economic growth process. In such a
situation the supply of labour in an economy would be strongly associated with the
growth process. In an economy like India, where density of population is very high,
labour is available in abundance and marginal productivity of labour is low, often
negative. So labour is not a constraining factor on growth rates, rather more than
required supply of labour leads to unemployment and other problems that can act as a
drag on economic growth.
Human Resource Development: Human resource development or human capital

formation can be at times as important as physical capital accumulation as has been
documented in literature. It provides skilled labour to the production process. It leads
to changes in the attitudes and institutions, which are conducive to the accelerating
economic growth. In most studies primary education has been found to be positively
significant to the economic growth.
Foreign investment: In an open economy foreign investment can play a crucial role
in stimulating economic growth. Together with funds such investments often brings
managerial expertise, technical knowhow, foreign currency etc. All are important to
country‘s economic growth. It can act as an indicator to assess the role of
liberalisation in the growth process.
Besides the above conventional factors which are by and large universally accepted as
significant affecting growth, there exits several other factors on which there is less
unanimity. These includes factors like exports, government expenditure etc. The
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influence of these factors on economic growth is highly variable. They may have a
growth stimulating effect at one place and negative effect or no effect at the some
other place or time. So the influence of these factors cannot be taken for granted and
need to be tested empirically.
3.8.2 Variables in the model
This section pins down the variables relevant to the model. It consists of indicators of
economic growth and financial sector development. For analysing the relationship
between financial development and economic growth the time period is 1968 to 2013,
so that a sufficient time period is covered during pre financial sector reforms and post
financial sector reforms.
Economic growth indicator: Economic growth is a measure of growth in aggregate

output of a nation during a specified time period. It can be measure by GDPfc at
constant prices. When the growth rates are to be used to judge the improvement in the
economic well being of people, or any other similar purpose, the rate expressed in per
capita terms would be more meaningful. In this analysis however, the objective is to
see the impact of financial development on economic growth, in terms of an overall
output expansion. So using the rates in per capita terms will not be meaningful. The
rates of growth of per capita will be affected by the growth rate of the population,
which has as such no bearing in context of role of finance. So as an indicator of
economic growth, the study has used the annual GDPfc at constant prices (EGFC).
Financial development indicators: Ideally financial development indicators should

related to the variety of institutes and markets available, how well they mobilise
resources, mange risk, facilitate transactions and so on. In practice it will not be
possible to find a variable that could truly reflect the whole gamut of services
provided by the financial sector. In empirical studies, financial intermediation has
largely been proxied by the level of real interest rates by the various monetary
aggregates, all of which pose significant interpretation problems according to
Bhattacharya, 2003. Some recent studies have used some other measures of
intermediation like deposits and /or credit in some form or the other. This study has
used following financial development indicators, which best relate their role to the
economic growth.
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Institutional credit to the private sector as a ratio of GDP (CR): In studies where
credit has been used as an indicator of financial development, it is only bank credit
that is considered. However, significant financial development takes place outside the
banking system. Moreover as the financial system develop the portion of the bank
credit to the total credit advanced usually falls. For this reason the credit advanced by
non baking financial institutions is also included in the study. Credit thus consist of
non-food credit advanced by scheduled commercial banks, credit advanced by non
scheduled commercial banks, cooperative banks and financial assistance disbursed by
the non- banking financial institutions. It excludes credit to the public sector in the
form of food credit and therefore is able to represent more accurately the role of
financial intermediaries in channelizing funds to the private market participants. This
measure will therefore be more directly linked to investment and growth than various
other measures often used in other studies. Chakraborty (2007) used bank credit as
variable to measure the banking sector in their study.
A number of studies on the topic have used the real rate of interest as an indicator of
financial intermediation. The McKinnon Shaw hypothesis suggests that the level of
the financial intermediation should be closely related to the prevailing real interest
rate. The view is that a positive interest rate stimulates financial savings and financial
intermediation thereby increases the supply of credit to the private sector. This in turn
stimulates investment and economic growth. In this context, it seems reasonable to
argue that savings do not increase only in response to real interest rates. With
financial development, the depth of financial sector increase and this provides easy
access of people in all regions to institutional credit. The number and variety of
financial assets variable is substantially more. Thus, transactional costs are much
lower and diversified assets are available to suit the needs and preferences of different
types of surplus units. The real interest rate therefore would rather be a poor indicator
of financial intermediation. Thus, it seemed for more sensible to directly use the
amount of credit channelled to the private sector rather than indirectly obtaining it via
real interest rate.
Monetary aggregates are other alternative sets of financial development often used in
the studies. It is argued that a monetised economy reflects a highly developed capital
market; hence the degree of monetisation should be closely related to the economic
growth. The aspect of the intermediation that is related to investment and growth is
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the ability of the financial sector to allocate credit. A liquid aggregate such as M1 or
M2 are mainly related to the ability of the financial sector to provide liquidity or a
medium of exchange and not to the allocation of the credit. It is in fact possible that a
high level of monetisation, measured by ratio of M1 to GDP is the result of financial
under development, while low level of monetisation is the result of a high degree of
sophistication of the financial markets which allow individuals to economise on the
money holdings. To take care of such a situation, a less monetary aggregate M3 has
sometimes been used as a proxy for degree of financial intermediation. Although it
may be more elated to the degree of credit market development, there may still be
influences other than that of financial depth. In particular because M3 still includes
liquid assets (M1). Some studies have used M3-M1, this ultimately comes to term
deposits in the system.
Deposits as an indicator do serve better than real rate of interest or any of the
monetary aggregates as the influence of the financial development on increased in
financial savings is directly captured. Yet it is not necessary that all deposits translate
into credit. In fact a large proportion goes to the public sector. The proportion of
credit going to public sector keeps changing with policies and priorities of the
government. The total amount of credit that results from a given amount of deposits
will depend on the efficiency of the financial sector and various Monterey policies of
the government from time to time. Considering all these it is found appropriate to use
the ratio of institutional credit to the private sector to GDP to measure the growth of
financial sector in the economy. This is most directly related to the investment and
economic growth.
Stock market capitalisation ratio of GDP: The role and nature of financial
institutions and financial markets are substantially different. In order to fully account
for the development of the financial sector it is important to include variables for the
markets. The indicator used in various studies relates to size of the secondary market.
The size of the stock market is positively correlated with the ability to mobilise capital
and diversify risk and thereby influences economic growth (Levine, 1996). The ratio
of the total value of all the listed shares in a stock market to the Gross Domestic
Product, called the Market Capitalisation Ratio (MCR) is used to measure stock
market size. It is a measure of both the stock market‘s ability to allocate capital to
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investment projects and to provide opportunities for risk diversification for investors.
Chakraborty (2007) used market capitalisation ratio to represent the stock market in
India.
Value Traded Ratio: Liquidity shows the level of activity in the stock market, and is
the ratio of stock markets‘ total value traded to GDP .Value Traded Ratio (VTR) is an
indicator of transaction costs also. This ratio does not directly measure the costs of
buying and selling securities at posted prices. Yet, averaged over a long time, the
value of equity transaction as a share of national output is likely to vary with the ease
of trading. Liquidity of the stock market is supposed to influence growth positively by
easing investment in large, long-term projects and by promoting the acquisition of
information about firms (Levine, 1991, Levine and Zervos, 1996).
Stock Market Turnover Ratio (TOR): Stock market Turnover Ratio (TOR) is the
indicator of stock market efficiency. It is the ratio of the value of total shares traded to
market capitalisation. It measures the activity or liquidity of a sock market relative to
its size. An active stock market will have a high turnover ratio and a less liquid
market will have a low turnover ratio (Demirguç-Kunt and Levine, 2001). Liquidity
and efficiency are two important attributes of stock markets, because, liquid and
efficient markets improve the allocation of capital and enhance prospects for long-
term economic growth (Bencivenga et al 1995).
Volatility: Other important attributes of stock market is volatility. Stock market

volatility indicates the ability of stock market to handle heavy trading without large
price swings. Developed stock markets are characterised by low levels of volatility.
However, this indicator is not considered in the regression analysis, since its
contribution to long-term economic growth turned out to be insignificant.
Other variables
Gross domestic capital formation as ratio of GDP (GDCF): Capital formation

takes place in private sector and public sector. The trends and composition of the
public and private sector and their influence on economic growth can often be
different. In such a case they need to be separately accounted for. In case of India
however, during the time period under study, the two trend to move parallel to each
other. Both seen equally related to economic growth initially three time series were
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examined: capital formation by private sector, capital formation by public sector and
total capital formation. All the three series follow a more or less similar pattern.
Moreover the correlation coefficients of each series with economic growth are nearly
the same. Therefore rather than taking the rates as separate variables and adding to the
number of variables , the study has used Gross Domestic Capital Formation (GDCF)
both public and private as single variable. Economic growth is supposed to be an
increasing function of capital formation (Barro, 1974).
Labour: Satisfactory data is not available either on total supply of the labour or on
workforce that is employed. The employment data is available only for the public
sector and organised private sector. These in no way truly represent the magnitude of
the workforce. This is because of the decreasing but still dominant presence of the
unorganised sector manifested in self employment, retail trade, agriculture etc. So
considering workforce is not possible.
Foreign investment: In case of India, although since liberalisation, foreign

investment has substantially increased. It still remains very small in relation to
country‘s GDP to have any noticeable effect on the growth process. Also data for
1980‘s is not available for foreign investment and interpolation may lead to errors.
The data format for FDI has been revised since 2000-2001. So that the data pre- post
2000 is not comparable.
Human Resource Development: Continuous time series data is not available for any
variable that can act for as a proxy for HRD. Therefore there was no option but to
leave out this variable.
Government investment expenditure: This variable has already been included in the
capital formation.
3.8.3 Time Series Analysis
Time series analysis has witnessed major developments since the mid 1980s. One of
these developments is the concept of cointegration. Before the appearance of
cointegration methods, traditional ordinary least square method (OLS) dominated the
time series literature. However, this approach studies the relationship between
economic variables without recognizing the possibility of the existence of non-
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stationarity in the data. A series is said to be stationary if it tends to return to its mean
value and fluctuated around it within a more or less constant range, while a non-
stationary series has a different mean at different points in time and its variance
increase with the sample size. A stationary series can be defined as one with a
constant mean, constant variance and constant autocovariances for each given lag
(Harris and Sollis, 2003).
As noted by Nelson and Plosser (1982) many macroeconomic time series are non-
stationary. As noted above, this means that the traditional ordinary least square
method cannot be applied; failure to recognize and take account of non-stationarity
will result in what is called the spurious regressions where the results obtained a
regression of a high R2 (coefficient of determination) and significant coefficient even
if the variables are totally unrelated. For example, regressing one non-stationary
variable onto another could result in a very high R2 for the regression, implying a
good correlation between the two variables. To overcome this problem (non-
stationary series) Granger (1986) and Engle and Granger (1987) establish the
concept of cointegration (the property where exists a long run relationship between
two non-stationary series).
Unit Root Tests
Before conducting the cointegration test, it is crucial to study the time-series property
of the data. In other words, it is necessary to test for stationarity of the data before
conducting regression analysis to avoid the problem of spurious regression. Testing
for the stationarity of the data means testing the order of integration of each variable
in the model, if a variable is integrated of degree (1) that means it is an 1(1)variable,
or in other words, it has a unit root (non-stationary variable). Therefore, testing for
non-stationarity is the same to testing if there is unit root in the series. In addition, if a
variable found to be non-stationary it is essential to know how many times we need to
difference it to become stationary. For example, when we need to difference it twice
to become stationary, it is called I (2) variable, which needs to be taken into account
when examining the cointegration relationships because it has different implications
on the number of cointegration relationships. In order to test whether a variable is
stationary or non-stationary, the Dickey-Fuller test and Phillips-Perron test are
implemented.
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Dickey-Fuller Test: The Dickey-Fuller (DF) test for a unit root in time series was
derived by Dickey and Fuller (Fuller, 1976 and Dickey & Fuller, 1979). The basic
objective of the test is to examine the null hypothesis of a unit root (non-stationarity)
against the alternative of the stationarity of the data in an autoregressive model.
Yt = pYt-1 + Xt δ + Ut
in which Xt are optional exogenous regressors which may consist of constant or a
constant and trend or neither, p and δ are parameters to be estimated, and Ut is
assumed to be white noise. If |p|=1, Yt is a non stationary series and if |p|< 1, Yt is a

stationary series.
Subtracting Yt-1 from both sides of the equation gives the following AR (1) process:
Δ Yt =α Yt-1 + Xt ‗δt + Ut
Where α = p-1, if α =0, then Yt is a non stationary series and if α <0 then the series is
stationary. Dickey and fuller calculated the critical values (CV) using Monte Carlo
techniques to test for the stationarity of the data.
Augmented Dickey-Fuller Test : The augmented Dickey-Fuller test is used to test

for unit roots in processes that are AR(P) rather than AR(1), where p>1. If a standard
Dickey-Fuller model is used when Yt follows an AR(p) process, then the error term
will be autocorrelated to compensate the misspecification of the dynamic structure of
Yt . This will invalidate the use of the Dickey-Fuller distributions, which are based on
the assumption that the error term is white noise. Consequently the basic Dickey-
Fuller test is extended to the following estimated equation:
Yt = Ѱ1 Yt-1 + Ѱ2 Yt-2 + …………… + Ѱp Yt-p + Ut
this can be expressed:
Δ Yt = Ѱ* Yt-1 + Ѱ *1 Δ Yt-1 + Ѱ *2 Δ Yt-2 + …………… + Ѱ *p-1 Δ Yt-p+1 + Ut
Where
Ѱ *=( Ѱ1+ Ѱ2+……….+ Ѱp ) -1
Here, if Ho: Ѱ* =0 is found to hold against HI: (Ѱ*<0, then y contains a unit root (non
stationary series).
Phillips-Perron (PP) Test: An alternative test for stationarity is proposed by Phillips
and Perron in 1988. It has become known as the PP test. To understand the P-P test, it
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is useful to compare the standard Dickey-Fuller test to the Augmented Dickey-Fuller
test. The second test involves adding an unknown number of lagged first differences
of the dependent variable to capture autocorrelated omitted variables that would
otherwise enter the error term. Instead of adding an extra terms in the data generating
process to the regression model when the series is of an order greater than AR(1), the
Phillips-Perron test undertakes a non-parametric correction to the t-test statistic to
account for autocorrelation that will be present. The CV for P-P test are the same as in
the ADF test.
VAR Lag Order Selection Criterion:
The most common procedure in choosing the optimal lag length is to estimate a VAR
model including all variables in levels (non-differenced). This VAR model should be
estimated for a large number of lags, then reducing down by re-estimating the model
for one lag less until we reach zero lag.
In each of the models, values of the AIC and the SIC criteria, as well as the
diagnostics concerning autocorrelation, heteroscedasticity, possible ARCH effects and
normality of the residuals inspected. In general, the model that minimizes AIC and
SIC is selected as the one with the optimal lag length. This model should also pass all
the diagnostic checks.
The step of discovering the long run relationship among explanatory variable requires
an adequate lag length of them in order to remove any serial correlation. The optimum
lag length is usually selected based on Akaike information criterion (AIC), Schwarz
information criterion (SIC) and Hannan-Quinn information criterion (HQ) test
statistic. Sequential modified LR test statistic
Cointegration
The discovery that the variables of interest are nonstationary means that OLS
techniques are not applicable, and so it is necessary to adopt a different strategy to
determine the relationship between the non-stationary variables. The concept of
cointegration of variables is vital in this regard. The economic interpretation of
cointegration is that if two or more series are linked to form an equilibrium
relationship spanning the long run, then the series will move closely together over
time, and the difference between them will be stable (stationary). If a two or more
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nonstationary variables are found to be cointegrated, this means that the variables
exhibit a long-run relationship (Harris and Sollis, 2003).
Once time-series have been established to be non-stationary, it is important to test

whether any relationships appearing when using OLS are purely spurious, or whether
the data exhibit common stochastic trends. Consider two series Xt and Yt. If these
series are both I(d), then one would expect in the absence of cointegration that the
residuals of a regression of Xt on Yt would also be I(d). However, if there exists a
vector that can be applied to the series such that the residual of the regression is of a
lower order of integration I(d-b), where b>O, then the two series is said to be
cointegrated of order (d,b), suggesting that the series have a long-run equilibrium,
despite both being non-stationary; any differences between their time paths arising
from an exogenous shock will not be continued in the long run. Thus, the concept of
cointegration produces the existence of a long equilibrium to which an economic
system converges over time (Harris and Sollis, 2003). There are different methods
used to test for cointegration of time series.
The Engle-Granger (1987) approach to testing the null hypothesis, that two I(1)
series, Xt and Yt are not cointegrated, involves testing whether the error terms of the
OLS regression of one variable on the other are stationary 1(0) or non-stationary
I(1).This test can be performed using any one of a number of tests, including the
Dickey-Fuller and Augmented Dickey-Fuller tests discussed earlier.
However, while the null hypothesis of a unit root and no cointegration is based on a t-
test with a non-normal distribution, in this case the standard Dickey-Fuller critical
values (or ADF) cannot be used in this test because the distribution of the test-
statistics under the null hypothesis is affected by the number of regressors included in
the regression. These required different critical values, these critical values are
provided by Mackinnon (1991).
There are limitations connected with the Engle-Granger approach. If there are more
than two variables in the model, there may be more than one cointegration vector.
Assuming that there is only one cointgration vector when in fact, there are more will
be inefficient, since we can only obtain a liner combination of these vectors when
estimating a single equation in the model.
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Johansen approach
The concerns about the limitations of the Engle-Granger approach, outlined above,
resulted in the development of an alternative procedure to test for cointegration
among economic variables, which can cope with an n-variable structure and in which
up to n-1 cointegration relations can exist. Johansen (1988) and Johansen and
Juselius (1990) established a Maximum Likelihood ratio tests to determine the
number of cointegration vectors in a multi-equation structure. The most important part
is the determination of the cointegrating rank (r). There are two popular methods for
determining the cointegrating rank:
1. The maximum eigenvalue

Let λ; denote the estimated eignvalues, then the maximum eigenvalue test is
calculated as:
λ max (r,r + 1) = -T ln (1-λ^ r + 1 )
The null hypothesis is that there are r = n cointegrating vectors against the alternative
is that r ≤ n +1.
2. The trace test

The trace test is similar to the maximum eigenvalue test.
λ Trace ( r ) = -T ∑ ^
i )
In this case the null hypothesis is again that there are r = n cointegrating vectors, but
alternative is that r ≤ n.
Table 3.1: Rank of matrix and its implications
r=0 There is no cointegration. No stable long run relationship
between variables. VECM is not possible (only VAR in first
differences).
0<r<k There are r cointegrating vectors. These vectors describe the
long run relationships between variables. VECM is o.k.
r=k All the variables are already stationary. No need to estimate
the model as VECM. VAR on untransformed data is o.k.
The Johansen approach is widely applied because it offers the best and most reliable
way in testing for long run relationships between non-stationary variables.
137
VAR Model
In view of possible endogeneity of each of the variables, such a model would not be
appropriate when we are not confident that a variable is exogeneous , the best way is
to treat each variable symmetrically. This is exactly done in a vector autoregressive
(VAR) model. Each variable is considered to be affected by current and past
realization of all variables including self. A multivariate VAR in standard form is
written as:
Y t = A0 + A1 Xt-1 +A2Xt-2 +…………………..+ A p X t-p + e t
Where Yt is (n x 1) vector of variables
A0 is (n x 1) vector of intercept term
Ai is (n x n)matrix of coefficients for all i=1…….p; p being the order of VAR
e t is (n x 1) vector of error terms.
VECM Model
A vector error correction model (VECM) is a restricted VAR designed for use with
nonstationary series that are known to be cointegrated. The VECM has cointegration
relations built into the specification so that it restricts the long-run behaviour of the
endogenous variables to converge to their cointegrating relationships while allowing
for short-run adjustment dynamics. The cointegration term is known as the error
correction term since the deviation from long-run equilibrium is corrected gradually
through a series of partial short-run adjustments. Above Equation can be rearranged
into an error correction mechanism form to give the VECM:
ΔYt = Π Yt-1 + ∑ Π i Δ Y t-1 + et
Where Π = - [ In - ∑ i ] and Πi = - [ ∑ j ]
Diagnostic test
The diagnostic tests were largely intended to establish the strength of the model and
its ability to offer correct and reliable inferences. To ensure that models are not miss
specified the test for serial correlation, normality and hetroscadasticity are conducted.
The equation error statistics provided information on the structure of the residuals
which should be 'white noise' that do not change over time and hence have no serial
correlation. The underlying theory is that, all empirical macroeconomic models are
stochastic in nature and so allow for error components or 'shocks' (Hendry, 1993). If
138
serial correlation is indicated in the residuals, then the standard errors would be
considered invalid and should not be used for inference.
The LM (Lagrange Multiplier) test is adopted in this study, is a general test for
error autocorrelation and allows for cases with higher orders or more complex forms
of error correlation (Asteriou and Hall, 2006). The null hypothesis of the LM test is
that there is no serial correlation up to lag order ‗p‘, where ‗p‘ is a pre-specified
integer.
The ARCH test is used to test of the null hypothesis of no heteroscedasticity. It is

also necessary to test for heteroscedasticity, which arises when the variance of the
residuals is changing across the sample, and could be a result of economic behaviour,
incorrect data transformation, or model misspecification among others (Hendry,
1995). The presence of heteroscedasticity would invalidate the conventionally
computed standard errors as the ordinary least squares (OLS) estimates would still be
consistent. White (1980) describes a general test for model mis-specification, since
the null hypothesis underlying the test assumes that the errors are both homoscedastic
and independence of the regressors, and that the linear specification of the model is
correct (Asteriou and Hall, 2006).
The Histogram Normality Test is used to test the null hyphothesis that residuals are
normally distributed or not.
F-Test is applied to find out whether the explanatory variables do actually have any
significant influence on the dependent variable. It tests the significance of R2. The
high value of ‗F‘ suggests significant relationship between Y and X‘s.
Coefficient of multiple determinations (R2) is applied to know the extent to which

all the explanatory variables affect the dependent variable. R2 is interpreted as the
fraction of the sample variation in Y that is explained by X. According to Roscoe
(1975), R2 is Simple Square of multiple R and provides an index of the amount of
variability in the dependent variable accounted for by the predictor variable.
R2
139
Durbin-Watson Test is applied for checking the autocorrelation among the variables.
The standard value of the test is 2, means if the value of the test result is near 2 then
we can say that there is no autocorrelation among the variables.
Stability Tests are used because there is a key assumption in econometric models that
parameters are constant throughout the sample period. In this study the recursive
residuals test that is CUSUM and CUSUMSQ TEST are adopted to check the validity
of this assumption. These tests according to Brown et al. (1975) cited in Lutkepohl
et al. (2005) is based on the cumulative sum of recursive residuals. The test plots the
cumulative sum together with the 95% critical line. The test finds parameter
instability if the cumulative sum goes outside the area between the two critical lines,
up to a particular period ‗t‘.
Testing for Causality
It is important to test for causality in time series studies because it helps to understand
the relationships among economic variables in a way that provides practical policy
implications. The Granger-causality test is the most commonly used and was
developed by Granger (1969). This test examines the impact of past values of a
variable Xt on the current value of a variable Yt.
A simple definition of Grange Causality, in the case of two time-series variables, X

and Y.
― X is said to Granger –cause Y if Y can be better predicted using the histories of both
X and Y than it can by using the history of Y alone.‖
We can test for the absence of Grange Causality by estimating the following VAR
model:
Yt =a0 + a1Yt-1+ ........+apYt-p + b1Xt-1+..........bpXt-p + ut
Xt = c0+c1Xt-1+.........+cpXt-p+ d1Yt-1+.........+dpYt-p + vt
Then testing H0:b1=b2=.........b p =0, against HA: ‗Not H0‘, is a test that X does not
Granger –cause Y.
140
Similarly testing H0: d1=d2=.........d p =0, against HA: ‗Not H0‘, is a test that Y does not
Granger –cause X.
In each case, a rejection of the null implies there is Granger causality.
The Granger causality test is easy to carry out and be able to apply in many kinds of
empirical studies. However traditional Granger causality has its limitations. First, as
pointed out by Gujarati (1995), a causality test is sensitive to model specification and
the number of lags. It would reveal different results if it was relevant and was not
included in the model. Therefore, the empirical evidence of two variables granger
causality is fragile because of this problem. Second, time series are often non
stationary (Maddala, 2001). This situation could exemplify the problem of spurious
regression. Gujarati (2006) had also said that when the variables are integrated, the
F-test procedure is not valid, as the test statistics do not have a standard distribution.
The Granger non causality test should not be tested in the VAR with the differences
of the data.VAR model can be used for other purposes with differenced data if the
series are I(1), but not cointegrated. If the time series are cointegrated then VECM
model can be estimated for the purposes other than testing for the Granger non
causality.
Toda and Yamamoto (1995) propose an interesting and simple procedure requiring
the estimation of an augmented VAR which guarantee the asymptotic distribution of
the Wald statistics (an asymptotic chi-square distribution) .The basic steps for the
Toda and Yamamoto (1995) procedure are:
Test each of the time series to determine their order of integration. Let the maximum
order of integration for the group of time series be m. Set up the VAR model in the
levels of the data, regardless of the order of integration of the various time series.
Most importantly the data should not be difference whether the time series are
integrated or not. Next estimate the appropriate maximum lag length for the variables
in the VAR, say ‗p‘, using the usual method. The VAR should be well specified
means there should be no serial correlation in the residuals, if need be, increase the ‗p‘
until any autocorrelation issues are resolved. If two or more time series have the same
order of integration and then test to see if they are cointegrated. No matter whether the
time series are cointegrated as it is not going to affect the results. It just provides a
141
possible cross check on the validity of the results at the end. Now add in m additional
lags of each of the variables into each of the equations and re-estimate the VAR. Test
the hypothesis that the coefficients of only the first ‗p‘ lagged values of X are zero in
the Y equation and then doing the same thing for the coefficients of the lagged values
of Y in the X equation. It is essential that coefficients for the extra m lags do not
include in the Wald test. They are just to fix up the asymptotic. The Wald test
statistics will be asymptotically chi-square distributed with ‗p‘ degree of freedom
(d.o.f.), under the null. Rejection of the null implies there is Granger causality. If two
or more time series are cointegrated then there must be Granger causality between
them- either one way or in both directions. However the converse is not true.
3.9 Scheme of the study
The whole study has been divided into three sections. In the first section, first chapter
deals with meaning and role of the banking sector in the economic development of the
Indian economy. Various reforms have been discussed in this chapter. The second
chapter brings the review of literature based on the library and online research. The
third chapter brings the need, scope, objectives, limitations and research methodology
used in the study.
The second section comprises three chapters. In the fourth chapter, a comparative
analysis has been done for the banking sector development in the pre and post- reform
periods, performance of the Indian financial institutions also analysed. The last
section of this chapter analysed the relationship among banking sector development
and economic growth in India along with the direction of causality. In the fifth
chapter, growth of the Indian financial markets, the relationship between stock market
development and economic growth in India along with the direction of causality is
analysed in the post-reform period. In the sixth chapter, relationship among banking
sector development, stock market development and economic growth in India is
analysed along with the direction of causality.
The third section comprises seventh chapter which summarises the findings and
conclusions of the present research and finds their policy implication and offer
suggestions for improving the same.
142
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Bhide, M.G., Prasad, A., Ghosh, S.(2001). Banking Sector Reforms-A critical
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Granger, C (1969). "Investigating causal relation by econometric models and cross-
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Granger, C.W.J. (1986). Developments in the study of cointegrated ecocomic

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Gujarati, D.N. (2006). Essential of Econometrics, 3rd edition, McGraw Hill.
Hendry, David F (1993). Dynamic Econometrics: Oxford University Press, New

York.
Johansen, S, (1988). "Statistical analysis of cointegration vectors", Journal of

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on cointegration", Oxford Bulletin of Economics and Statistics, vol. 52, pp. 169-
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http://econ.worldbank.org.
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225-250.

145
CHAPTER- 4
BANKING SECTOR DEVELOPMENT AND ECONOMIC

GROWTH IN INDIA: PRE AND POST FINANCIAL SECTOR
REFORMS
A substantial advancement of the Indian financial sector had occurred during the 1991
and subsequent to the financial sector reforms. This chapter presents the
developments of the Indian banking sector that has taken place and compares group
wise performance of the banks in pre and post- reforms of 1991. The last section of
this chapter establishes relationship and direction of causality between banking sector
development and economic growth of India. The focus of this chapter is on financial
institutions and financial markets are studied in a separate chapter.
4.1 Indicators of banking sector development
The Indian financial sector has shown a remarkable progress, both in the qualitative
and quantitative terms over the period of more than 67 years. The number and density
of banking and non-banking financial institutions has greatly increased. The entry of
the private and foreign banks have increased the competition and made the financial
sector more efficient in its functioning. Non-performing assets are now lower and the
capital adequacy ratio is much higher. Computerisation and e-transactions has
strengthened the saving and investments in the economy. Bank deposits and credit
have all increased very tremendously, only a part of the increase is being explained by
the inflation.
In order to see the impact of the financial sector reforms on the development of the
banking sector, it is required to make a comparative study of the development prior to
reforms and after the reforms. This is done on the basis of number of indicators and
the time period for this is 1967-68 to 2012-13.
4.1.1 Gross Domestic Savings
The basic function of the financial system is to tap the surplus funds available in the
economy and channel them to the productive investments. The extent of development
of the financial system best manifests itself in the success of its basic function.
Savings are done by government, households and the private corporate sector. The
dominant saver out of the various savers in India is the household sector followed by
146
the private corporate sector. Table no. 4.1.1 shows that the contribution of the public
sector to total domestic savings is small and lately becomes negative. Both public
sector and the private corporate sector are net deficit spenders who draw upon the
savings of the household sector. The household sector also draws from the other
sectors (banks and other lending institutions) but its savings far exceed the borrowings
as shown by the Table no. 4.1.1, so household is the only surplus sector in the
economy. It is very important for the financial sector to increase this surplus and
make more and more of it available for the investment in the economy.
Household savers require store of value so that they get motivated to hold their
savings. The financial sector promotes savings by providing numerous services of
financial markets and financial intermediaries together with wide variety of financial
assets. Lots of combinations of risk and return have become available to the savers
and scope of portfolio choice has greatly improved with the financial progress and
innovations in technology so that savers tend to save more. Financial progress
generally induces larger savings out of the same level of income. More of these
savings are in the forms of financial assets as deposits, currency, insurance policies,
bonds etc. rather than physical assets like gold or real estate. These assets are less
risky, more liquid and easy to store and manage than most tangible assets. Thus out of
given savings, the proportion of financial assets (excluding currency) increased. This
is financialisation of household savings.
Mobilisation of savings takes place when people buy financial assets. The act of
saving and the act of investment is separated by the financial assets. People buy assets
like bank deposits, insurance policies etc. from financial institutions (these are
secondary securities as against primary securities issued by ultimate borrowers like
bonds, company deposits etc.). These financial institutions allocate their savings
further among competing borrowers. This represents the financial intermediation or
institutionalisation of savings i.e., going to borrowers through institutions rather than
directly via primary securities.
The development of the financial sector provides much more facilities and
opportunities for utilisation of the surplus funds. So people save more and more of the
savings are in the forms of financial assets rather than physical assets. These financial
147
assets are held with institutions rather than privately or as currency with individuals or
in primary securities. Gross domestic savings are shown by the following table 4.1.1.
Table 4.1.1 Gross Domestic Savings as percentage of GDP

Pre-reform period
House-hold Sector Post-reform period
House-hold Sector
Private Corporate
Corporate Sector
Public Sector
Public Sector
Private
Sector
Total
Total
Year Year
1967-68 8.6 1.1 2.5 12.1 1991-92 15.7 3 2.6 21.3

1968-69 8.1 1.1 2.9 12.0 1992-93 16.5 2.6 2.2 21.3
1969-70 9.8 1.2 3.1 14.1 1993-94 17 3.4 1.3 21.7
1970-71 9.5 1.4 3.4 14.3 1994-95 17.9 3.4 2.3 23.6
1971-72 10.3 1.5 3.3 15.1 1995-96 16.2 4.8 2.6 23.6
1972-73 9.5 1.4 3.2 14.1 1996-97 15.8 4.4 2.2 22.4
1973-74 11.7 1.6 3.5 16.8 1997-98 18.1 4.2 1.9 24.2
1974-75 10.7 1.8 4.1 16.7 1998-99 19.5 3.8 -0.2 23.2
1975-76 11.3 1.2 4.8 17.4 1999-2000 21.8 4.3 -0.5 25.7
1976-77 12.0 1.3 5.6 18.8 2000-01 21.4 3.7 -1.3 23.8
1977-78 12.9 1.3 5.0 19.2 2001-02 23.2 3.3 -1.6 24.9
1978-79 14.4 1.4 5.2 21.0 2002-03 22.3 3.9 -0.3 25.9
1979-80 13.0 1.9 5.0 19.9 2003-04 23.2 4.6 1.3 29
1980-81 12.1 1.6 4.1 17.8 2004-05 23.6 6.6 2.3 32.4
1981-82 10.8 1.5 5.2 17.5 2005-06 23.5 7.5 2.4 33.4
1982-83 11.2 1.5 5.1 17.8 2006-07 23.2 7.9 3.6 34.6
1983-84 11.8 1.4 3.9 17.1 2007-08 22.4 9.4 5 36.8
1984-85 12.8 1.6 3.5 17.8 2008-09 23.6 7.4 1 32
1985-86 12.7 1.9 3.9 18.4 2009-10 25.2 8.4 0.2 33.7
1986-87 13 1.6 3.5 18.1 2010-11 23.5 7.9 2.6 34
1987-88 15.6 1.6 2.8 20 2011-12 22.3 7.2 1.3 30.8
1988-89 15.3 1.9 2.7 20 2012-13 22 7.1 1.2 30.3
1989-90 16.5 2.4 2.4 21.3
1990-91 18.5 2.6 1.8 22.9
Source: Economic Surveys (various issues) and Handbook of Statistics on Indian Economy 2012-13.
Statistical Tables Relating to Banks in India, Published by the Reserve Bank of India (Various
Issues). Database on Indian Banking Published by IBA, Mumbai. Report and trends on the
progress of banks in India (Various issues).
148
The above table shows data related to Gross Domestic Savings from 1967-68 to 2012-
13. The magnitudes are shown as percentages to Gross Domestic Product at current
market prices (2004-2005). The table shows separate contribution made by the
household sector, private corporate sector and the public sector in India. It can be seen
from the table that the dominant saver in India is the household sector followed by the
private corporate sector and public sector contribution is very small (even negative)
in the total domestic savings of India.
Figure 4.1.1 below illustrate the trend in the household sector savings, private
corporate sector savings, public sector savings and Gross domestic savings as
percentage of GDP at current market prices.
Figure 4.1.1 Savings as percentage of GDP

40
30
20
10
0
1993-94
2003-04
1967-68
1969-70
1971-72
1973-74
1975-76
1977-78
1979-80
1981-82
1983-84
1985-86
1987-88
1989-90
1991-92
1995-96
1997-98
2001-02
2005-06
2007-08
2009-10
2011-12
1999-2000
-10
House-hold Sector Private Corporate Sector Public Sector Total
It can be seen from the above figure that there is noticeable up trend in the household
savings in the year after 1990s. For total savings the noticeable increase in the rate
occurs somewhat late. But increase in the rate is more marked in the case of total
savings than the household savings.
The magnitude of household sector in total savings in India is very large and
magnitude of the private corporate sector and the government sector is very small. So
it is only the savings of the household sector whose magnitude is affected by the
changes in the financial sector. In order to measure the financial development, it is
very much important to look at the savings of the household sector. Therefore the data
149
is analysed for structural break includes both Household Sector Savings and Total
Gross Domestic Savings.
The rate has been obtained for the two sub periods (break taken in the year 1990-
1991) and for the entire time period for which data is available. Subsequently Chow
test (Gujarati, 2007) for structural break is performed to test for the impact of
financial sector reforms on both Household Sector Savings and Total Gross Domestic
Savings.
Table 4.1.2 Regression Coefficients and Growth Rate for Savings
House-hold Sector Savings Total Gross Domestic Savings

Pre- Post- Pre- Post-
Total Total
reform reform reform reform
period Period
period period period period
8.33 16.15 7.63 13.38 19.78 11.73
Intercept
(0.56) (0.72) (0.44) (0.66) (1.10) (0.70)
0.31* 0.41* 0.37* 0.33* 0.68* 0.45*
b
(0.03) (0.05) (0.02) (0.04) (0.08) (0.02)
r2 0.74 0.73 0.91 0.70 0.77 0.87
d.f. 22 20 44 22 20 44
t-calculated 7.87 7.39 22.31 7.10 8.17 17.27
t-critical 2.82 2.84 2.69 2.82 2.84 2.69
F- calculated 2.70 7.72
F-critical 2.43 2.43
* Significant at the 0.01 probability level (2 tailed) F- Chow Test
b- Growth Rate r2 – Coefficient of Simple Determination. d.f. – degrees of freedom.
Figures in parenthesis indicate the standard errors.
This is clearly shown by the above table that the average annual rate of growth, given
by the estimated value of the parameter ‗b‘, has increased to 0.41 % during post-
reform period as compared to 0.31 % during pre- reform period in case of household
savings. The average annual rate of growth has increased to 0.68% during post-
reform period as compared to 0.33 % during pre- reform period in case of total gross
domestic savings. The growth rate in case of total gross domestic savings is more than
double in the post reform period. The regression line has given a good fit to the data,
since this line explained 91 percent during total period, 73 percent during pre-reform
period and 74 percent during post-reform period of the total variation of the Y values
around their mean in the case of household sector savings. In the case of total gross
domestic savings the regression line has also given a good fit to the data, since this
line explained 70 percent during pre-reform period, 77 percent during post-reform
150
period and 87 percent during the total period of the total variation of the Y values
around their mean.
The calculated ‗t‘ values are greater than the critical values obtained from the tables in
all cases at 1% level of significance. This implies that the estimated growth rates are
statistically significant in all the cases. The F -test is also rejected as the calculated F
values are greater than the critical values obtained from the tables in both cases at
10% level of significance. This indicates a structural break corresponding to the
reforms. This implies that in the period after 1990-1991 the average annual rate of
growth of both total domestic savings and the household savings have substantially
increased and this increase is statistically significant. The observed increase in growth
rates in the period after 1990-1991 would also contain the effect of a number of other
changes going on in the economy after the economic reforms of 1991. However, one
can reasonably expect that in case of financial variables the predominant effect would
be of those changes taking place in the financial sector. In any case the magnitude of
change is substantial in both cases so that even after allowing for some impact of
other factors a margin remains that can be attributed to the financial sector reforms.
4.1.2 Gross Domestic Capital Formation

The term capital formation means the act of purchasing tangible or real assets for
utilising them in productive activities. Besides investment in the tangible assets,
change in stock is also a part of the investment. Stock may be of raw material; semi
finished goods or finished goods. Investment can be either gross investment or net
investment. The difference between the two being consumption of fixed capital or
depreciation. Net values give the true measure of addition to the productive capacity
of the economy even then it is common to use gross values for various analytical
purposes due to arbitrariness in calculation of depreciation. Investment is done by the
government sector and the private sector. The private sector investment is more
responsible for the development of the financial system and economic development.
Table 4.1.3 give the contribution of the public and private sector separately for the
capital formation in the economy. It is clear from the table that the contribution of the
private sector is more than the public sector even before the financial sector reforms.
After the reforms the difference is substantially increased. Private capital formation
has increased much faster than the total capital formation in the economy.
151
Table 4.1.3 Gross Domestic Capital Formation as percentage of GDP
Pre-reform period Post-reform period
Adjusted
Adjusted
Private
Private
Total*
Total*
Public
Public
Sector
Sector
Sector
Sector
Year Year
1967-68 6.7 8.6 14.3 1991-92 10.2 12.3 21.8

1968-69 6.1 8.1 13.1 1992-93 9.5 14.7 23
1969-70 5.8 9.4 14.6 1993-94 9.1 12.2 22.2
1970-71 6.4 8.9 15.1 1994-95 9.7 13.5 24.7
1971-72 7.1 9.7 16.0 1995-96 8.6 17.5 25.3
1972-73 7.6 8.2 14.7 1996-97 7.8 14.3 23.7
1973-74 7.6 9.0 17.3 1997-98 7.4 17.1 25.6
1974-75 7.3 11.3 17.5 1998-99 7.3 16.3 24.2
1975-76 9.1 9.4 17.2 1999-2000 7.7 18.5 26.8
1976-77 9.8 8.3 17.4 2000-01 7.2 16.4 24.4
1977-78 8.4 9.8 17.8 2001-02 7.2 17.8 24.3
1978-79 9.4 10.6 21.1 2002-03 6.5 18 24.8
1979-80 10.2 10.7 20.4 2003-04 6.6 18.7 26.9
1980-81 9.2 8.9 19.2 2004-05 7.4 23.8 32.8
1981-82 11 10.8 18.9 2005-06 7.9 25.2 34.7
1982-83 11.9 10.1 19.1 2006-07 8.3 26.4 35.7
1983-84 10.7 9.3 18.2 2007-08 8.9 28.1 38.1
1984-85 11.5 10 19.1 2008-09 9.4 24.8 34.3
1985-86 11.9 11.5 20.6 2009-10 9.2 25.4 36.5
1986-87 12.5 10.9 20.1 2010-11 8.4 26.5 36.8
1987-88 10.8 11.8 21.9 2011-12 7.9 24.9 35
1988-89 10.8 13.1 22.8 2012-13 8.2 24.1 34.6
1989-90 10.8 13.1 23.7
1990-91 10.6 14.3 26
*Adjusted Total Capital Formation includes valuables and errors and omissions.
Sources are same as in table 4.1.1
The above table shows data related to Gross Domestic Capital Formation from 1967-
68 to 2012-13. The magnitudes are shown as percentages to Gross Domestic Product
152
at current market prices (2004-2005). Figure 4.1.2 shows the Gross Domestic Capital
Formation and the contribution of public and private sector separately.
Figure 4.1.2
Gross Domestic Capital Formation as percentage of GDP
50
40
30
20
10
0
1967-68
1969-70
1971-72
1973-74
1975-76
1977-78
1979-80
1981-82
1983-84
1985-86
1987-88
1989-90
1991-92
1993-94
1995-96
1997-98
2001-02
2003-04
2005-06
2007-08
2009-10
2011-12
1999-2000
Public sector Private Sector Total Adjusted
Both the curves for Private sector capital formation and gross domestic capital
formation are steeper in the figure after the early 1990‘s than before period. This
indicates an increase in the rate of growth after the reforms. The gap between the two
curves represents capital formation by the public sector. The contribution of the
public sector in the gross domestic capital formation has been declined consistently
since 1991 up to 2002-03 and after that increased somewhat.
The magnitude of private sector in total capital formation in India is very large and
magnitude of the public sector is very small. So it is only the private sector whose
magnitude is affected by the changes in the financial sector. In order to measure the
financial development, it is very much important to look at the private sector capital
formation and total gross capital formation. Therefore the data is analysed for
structural break includes both private sector capital formation and total gross capital
formation.
The rate has been obtained for the two sub periods (break taken in the year 1990-
1991) and for the entire time period for which data is available. Subsequently Chow
test (Gujarati, 2007) for structural break is performed to test for the impact of
financial sector reforms on both private sector capital formation and total gross capital
formation.
153
Table 4.1.4 Regression Coefficients and Growth Rate for Gross Domestic Capital
Formation
Private Sector Capital Total Gross Domestic Capital
Formation Formation
Total Total
period period
7.93 11.47 5.00 13.41 19.83 12.21
Intercept
(0.43) (0.94) (0.73) (0.53) (1.14) (0.73)
0.18* 0.73* 0.42* 0.41* 0.79* 0.48*
b
(0.03) (0.07) (0.02) (0.03) (0.08) (0.02)
r2 0.63 0.84 0.84 0.85 0.81 0.88
d.f. 22 20 44 22 20 44
t-calculated 6.11 10.19 15.45 11.10 9.12 17.69
t-critical 2.82 2.84 2.69 2.82 2.84 2.69
Notes are same as in table 4.1.2
The above analysis brings out that for total Gross Domestic Capital Formation
(GDCF) rate of average annual growth is increased to 0.79 % in the post reform
period as compared to the 0.41 % in the pre-reform period. It is clear from the above
equations that the rate of growth is nearly doubled in the post reform period for total
Gross Domestic Capital Formation (GDCF). The private sector capital formation is
also increased during the post-reform period from 0.18 % to 0.73%. The rate of
growth has nearly four times in the post reform period for the private sector capital
formation. The regression line has given a good fit to the data, since this line
explained 84 percent during total period, 63 percent during pre-reform period and 84
percent during post-reform period of the total variation of the ‗Y‘ values around their
mean in the case of private sector capital formation. In the case of total gross domestic
capital formation the regression line has also given a good fit to the data, since this
line explained 85 percent during pre-reform period, 81 percent during post-reform
period and 88 percent during the total period of the total variation of the ‗Y‘ values
around their mean.
The associated ‗t‘ values are greater than the critical values obtained from the tables at
1 % level of significance in all the cases. This implies that the estimated growth rates
are statistically significant in all cases. The F- test is rejected in both the cases at 1 %
level of significance thus indicating a structural break corresponding to the reforms.
This implies that in the period after 1990-1991, the average annual rate of growth of
154
both Gross domestic capital formation and private sector capital formation has
substantially increased and that this increase is statistically significant. In this case
also, it needs to be taken into account that the observed increase in the growth rates in
the period 1990-1991 would also include the effect of a number of other changes
going on in the economy after the economic reforms of 1991. The effect of other
changes could be more important but in any case the magnitude of change is
substantial here too, so that even after allowing for some impact of other factors a
margin remains that can be attributed to the financial sector reforms.
From the above analysis on the savings and capital formation rates, one can infer that
on the whole a substantial increase in the rate of growth of both savings and capital
formation is occurred after the reforms. The maximum change is analysed in the case
of capital formation by the private sector. The savings and investments by the public
sector are not directly related to the changes in the financial sector and are determined
by a numbers of other factors and fiscal priorities of the government. The household
savings and capital formation by the private sector are the variables which are of the
greater relevance in the context of development in the financial sector.
4.1.3 Deposits
Success of any financial sector depends on how much of the surplus money it is able
to collect from the surplus sectors. It is the basic function of the financial system to
collect the surplus funds. Deposits are accepted by many agencies from others under
different terms and conditions. In India banks, post offices and non bank companies
accept deposits and provide them to others who are in need of money (Gupta, 1999).
This part of the section provides information on the deposits accepted by the
organised sector of the financial sector i.e., bank deposits and deposits accepted by
non banking companies. Table 4.1.5 gives data on relative magnitudes of demand
deposits and time deposits of scheduled commercial banks. The ratio of time deposits
to demand deposits and to the total deposits shows the distinct jump in the year 1977-
78. According to Gupta (1999), this corresponds to a change in classification of total
deposits as between demand and time deposits. After accounting for the change in
classification, one can say that the proportion of time deposits has shown a steady
overall uptrend. The trend has been somewhat more marked for around a decade
starting mid 1990‘s. It may be noted that while the proportion of time deposits in
155
particular did not show a sharp uptrend, individually both demand and time deposits
have shown substantial increase after the reforms.
Table 4.1.5 Deposits of Scheduled Commercial Banks

Time Time Time Time
Deposits / Deposits/ Deposits / Deposits/
Year Year
Demand Total Demand Total
Deposits Deposits Deposits Deposits
1970-71 1.25 55.40 1991-92 4.12 80.43
1971-72 1.27 55.91 1992-93 4.78 82.67
1972-73 1.28 56.02 1993-94 4.57 82.02
1973-74 1.34 57.15 1994-95 4.03 80.11
1974-75 1.38 57.95 1995-96 4.38 81.42
1975-76 1.43 58.80 1996-97 4.58 82.08
1976-77 1.53 60.40 1997-98 4.84 82.87
1977-78 3.56 78.02 1998-99 5.08 83.55
1978-79 3.64 78.40 1999-2000 5.39 84.34
1979-80 3.78 79.05 2000-01 5.75 85.19
1980-81 3.87 79.46 2001-02 6.21 86.13
1981-82 4.22 80.81 2002-03 6.52 86.71
1982-83 4.14 80.54 2003-04 5.69 85.04
1983-84 4.36 81.31 2004-05 5.85 85.41
1984-85 4.11 80.42 2005-06 4.78 82.71
1985-86 4.47 81.7 2006-07 5.08 83.55
1986-87 4.34 81.26 2007-08 5.1 83.6
1987-88 4.83 82.82 2008-09 6.33 86.36
1988-89 5 83.32 2009-10 5.96 85.63
1989-90 4.79 82.69 2010-11 7.12 87.68
1990-91 4.8 82.73 2011-12 8.45 89.42
2012-13 9.19 90.12
156
Table 4.1.6 and 4.1.7 below gives data on deposits of the whole banking system in the
pre-reform period and post-reform period.
Table 4.1.6 Deposits of the Banking System (1970-71 to 1990-91)

(Rupees in Crores)
Deposits of
Total Total
state Total Total
Deposit of Deposits Deposit of
cooperatives bank Bank
Year SCB of non commercial
maintaining deposits Deposits/
( including SCB banks
account with GDP
RRBs)
RBI
1970-71 5906 15 5921 138 6059 12.72

1971-72 7106 11.1 7117.1 163 7280.1 14.27
1972-73 8643 12.6 8655.6 188 8843.6 15.73
1973-74 10139 15.5 10154.5 225 10379.5 15.17
1974-75 11828 19.4 11847.4 242 12089.4 14.97
1975-76 14155 25.5 14180.5 270 14450.5 16.67
1976-77 17566 21.6 17587.6 352 17939.6 19.20
1977-78 22212 13.4 22225.4 427 22652.4 21.40
1978-79 27016 10.4 27026.4 494 27520.4 24.00
1979-80 31759 13.1 31772.1 570 32342.1 25.72
1980-81 37988 8.2 37996.2 623 38619.2 25.81
1981-82 43733 9.9 43742.9 667 44409.9 25.26
1982-83 51358 12.2 51370.2 733 52103.2 26.5
1983-84 60596 14.8 60610.8 798 61408.8 26.81
1984-85 72245 17.5 72262.5 923 73185.5 28.52
1985-86 85404 22.2 85426.2 1029 86455.2 29.86
1986-87 102723 28.4 102751 1194 103945 32.09
1987-88 118045 35.6 118081 1381 119462 32.44
1988-89 140150 50 140200 1697 141897 32.48
1989-90 166959 59.5 167019 2017 169036 33.68
1990-91 192541 74.8 192616 2152 194768 33.22
157
Table 4.1.7 Deposits of the Banking System (1991-92 to 2012-13)
(Rupees in Crores)
Deposits of
Total Total
state Total Total
Deposit of Deposits Deposit of
cooperatives bank Bank
Year SCB of non commercial
maintaining deposits Deposits/
( including SCB banks
account with GDP
RRBs)
RBI
1991-92 230758 77.4 230835 2576 233411 34.64
1992-93 268572 86.1 268658 2831 271489 35.05
1993-94 315132 90.5 315223 3415 318638 35.75
1994-95 386859 66.3 386925 3850 390775 37.37
1995-96 433819 1.7 433821 4286 438107 35.71
1996-97 505599 0.9 505600 5377 510977 36
1997-98 598485 0.0 598485 5628 604113 38.42
1998-99 714025 0.0 714025 7511 721536 40.01
1999-2000 813344 0.0 813344 8870 822214 40.86
2000-01 962618 0.0 962618 9682 972300 44.83
2001-02 1103360 0.0 1103360 12119 1115479 47.5
2002-03 1280853 0.0 1280853 12226 1293079 51.1
2003-04 1504416 0.0 1504416 13782 1518198 53.5
2004-05 1700199 0.0 1700199 14581 1714780 52.89
2005-06 2109049 0.0 2109049 15665 2124714 57.53
2006-07 2611934 0.0 2611934 17105 2629039 61.22
2007-08 3196940 0.0 3196940 20433 3217373 64.51
2008-09 3834110 0.0 3834110 23094 3857204 68.51
2009-10 4492826 0.0 4492826 26896 4519722 69.77
2010-11 5207969 0.0 5207969 28559 5236528 67.17
2011-12 5909082 0.0 5909082 31342 5940424 66.19
2012-13 6750454 0.0 6750454 35651 6786105 67.72
158
It can be seen from the table that the deposits of both the commercial banks and
cooperative banks have increased at rapid rates. In relative terms the deposits of non
scheduled commercial banks and cooperative banks are of significant magnitude in
comparison to those of scheduled commercial banks. In 1997-98 the distinction
between scheduled and non scheduled commercial banks has been done away with.
The total bank deposits as percentage to GDP have substantially increased during the
period of study.
Figure 4.1.3 below illustrates the trend in the total bank deposits as percentage to
GDP.
Figure 4.1.3: Bank Deposits as percentage to GDP
80
70
60
50
40
30
20
10
0
1970-71
1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
2004-05
2006-07
2008-09
2010-11
2012-13
Bank Deposits
Although the curve is steadily moving upward from the beginning of the time period
itself; the uptrend is more marked after the early 1990‘s. Same results are obtained on
the basis of regression analysis also. The rates are obtained for the two sub periods
(break taken in the year 1990-1991) and for the entire time period for which data is
available. Subsequently Chow test (Gujarati, 2007) for structural break has been
performed to test for the impact of financial sector reforms on deposits. The table
4.1.8 shows Regression Coefficients and Growth Rate for Deposits in the pre- reform
period, post- reform period and total period.
159
Table 4.1.8 Regression Coefficients and Growth Rate for Deposits
Deposits of the Banking System

Pre-reform period Post-reform period Total period
11.81 27.79 8.81
Intercept
(0.60) (1.40) (1.26)
1.12* 1.96* 1.30*
b
(0.04) (0.10) (0.05)
r2 0.97 0.94 0.94
d.f. 19 20 41
t-calculated 23.32 18.30 26.13
t-critical 2.86 2.84 2.70
F- calculated 36.41
F-critical 5.19
The above analysis brings out that for deposits of the banking system, the rate of
average annual growth is increased in the post- reform period to 1.96 % as compared
to 1.12 % in the pre- reform period. The regression line has given a good fit to the
data, since this line explained 94 percent during total period, 97 percent during pre-
reform period and 94 percent during post-reform period of the total variation of the
‗Y‘ values around their mean in the case of deposits of the banking system.
The t- test for the significance of the slope coefficients is rejected at level of
significance at 1%, thereby implying that the estimated growth rates are statistically
significant. The F- test is also rejected indicating that a structural break corresponding
to the reforms. This implies that in the period after 1990-1991 the average annual rate
of growth of the bank deposits has substantially increased and that this increase is
statistically significant. It can be seen from the growth rate ‗b‘ that the growth rate
was high even before the reforms. In the case of deposits the influences other than
those relating to the financial sector would be minimal so that almost entire increase
can be attributed to the aforesaid reforms.
4.1.4 Deposits of Non Banking Companies (NBCs)

Statistical studies on NBCs are faced with difficulties for several reasons. Firstly, only
a small proportion of these file return with RBI and with time this proportion is
increasing so that at least a part of increase in deposits could actually be due to greater
proportion of such deposits getting accounted. Secondly, with effect from 1997, the
NBCs are being more comprehensively defined, their coverage being more extensive,
so that more and more companies would fall under NBCs. Moreover the reporting
160
format in the pre and post 1997 period is also different, therefore the data before and
after 1997 cannot be compared. Data before 1997 period is available in terms of
regulated deposits (those deposits which are subject to ceilings and other restrictions
imposed by the regulatory measures) and exempted deposits/borrowings (those which
are outside the scope of regulatory measures). It must be noted that deposits here
mean any money received by an NBC by way of deposits or a loan or any other form.
Since April-may, 1993 apart from the usual deposits they mean inter corporate loans,
and borrowings by private limited NBCs from their shareholders. Table 4.1.9 below
gives the available data on the deposits of NBCs.
Table 4.1.9: Deposits of NBCs.
(Rupees crores)
Non Bank Non Bank Non
Total
Year Financial Financial
Deposits
Companies Companies
1970-71 150 419 569
1971-72 211 481 692
1972-73 230 517 748
1973-74 304 725 1029
1974-75 442 754 1197
1975-76 462 804 1265
1976-77 696 1039 1735
1977-78 750 1313 2063
1978-79 1039 1598 2636
1979-80 1613 1841 3454
1980-81 1476 2712 4188
1981-82 1746 3746 5492
1982-83 2430 6764 9194
1983-84 3161 7963 11124
1984-85 4356 11784 16140
1985-86 4960 13113 18072
1986-87 5942 15459 21400
1987-88 7500 16705 24204
1988-89 10485 18120 28605
1989-90 14643 21439 36082
1990-91 17236 26837 44074
1991-92 20439 30746 51185
1992-93 44956 103141 148097
1993-94 56437 129343 185781
1994-95 85495 158511 244006
1995-96 101672 186909 288582
1996-97 124370 223873 348243
161
Table 4.1.10: Deposits of NBFCs.
(Rupees crores)
NBFCs RNBCs Total
Year Total No. of Total No. of Total No. of
Public Public Total public
end Reporting Reporting Reporting
Deposits Deposits deposits
March Companies Companies Companies
1998 1420 13571.7 9 10248.7 1429 23820.4
1999 1536 9785 11 10644.3 1547 20429.3
2000 996 8338 9 11003.8 1005 19341.8
2001 974 6459.4 7 11625.2 981 18084.6
2002 905 5933 5 12888.8 910 18821.8
2003 870 5034.6 5 15065 875 20099.6
2004 774 4317.1 3 15326.7 777 19643.8
2005 700 3926 3 16600 703 20526
2006 428 2447 3 20175 431 22622
2007 401 2075 3 22622 404 24697
2008 364 2042 2 22358 366 24400
2009 336 1971 2 19596 338 21567
2010 308 2831 2 14521 310 17352
2011 297 4098 2 7902 299 12000
2012 271 5735 2 4265 272 10000
2013 254 7085 2 3501 256 10586
NBFC : Non-banking financial company RNBC : Residuary non-banking company
Note : 1. Data format has changed after 1996-97 due to new reporting format following changes in
the regulatory framework in1998. 2. NBFCs include Deposit taking NBFCs (NBFCs-D), Mutual
Benefit Financial Companies (MBFCs)/Notified Nidhis, Mutual Benefit Companies
(MBCs)/Potential Nidhis, etc till 2004-05 and only NBFCs-D thereafter.
Source: Handbook of statistics on the Indian Economy published by Reserve Bank of India (Various
issues)
The table 4.1.9 gives data on aggregate deposits of non banking financial companies
(NBFCs). It is noted that total deposits increased from 569 crores in 1970-71 to
348243 crores in 1996-97. After 1997, continuous time series data is available only on
public deposits in Non Banking Financial Companies (NBFCs). This data is given
separately in the table no. 4.1.10 for the NBFC and Non Bank Non Financial
Companies (NBNFC) also known as Residuary Non-banking Company after 1997. It
may be noted here that the non financial companies have done much greater amount
of business of accepting deposits. Another point to note here is the sharp increase in
the deposits of both these types of companies after the reforms. Even after allowing
162
for increase due to wider coverage, a big magnitude of increase would still remain,
that can be caused by financial sector reforms. It is also evident in the figure 4.1.4
below. All the three curves rise steeply after the reforms.
Figure 4.1.4 Deposits of NBFCs
400000
350000
300000
250000
200000
150000
100000
50000
0
Non Bank Financial Companies Non Bank Non Financial Companies

Total aggregate Deposits
4.1.5 Deposits area wise
The analysis of total deposits of Scheduled Commercial Banks (SCBs) does not give
adequate information relating to the deposits mobilized in different areas. In order to
measure financial development, it is very much important to look at the deposits
mobilised in different areas. Hence an attempt is made to analyze the deposits
mobilized from different regions.
Table 4.1.11 shows area wise deposits of Scheduled commercial Banks (SCBs) in
terms of percentage to the total deposits from 1970-71 to 2012-13. The table shows
deposits in rural, Semi-urban, urban and metropolitan areas separately in India. It can
be seen from the table that the deposits are more in metropolitan areas followed by
urban area.
In the pre-reform period, the percentage of rural deposit has increased from 5.9
percent to 15.46 percent, but it declined to 9.60 percent by 2013.The percentage of
semi urban deposit steadily declined during pre and post-reform periods. The urban
deposit also declined constantly in the post-reform years, but the metropolitan
deposits are steadily increased during post-reform periods. So in the post-reform
163
period, rural, semi urban and urban deposits are declined and metropolitan deposits
are increased.
Table 4.1.11: Deposits area wise

(In Percentages)
Metropolitan
Metropolitan
Semi Urban
Semi Urban
Urban
Urban
Rural
Rural
Year Year
1970-71 5.9 22.0 24.6 47.4 1991-92 15.08 19.65 23.32 41.95
1971-72 6.5 22.4 25.0 46.2 1992-93 15.01 19.43 23.18 42.39
1972-73 7.1 23.3 25.4 44.2 1993-94 15.23 19.46 22.92 42.40
1973-74 7.8 22.7 24.8 44.8 1994-95 13.67 18.85 22.19 45.30
1974-75 8.1 22.2 24.6 45.0 1995-96 14.39 19.52 22.43 43.66
1975-76 8.7 22.6 24.9 43.9 1996-97 14.74 19.59 22.49 43.18
1976-77 9.0 22.3 24.8 43.8 1997-98 14.54 19.39 22.62 43.46
1977-78 9.9 22.4 25.1 42.6 1998-99 14.71 19.49 22.94 42.86
1978-79 10.6 22.5 24.9 42.0 1999-2000 14.67 19.72 23.00 42.60
1979-80 11.93 22.97 25.26 39.84 2000-01 14.69 19.61 22.94 42.76
1980-81 13.02 23.18 24.66 39.13 2001-02 14.19 19.14 22.74 43.93
1981-82 13.78 22.91 25.02 38.29 2002-03 13.83 18.94 22.76 44.46
1982-83 14.09 23.53 24.88 37.50 2003-04 12.91 17.75 21.86 47.49
1983-84 14.37 20.74 25.95 38.93 2004-05 12.20 16.93 21.46 49.41
1984-85 13.39 21.55 26.25 38.81 2005-06 10.81 14.45 20.60 54.14
1985-86 13.89 21.15 25.69 39.27 2006-07 9.74 13.76 20.51 55.99
1986-87 14.33 21.26 26.04 38.38 2007-08 9.34 13.24 20.24 57.19
1987-88 15.06 21.66 25.62 37.67 2008-09 9.28 13.51 20.98 56.23
1988-89 14.99 21.38 25.06 38.57 2009-10 9.22 13.46 20.72 56.60
1989-90 15.26 21.16 24.67 38.91 2010-11 9.15 13.30 20.60 56.94
1990-91 15.46 20.66 24.50 39.38 2011-12 9.43 13.86 20.94 55.77
2012-13 9.60 14.0 21.3 55.10
Note: Data as on last Friday of June from 1981 to 1989 and as on 31st March from 1990 onwards.
Source: Basic Statistical Returns of Scheduled Commercial Banks in India. Economic surveys (various
issues). The Handbook of statistics on Indian economy 2012-13.
164
Figure 4.1.4(a) also shows that there is evident increase in the deposits of
metropolitan areas and the rural; semi urban and urban deposits have declined in the
post-reform period
Figure 4.1.4(a): Deposits area wise
70
60
50
40
30
20
10
2004-05
1970-71
1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
2006-07
2008-09
2010-11
2012-13
Rural Semi Urban Urban Metropolitan
Same results as shown by the curves in the above figure are obtained on the basis of
regression analysis also. Therefore, the rates are obtained for the two sub periods
available. The table 4.1.12 shows Regression Coefficients and Growth Rates for area
wise Deposits in the pre- reform period, post- reform period and total period.
This is clearly shown by the table that the average annual rate of growth, given by the
estimated value of the parameter ‗b‘, is decreased during post-reform period to -0.34
as compared to pre reform period of 0.51 in case of rural deposits.
165
Table 4.1.12 Regression Coefficients and Growth Rate for area wise Deposits

5.99 23.06 24.85 46.10
Intercept
(0.38) (0.31) (0.22) (0.66)
Pre- 0.51* -0.08* 0.09* -0.45*
b
reform (0.03) (0.02) (0.02) (0.05)
period r2 0.93 0.40 0.55 0.79
d.f. 19 19 19 19
t-calculated 17.0 4.0 4.5 9.0
t-critical 2.86 2.86 2.86 2.86
16.50 21.45 23.48 38.58
Intercept
(0.45) (0.57) (0.25) (1.25)
Post- -0.34* -0.37* -0.13* 0.85*
b
reform (0.03) (0.04) (0.02) (0.09)
period r2 0.83 0.78 0.70 0.80
d.f. 20 20 20 20
t-calculated 11.33 9.25 6.5 9.44
t-critical 2.84 2.84 2.84 2.84
11.03 24.72 26.27 37.98
Intercept
(0.88) (0.43) (0.27) (1.46)
0.09* -0.23* -0.13* 0.31*
Total b
(0.02) (0.02) (0.01) (0.06)
period
r2 0.50 0.82 0.77 0.42
d.f. 41 41 41 41
t-calculated 4.5 11.5 13.0 5.17
t-critical 2.70 2.70 2.70 2.70
The average annual rate of growth is decreased during post reform period to -0.37 as
compared to pre-reform period of -0.08 in case of semi urban deposits. The average
annual rate of growth is decreased during post-reform period to -0.13 as compared to
166
pre-reform period of 0.09 in case of urban deposits. The average annual rate of growth
is increased during post reform period to 0.85 as compared to pre reform period of
-0.45 in case of metropolitan deposits. The average annual rate of growth of
metropolitan deposits is 0.31 during total period, which is higher than rural, urban and
semi-urban areas in the total period. The growth rate for the metropolitan deposits is
nearly tripled in the post-reform period. The regression line has given a good fit to the
data, since almost all the lines explained more than 50 percent during total period,
pre-reform period and post-reform period of the total variation of the ‗Y‘ values
around their mean in the case of rural, semi urban, urban and metropolitan area
deposits. The calculated t -values are greater than the critical values obtained from the
tables in all cases at 1% level of significance. This implies that the estimated growth
rates are statistically significant in all the cases.
4.1.6 Institutional Finance/ Credit
The surplus fund of the economy which is collected by the financial system must be
channelized in productive ways for the development of the economy. This is done in
the various forms of credit to the deficit spenders in the economy. Broadly speaking
credit is finance made available by one party to another (Gupta, 1999). The party
who give credit may be financial institution, private money lender, a seller supplying
goods against buyer promise of future payment, a shareholder or an owner giving
funds to the firm viewed as a separate legal entity. Credit helps the business units in
their expansion plans and consequently progress of the economy. The main focus of
this chapter is confined to institutional finance or credit. Finance through share is a
subject of later chapter of financial markets.
There are several sources of institutional credit in the economy. Commercial banks
are the major source of institutional finance although their importance is decreasing
with the time as a number of other financial institutions like development banks, non
banking financial institutions come up and developing in the economy.
Banking sector made available credit to the deficit spenders. The specialised financial
institutions at all India and state levels, non bank finance companies and large number
of unorganised operators providing credit. Out of all these commercial banks finance
(the term ‗finance‘ has been used rather than ‗credit‘ due to inclusion of bank
investments that is not strictly credit) is still the dominant source although its relative
167
importance has declined in the recent years. Consistent data on credit from NBFCs in
totality is not available. In context of private unregulated credit markets too, reliable
and complete information is not available about their operations as there is no official
or unofficial agency to which such financers report their operations. So the study has
used bank finance together with financial assistance provided by Non Banking
Financial Institutions (NBFI) in the analysis.
Table 4.1.13 gives the available data on institutional finance to the private sector.
Financial assistance from the banking system to the private sector includes bank credit
and the investments made by the banking sector in other than government and
approved securities. Total bank credit that goes to the banking sector is obtained as
the sum of non-food credit advanced by the scheduled commercial banks and the
credit provided by the non SCB and cooperative banks. For the financial assistance
provided by the financial institutions, state level institutions (SFCs and SIDCs) are
not included because in respect of these data is available only up to 2004. Six all India
financial institutions (SIDBI, LIC, GIC, TFCI, IVCF and IFCI) are included for which
the data is available till 2013. The others are not included in the analysis to maintain
the comparability of data.
The data is more informative and meaningful when expressed in terms of percentages
to GDP at current prices. This is done in the table no. 4.1.13. The second column of
the table gives total bank finance as percentage to GDP at market price and the third
column provide information on financial assistance that has been provided by the all
India financial institutions as percentage to GDP. Total institutional finance as
percentage of GDP is shown in the fourth column of the table. The bank finance
increased from a little above 8.9 % of the Gross Domestic Product in the year of
1967-68 to nearly 21 % by 1990‘s. After mid 1990‘s it registered increase to reach
nearly 50 % in 2006-07 and more than 54 % in 2012-13. Most of this increase has
taken place in the recent years as can be seen from the figure 4.1.5 also. The finance
provided by the all India financial institutions, is grown rapidly during the 1990‘s
although it is always less than 1.67 % during the whole study period.
168
Table 4.1.13: Rate of institutional finance to the private sector
Total bank finance
Total bank finance

FA by AIFIS as %
FA by AIFIS as %
Total institutional
Total institutional
finance as % of
finance as % of
as % of GDP
as % of GDP
of GDP
of GDP
GDP
GDP
Year Year
1967-68 8.90 0.05 8.95 1991-92 20.13 0.74 20.87

1968-69 8.97 0.04 9.01 1992-93 21.75 0.76 22.51
1969-70 8.98 0.04 9.02 1993-94 20.39 0.69 21.08
1970-71 9.69 0.05 9.74 1994-95 21.84 0.77 22.61
1971-72 9.97 0.06 10.02 1995-96 23.18 1.06 24.24
1972-73 10.69 0.07 10.76 1996-97 23.27 0.97 24.25
1973-74 10.58 0.08 10.66 1997-98 25.19 1.03 26.22
1974-75 10.46 0.11 10.57 1998-99 25.27 0.97 26.24
1975-76 11.16 0.07 11.23 1999-2000 26.08 0.89 26.97
1976-77 12.14 0.10 12.24 2000-01 27.94 0.77 28.71
1977-78 12.61 0.09 12.71 2001-02 28.7 0.74 29.44
1978-79 15.02 0.09 15.11 2002-03 32.72 0.64 33.36
1979-80 16.76 0.17 16.93 2003-04 33.89 0.76 34.65
1980-81 17.09 0.15 17.24 2004-05 37.61 0.47 38.08
1981-82 16.85 0.19 17.04 2005-06 44.61 0.57 45.18
1982-83 17.61 0.17 17.78 2006-07 49.42 0.9 50.32
1983-84 17.31 0.2 17.51 2007-08 51.87 0.92 52.79
1984-85 18.11 0.21 18.32 2008-09 53.33 1.67 55.01
1985-86 18.68 0.27 18.94 2009-10 53.26 1.42 54.68
1986-87 19.26 0.3 19.56 2010-11 52.96 1.13 54.09
1987-88 20 0.3 20.3 2011-12 53.84 1.12 54.96
1988-89 21 0.36 21.36 2012-13 54.62 0.89 55.51
1989-90 22.56 0.35 22.91
1990-91 20.87 0.69 21.56
Source: Statistical tables relating to banks in India (1979-2009).Handbook of statistics on the Indian
economy 2012-13.
169
Figure 4.1.5 shows that the curves of bank finance and total institutional finance as
percentage to GDP are both gradually rising at first and then rapidly after the mid
1990‘s. The curves are almost overlapping due to the small magnitude of the finance
provided by the All India Financial Institutions (AIFIs).
Figure 4.1.5: Rate of institutional finance to the private sector
60
50
40
30
20
10
0
1971-72
1967-68
1969-70
1973-74
1975-76
1977-78
1979-80
1981-82
1983-84
1985-86
1987-88
1989-90
1991-92
1993-94
1995-96
1997-98
2001-02
2003-04
2005-06
2007-08
2009-10
2011-12
1999-2000
Total bank finance FA by AIFIS Total institutional finance
The sharp change in the growth of institutional finance after the reforms is also
brought out by results of the regression analysis. The rates are obtained for the two
sub periods (break taken in the year 1990-1991) and for the entire time period for
which data is available. Subsequently chow test (Gujarati, 2007) for structural break
is performed to test for the impact of financial sector reforms on institutional finance.
The table 4.1.14 shows Regression Coefficients and Growth Rate for institutional
finance to the private sector in the pre- reform period, post- reform period and total
period.
It can be seen from the equations that the average annual rate of growth is increased
during post-reform period to 1.99 as compared to pre-reform period of 0.64 in case of
institutional finance to the private sector. The rate of growth given by the estimated
value of the parameter ‗b‘, is increased by more than three times in the post-reforms
period as compared to pre-reform period in case of institutional finance to the private
sector.
170
Table 4.1.14: Regression Coefficients and Growth Rate for Institutional
Finance to the Private Sector
Pre-reform period Post-reform period Total period
6.95 13.54 1.56
Intercept
(0.38) (1.72) (1.67)
0.64* 1.99* 1.00*
b
(0.03) (0.13) (0.06)
r2 0.96 0.92 0.86
d.f. 22 20 44
t-calculated 21.33 15.30 16.67
t-critical 2.82 2.84 2.69
F- calculated 58.16
F-critical 5.15
The regression line has given a good fit to the data, since this line explained 86
percent during total period, 96 percent during pre-reform period and 92 percent during
post-reform period of the total variation of the ‗Y‘ values around their mean in the
case of institutional finance to the private sector. The calculated t -values are greater
than the critical values obtained from the tables in all cases at 1% level of
significance. This implies that the estimated growth rates are statistically significant in
all the cases. The F -test for equality of slope coefficients is also rejected as the
calculated F values are greater than the critical values obtained from the tables at 1%
level of significance. This indicates a structural break corresponding to the reforms.
This implies that in the period after 1990-91, the annual rate of growth of institutional
finance to the private sector is substantially increased and this increase is statistically
significant. The observed increase in growth rates in the period after 1990-1991
would also contain the effect of a number of other changes going on in the economy
after the economic reforms of 1991. But it can be seen from the coefficient of ‗b‘ that
the growth rate was high even before the reform period. In the case of institutional
finance to the private sector, as in deposits the influence other than those relating to
the financial sector would be minimal, so that almost all increase can be attributed to
the aforesaid reforms.
171
4.1.7 Credit Area Wise
The analysis of the total amount of credit does not provide complete information
relating to the credit granted by Scheduled commercial Banks (SCBs). It is necessary
to analyze the area wise credit position.
Table 4.1.15: Credit area wise as percentage to total credit
Metropolitan
Metropolitan
Semi Urban
Semi Urban
Urban
Urban
Rural
Rural
Year Year
1970-71 3.8 13.8 21.3 61.1 1991-92 20.13 16.71 22.04 41.12
1971-72 4.6 14.0 21.2 60.2 1992-93 18.70 15.61 20.69 45.00
1972-73 4.8 14.3 22.4 58.4 1993-94 17.55 15.06 20.57 46.83
1973-74 5.3 14.7 22.9 57.1 1994-95 15.90 15.08 17.67 51.36
1974-75 5.9 15.1 24.0 55.0 1995-96 15.16 14.48 17.43 52.92
1975-76 5.8 13.3 21.8 59.1 1996-97 14.16 14.28 18.21 53.35
1976-77 6.5 13.8 22.4 57.4 1997-98 14.59 14.10 18.13 53.19
1977-78 7.5 15.1 22.5 55.0 1998-99 14.10 14.33 18.49 53.08
1978-79 8.4 15.6 22.7 53.3 1999-2000 12.92 14.08 17.30 55.70
1979-80 9.63 16.41 22.31 51.66 2000-01 12.79 13.21 17.70 56.30
1980-81 11.61 17.48 22.20 48.71 2001-02 13.37 13.74 18.87 54.02
1981-82 12.68 17.42 21.90 47.99 2002-03 14.09 13.78 18.90 53.24
1982-83 12.19 17.50 22.20 48.11 2003-04 12.49 13.05 19.31 55.16
1983-84 14.44 16.27 23.44 45.85 2004-05 13.92 12.39 18.42 55.26
1984-85 13.96 18.12 23.00 44.92 2005-06 13.17 11.55 18.26 57.02
1985-86 14.63 17.69 22.35 45.33 2006-07 12.11 10.93 17.99 58.98
1986-87 15.11 17.70 22.77 44.42 2007-08 13.37 10.59 17.82 58.22
1987-88 15.83 18.41 22.53 43.23 2008-09 10.87 10.92 17.51 60.70
1988-89 16.14 17.89 22.65 43.32 2009-10 11.51 11.00 17.75 59.74
1989-90 24.41 16.87 21.50 37.22 2010-11 9.63 11.09 19.13 60.15
1990-91 21.45 16.75 22.04 39.77 2011-12 9.21 11.00 17.80 62.00
2012-13 9.48 12.23 17.88 60.41
Note : Data as on last Friday of June from 1981 to 1989 and as on 31st March from 1990 onwards.
Source : Basic Statistical Returns of Scheduled Commercial Banks in India..Banking Statistics 1972,
1995 and Report on Trend and Progress on banking in India, Reserve Bank of India, Mumbai, 2004.
Economic surveys (various issues) and the handbook of statistics on Indian economy 2012-13.
172
Table 4.1.15 shows area wise credit of Scheduled commercial Banks (SCBs) in terms
of percentage to the total credit from 1970-71 to 2012-13. The table shows credit in
rural, Semi-urban, urban and metropolitan areas separately in India.
It is evident from the table that the relative share of rural credit to total credit is
considerably lower than the credit delivery to other areas. Before the reforms credit in
the rural area increased from 3.8 percent to 21.45 percent upto 1990-91 and decreased
continuously after the reforms from 20.13 to 9.48 percent in 2012-13. This points
towards the neglect of rural sector by the banks in the post reform period. The
percentage of semi-urban and urban credits has more or less continuously declined
both in pre and post -reform periods. But the percentage of metropolitan credit
decreased in the pre- reform period to 39.77 percent and increased in the post reform
period to 60.41 percent. This is also supported by the findings of Nair (2000) and
Shetty (2004).
Figure 4.1.6 also shows that there is evident increase in the credit of metropolitan
areas and the rural, semi urban and urban credit have declined in the post-reform
period
Figure 4.1.6: Credit area wise as percentage to total credit
70
60
50
40
30
20
10
0
1974-75
2008-09
1970-71
1972-73
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
2004-05
2006-07
2010-11
2012-13
In order to measure the financial development, it is very much important to look at the
credits in different areas. Therefore the rate has been obtained for the two sub periods
available.
173
Table 4.1.16 Regression Coefficients and Growth Rate for area wise Credit

1.46 13.63 22.26 62.64
Intercept
(0.74) (0.41) (0.31) (0.71)
Pre- 0.88* 0.22* 0.01* -1.12*
b
reform (0.06) (0.03) (0.02) (0.05)
period r2 0.92 0.71 0.60 0.95
d.f. 19 19 19 19
t-calculated 14.67 7.33 0.5 22.4
t-critical 2.86 2.86 2.86 2.86
18.10 16.09 19.59 46.22
Intercept
(0.51) (0.29) (0.47) (0.97)
Post- -0.39* -0.26* -0.09* 0.73*
b
reform (0.04) (0.02) (0.03) (0.07)
period r2 0.83 0.87 0.65 0.83
d.f. 20 20 20 20
t-calculated 9.75 13.0 3.0 10.43
t-critical 2.84 2.84 2.84 2.84
9.45 17.04 23.61 49.91
Intercept
(1.33) (0.56) (0.37) (1.99)
0.13 -0.11* -0.14* 0.12
Total b
(0.05) (0.02) (0.01) (0.07)
period
r2 0.14 0.38 0.70 0.15
d.f. 41 41 41 41
t-calculated 2.6 5.5 14.0 1.71
t-critical 2.70 2.70 2.70 2.70
This is clearly shown by the above table that the average annual rate of growth, given
by the estimated value of the parameter ‗b‘, is decreased during post -reform period to
-0.39 as compared to pre- reform period of 0.88 in case of rural credit. The average
annual rate of growth is decreased during post -reform period to -0.26 as compared to
pre reform period of 0.22 in case of semi urban credit. The average annual rate of
growth is decreased during post- reform period to -0.09 as compared to pre-reform
period of 0.01 in case of urban credits. The average annual rate of growth is increased
during post- reform period to 0.73 as compared to pre- reform period of -1.12 in case
of metropolitan credit. The same results are shown by the regression analysis as
shown by the figure 4.1.6 that in the post-reform period growth rate of the
institutional finance to the private sector is decreased in the case of rural, semi-urban
174
and urban areas but increased in the case of metropolitan area in comparison to the
pre-reform period. The regression line has given a good fit to the data, since all the
lines explained more than 60 percent during pre-reform period and post-reform period
of the total variation of the ‗Y‘ values around their mean in the case of rural, semi
urban, urban and metropolitan area credit. The calculated t- values are greater than the
critical values obtained from the tables in all cases at 1% level of significance. This
implies that the estimated growth rates are statistically significant in all the cases
during pre and post reform periods.
On comparing the equations for credit and deposits it may be noted that prior to the
reforms the growth rate of credit was around half the growth rate of deposits.
Subsequent to the reforms the growth rates of the deposits and credit are
approximately same. It also brings out the increase in the proportion of deposits that
have been channelled to the private sector via financial system. This has been made
possible only by the substantial reduction in the CRR, SLR and priority sector
lending. The banks and the financial institutions now have much greater freedom to
deploy the available funds.
4.1.8 Density of the financial system
The structure of the financial system undergoes a number of changes quantitatively

and qualitatively with the development of the financial sector in the economy. Due to
the financial development the role of the banking sector declines and other sectors
play very important role in the financial system. There is emergence and growth of
the strong, active, large size etc. Non banking financial sector like stock market, debt
market, insurance companies, pension funds, specialised financial institutions, mutual
funds etc. Private banking both domestic and foreign becomes important and
developed.
Many economists have different views regarding financial structure as indicator of

financial development. Cameron study on ―banking in the early stages of
industrialisation‖ shows a wide range of successful financial systems. The system that
is best at one place and time may not work successfully in other circumstances. The
structure of the financial system is different and related to legal, social, political,
economic conditions of every country (Cameron, 1967). The structure and
175
behavioural characteristics of a financial system greatly determines the effectiveness
with which it plays its role in the economic growth and development.
Table 4.1.17: Density of the Financial System
No. of No. of
Population/ Population/
SCB SCB
bank bank
Year branches / Year branches /
offices offices
million million
per1000 per1000
population population
1970-71 43 23 1991-92 14 71
1971-72 41 25 1992-93 14 70
1972-73 37 27 1993-94 14 69
1973-74 34 29 1994-95 15 69
1974-75 32 32 1995-96 15 68
1975-76 29 35 1996-97 15 67
1976-77 25 40 1997-98 15 67
1977-78 23 44 1998-99 15 66
1978-79 21 47 1999-2000 15 65
1979-80 20 49 2000-01 15 65
1980-81 19 53 2001-02 16 64
1981-82 18 57 2002-03 16 63
1982-83 17 59 2003-04 16 63
1983-84 16 63 2004-05 16 63
1984-85 14 70 2005-06 16 63
1985-86 14 71 2006-07 16 64
1986-87 14 70 2007-08 15 67
1987-88 14 70 2008-09 14 70
1988-89 14 72 2009-10 14 73
1989-90 14 73 2010-11 13 77
1990-91 14 72 2011-12 12 82
2012-13 12 87
The indicators in the table 4.1.17 deals with the changes that have taken place within
the financial structure itself with the development of the financial system. The
indicators as provided in the above table help in judging the density of the financial
system. The ratio of population per bank office gives Cameron‘s measure for density.
The other measure, number of Scheduled Commercial Bank offices per million
populations is in fact just a mirror reflection.
176
Figure 4.1.7 below illustrates the trend in the population/ bank offices per 1000
persons and number of scheduled commercial banks/million populations. These
measures show a rapid increase in the density from 1970-71. By the mid 1980‘s the
density of the Indian banking system had already reached at appreciable levels. As per
the standard prescribed by the Cameron these magnitudes belongs to the moderate to
high levels. Thus, ever since the late 1980‘s India has been holding on to nearly same
density levels that are satisfactory by all standards. The improvements had all taken
place by late 1980‘s and reasonably satisfactory levels of density had been achieved.
This has been largely made possible as a result of deliberate policy of the government
of extending the geographical spread and functional reach of the Indian banking
system.
Figure 4.1.7: Density of the Financial System
100
90
80
70
60
50
40
30
20
10
0
1981-82
1971-72
1973-74
1975-76
1977-78
1979-80
1983-84
1985-86
1987-88
1989-90
1991-92
1993-94
1995-96
1997-98
2001-02
2003-04
2005-06
2007-08
2009-10
2011-12
1999-2000
Population/bank offices per 1000

No. of SCB branches /million population
The sharp change in the growth of density after the reforms is also brought out by the
regression analysis. The rates are obtained for the two sub periods (break taken in the
year 1990-1991) and for the entire time period for which data is available.
Subsequently chow test (Gujarati, 2007) for structural break is performed to test for
the impact of financial sector reforms on density of the financial sector. The table
4.1.18 shows Regression Coefficients and Growth Rate for density in the pre- reform
period, post- reform period and total period.
177
Table 4.1.18: Regression Coefficients and Growth Rate for Density of Financial System
Population/bank offices No. of SCB branches /million

per1000 population
Total Total
period period
38.39 15.34 28.38 20.21 64.03 38.45
Intercept
(1.62) (0.52) (1.68) (1.49) (2.57) (3.04)
-1.44* -0.10* -0.44* 2.83* 0.41* 0.99*
B
(0.12) (0.04) (0.07) (0.12) (0.19) (0.12)
r2 0.87 0.50 0.53 0.97 0.48 0.62
d.f. 19 20 41 19 20 41
t-calculated 12.0 2.50 6.28 23.58 2.16 8.25
t-critical 2.09 2.08 2.02 2.09 2.08 2.02
The above analysis brings out that for population/ bank offices rate of average annual
growth is increased to -0.10 % in the post-reform period as compared to the -1.44 %
in the pre-reform period, but the sign is negative which shows that in the pre- reform
period population per bank offices decreased at higher rate than in the post- reform
period. In the case of number of scheduled commercial banks per million populations
is increased at the rate of 2.83 in the pre- reform period and 0.41 percent in the post-
reform period. The regression line has given a good fit to the data, since the lines
explained 53 percent during total period, 87 percent during pre-reform period and 50
percent during post-reform period of the total variation of the ‗Y‘ values around their
mean in the case of population/ bank offices. In the case of number of scheduled
commercial banks per million populations the regression line has also given a good fit
to the data, since this line explained 97 percent during pre-reform period, 48 percent
during post-reform period and 62 percent during the total period of the total variation
of the ‗Y‘ values around their mean.
The associated ‗t‘ values are greater than the critical values obtained from the tables at
5 % level of significance in all the cases. This implies that the estimated growth rates
are statistically significant in all cases. The F-test is rejected in both the cases at 1 %
level of significance thus indicating a structural break corresponding to the reforms.
178
4.1.9 Branch Expansion
Branch expansion is an important yardstick to measure the spread of the volume of

business of banks. The geographical distribution of bank branches is an important
variable for analyzing the attitudes of banks towards the development of the society.
In places where bank branches are more, better and increased banking facilities can be
ensured in the society and a good system of banking culture can be developed among
people, which is a prime requirement in the development of an economy. Table 4.1.19
shows branch expansion of SCBs in India during the period 1970-71 to 2012-13.
Table 4.1.19: Population Group wise branches of Scheduled Commercial Banks

as percentage to total scheduled commercial banks
Metropolitan
Metropolitan
Semi Urban
Semi Urban
Urban
Urban
Rural
Rural
Year Year
1970-71 36 34 16 15 1991-92 58 19 14 9
1971-72 35 32 18 14 1992-93 58 19 14 9
1972-73 36 31 18 15 1993-94 57 19 14 9
1973-74 36 30 18 15 1994-95 53 21 14 11
1974-75 36 30 19 15 1995-96 52 22 14 12
1975-76 36 30 19 15 1996-97 52 22 15 12
1976-77 38 29 18 14 1997-98 51 22 15 12
1977-78 42 27 17 13 1998-99 51 22 15 12
1978-79 44 26 17 13 1999-2000 50 22 15 13
1979-80 47 25 16 12 2000-01 49 22 16 13
1980-81 49 24 15 12 2001-02 49 22 16 13
1981-82 52 22 15 11 2002-03 49 22 16 13
1982-83 54 22 14 10 2003-04 48 22 16 13
1983-84 56 21 13 10 2004-05 47 23 17 14
1984-85 59 19 13 9 2005-06 43 23 17 17
1985-86 56 20 14 11 2006-07 42 23 18 17
1986-87 56 20 13 11 2007-08 40 23 19 18
1987-88 56 20 13 11 2008-09 39 24 19 18
1988-89 57 19 13 10 2009-10 38 24 20 18
1989-90 58 19 13 9 2010-11 37 25 19 18
1990-91 58 19 13 9 2011-12 37 26 19 18
2012-13 37 27 19 17
179
The following figure 4.1.8 shows that in the pre reform period the number of rural
branches increased and in the post-reform period the growth rate is declined. The
situation is different in the case of semi urban, urban and metropolitan branches as
these decreased during the pre reform period and increased in the post-reform period.
Figure 4.1.8: Population Group wise branches of Scheduled Commercial Banks

as percentage to total scheduled commercial banks
70
60
50
40
30
20
10
0
1972-73
1970-71
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
2004-05
2006-07
2008-09
2010-11
rural semi urban urban metro 2012-13
Same results are obtained on the basis of regression analysis also. The regression
coefficients and growth rates have been obtained for the two sub periods (break taken
in the year 1990-1991) and for the entire time period for which data is available. The
regression equations for the pre- reform period, post- reform period and total period
respectively are shown in the table 4.1.20.
This is clearly shown by the table that the average annual rate of growth, given by the
estimated value of the parameter ‗b‘, has decreased during post- reform period to -
1.04 as compared to pre- reform period of 1.43 in case of rural branches. The average
annual rate of growth has increased during post-reform period to 0.29 as compared to
pre-reform period of -0.80 in case of semi urban branches. The average annual rate of
growth has increased during post- reform period to 0.30 as compared to pre-reform
period of -0.31 in case of urban branches and to 0.45 from -0.31 in case of
metropolitan branches of scheduled commercial banks.
180
Table 4.1.20: Regression Coefficients and Growth Rate for branches of SCBs
Semi
Rural Urban Metropolitan
Urban
31.82 33.53 19.07 15.57
Intercept
(1.23) (0.56) (0.47) (0.37)
Pre-
1.43* -0.80* -0.31* -0.31*
reform b
(0.09) (0.04) (0.04) (0.03)
period
r2 0.92 0.94 0.79 0.86
d.f. 19 19 19 19
t-calculated 15.88 20.00 7.75 10.33
t-critical 2.09 2.09 2.09 2.09
Semi
Urban
59.22 19.06 12.95 8.78
Intercept
(0.57) (0.33) (0.21) (0.40)
Post-
-1.04* 0.29* 0.30* 0.45*
reform b
(0.04) (0.02) (0.01) (0.03)
period
r2 0.97 0.87 0.95 0.92
d.f. 20 20 20 20
t-calculated 26.00 14.50 30.00 15.00
t-critical 2.08 2.08 2.08 2.08
Semi
Urban
47.12 26.49 15.24 11.13
Intercept
(2.53) (1.13) (0.66) (0.79)
Total 0.03* -0.13* 0.05* 0.08*
b
period (0.01) (0.04) (0.02) (0.03)
r2 0.40 0.60 0.50 0.56
d.f. 41 41 41 41
t-calculated 3.00 3.25 2.5 2.67
t-critical 2.02 2.02 2.02 2.02
The regression line has given a good fit to the data, since all the lines explained more
than 60 percent during pre-reform period and post-reform period of the total variation
of the ‗Y‘ values around their mean in the case of rural, semi urban, urban and
metropolitan area branches. The calculated ‗t‘ values are greater than the critical
values obtained from the tables in all cases at 5% level of significance. This implies
that the estimated growth rates are statistically significant in all the cases during pre
and post- reform periods.
181
Although the total number of branches has increased marginally in the post reform
period, the position of rural branches is entirely different. In the pre reform period the
number of rural branches increased and in the post-reform period the growth rate
declined. This is in conformity with the findings of Shetty (2004) and Valsamma
(2005). This decline in rural offices of banks, both in absolute and percentage terms
has largely been due to the policy of RBI. The same kind of findings was drawn by
Khan and Rahmatullah (2005).
Apart from the above measures, decline in the importance of the banking system is
one of the important manifestations of financial development as emphasised in
literature. In case of India it has been noted on the basis of available data that the
banking sector has experienced a small decline in importance and other financial
institutions have become somewhat more important. New agencies different from
commercial banks have appeared on the financial seen and have become important.
Some of the segments that existed earlier have become more important than before
both in collecting the available funds in terms of deposits and disbursing credit to the
non –government sectors.
Apart from the changes in the relative importance of the banking system, some
changes have taken place within the banking system also. This includes entry of the
number of private (domestic and foreign) banks after the removal of restrictions on
entry. With this the share of public sector banks in total bank assets and business was
bound to decline. The public sector banks themselves have started accessing the
capital markets for funds. It has been shown in the next section that the new banks
that appeared on the financial scene had high level of profitability, efficiency and
productivity right from inception. Under competitive pressure from these the
productivity and efficiency levels of public sector banks also increased as has been
documented in various studies on banking efficiency.
182
4.2 Comparative performance of banks in pre and post-financial
sector reforms
It is noted in the previous section that substantial development of the financial sector
has taken place after the reforms. Now it remains to examine the financial health of
the constituents of the banking sector. The performance of the financial sector is
examined in terms of level of profitability, non- performing assets, capital adequacy
ratio and various indicators of efficiency and productivity. In this section an attempt is
made to compare the performance of public sector banks ( i.e., Nationalised Banks
and State Bank of India and its associates), Private Sector Banks, Foreign Banks and
Regional Rural Banks, all Scheduled Commercial Banks excluding RRBs and for all
Scheduled Commercial Banks including RRBs. This is however possible only if the
adequate data is available in the pre reform period and post reform period and it does
not show wide fluctuations. For this purpose, exponential trend values and growth
rates are computed by using regression analysis for those indicators for which the
sufficient data is available in the pre- reform period and post- reform period. In cases
where substantial data is not available for pre-reform period, simple data analysis is
done. Regression analysis in such cases will not be able to give meaningful results.
The performance is analysed with respect to different indicators taken for the purpose
of the study in pre-reform period (1980-1991) and post-reform period (1992-2013)
along with the entire study period (1980-2013).
4.2.1 Total Deposits

Deposit is an important variable examined for measuring the performance of banks.
The economic development of a country is, to a large extent, dependent on bank credit
and the nature of credit is dependent on the nature of deposits received from the
public. Deposits are the sum of type wise deposits and location wise deposits. Type
wise deposits include demand deposits, saving bank deposits, term deposits and other
deposits. The demand and term deposits include deposits from banks and deposits
from others. The position of deposits is exhibited in Table 4.2.1 for pre-reform period,
4.2.2 for post-reform period and 4.2.3 for the entire study period.
183
Table 4.2.1
Bank Group Wise Trend Values, Regression Coefficients and
(Rs. in Crores)
All All
Year SBG NBs PSB FBs RRBs SCBs SCBs
(Excl. (Incl.
RRBs) RRBs)
1980 12381.97 27394.92 2378.905 997.7371 259.0964 43068.97 43281.56
1981 14617.34 32431.92 2711.618 1256.222 259.0964 50969.35 51306.55
1982 17256.28 38395.04 3090.864 1581.674 481.0522 60318.94 60819.48
1983 20371.64 45454.58 3523.151 1991.441 655.4772 71383.57 72096.24
1984 24049.43 53812.13 4015.898 2507.367 893.1471 84477.86 85463.86
1985 28391.18 63706.35 4577.56 3156.954 1216.994 99974.1 101310
1986 33516.78 75419.78 5217.776 3974.831 1658.264 118312.9 120094.3
1987 39567.72 89286.91 5947.532 5004.597 2259.536 140015.7 142361.4
1988-89 46711.07 105703.7 6779.352 6301.146 3078.822 165699.5 168757.1
1989-90 55144.03 125139 7727.51 7933.595 4195.174 196094.7 200047
1990-91 65099.45 27394.92 8808.276 9988.964 5716.305 232065.5 237138.4
1980-1991
All All
SBG NBs PSB FBs RRBs SCBs SCBs
(Excl. (Incl.
RRBs) RRBs)
28391.18 63706.35 4577.56 3156.954 1216.994 99974.1 101310
Intercept
(0.012) (0.004) (0.019) (0.040) (0.026) (0.005) (0.005)
* * * * * *
1.180 1.183 1.139 1.259 1.362 1.183 1.185*
b
(0.003) (0.001) (0.006) (0.012) (0.008) (0.001) (0.001)
2
r 0.995 0.999 0.980 0.973 0.993 0.999 0.999
d.f. 9 9 9 9 9 9 9
F-Value 1827.428 12979.83 451.993 326.732 1322.009 9025.40 9465.132
Growth
18.0 18.38 13.98 25.90 36.25 18.34 18.54
Rate
* Significant at the 0.01 probability level (2 tailed)Notes: Data for the year 1980 to 1987 relates to the calendar
year (i.e., January- December), while those for the years 1988-89 pertain to the 15 months i.e., January to
December 1988 and January to March 1989. So wherever the flow variable is involved it has been deflated by a
factor 12/15=0.8 .so that it reflects magnitude appropriate to 12 months duration on an average basis.1989-90
onwards data is available on the basis of the conventional financial years as followed in India i.e., 1st April to 31st
march.
SBG- State Bank of India and its associates, NBs – Nationalised Banks, PSB- Private Sector Banks, FBs- Foreign
Banks, RRBs – Regional Rural Banks, All SCBs- All Scheduled Commercial Banks.
b- Regression Coefficient r2 – Coefficient of Simple Determination. d.f. – degrees of freedom.
Figures in parenthesis indicate the standard errors.
Source - Statistical Tables Relating to Banks in India, Published by the Reserve Bank of India ( Various Issues ).
Database on Indian Banking Published by IBA, Mumbai.
Performance highlights of public Sector, Private Sector and foreign banks in India published by IBA,
Mumbai ( Various Issues ).
Report and trends on the progress of banks in India (Various issues ).
184
Table 4.2.2
(Rs. in Crores)
All SCBs All SCBs
Year SBG NBs PSB FBs RRBs (Excl. (Incl.
RRBs) RRBs)
1991-92 74375.25 140682.2 15394.89 17861.82 7196.49 246435.8 253789.1
1992-93 86244.13 164460.9 19329.35 20475.93 8502.957 289566.9 298246
1993-94 100007.1 192258.8 24269.33 23472.63 10046.6 340246.8 350490.4
1994-95 115966.3 224755.3 30471.81 26907.9 11870.49 399796.7 411886.6
1995-96 134472.3 262744.4 38259.46 30845.94 14025.48 469769.1 484037.7
1996-97 155931.6 307154.6 48037.38 35360.31 16571.7 551987.9 568827.7
1997-98 180815.3 359071.2 60314.24 40535.37 19580.16 648596.7 668470.5
1998-99 209670 419763 75728.68 46467.81 23134.79 762114 785568
1999-2000 243129.4 490713.1 95082.57 53268.48 27334.73 895499 923177.8
2000-01 281928.3 573655.6 119382.7 61064.44 32297.14 1052229 1084893
2001-02 326918.7 670617.4 149893.2 70001.36 38160.44 1236390 1274936
2002-03 379088.8 783968.1 188201.3 80246.21 45088.18 1452782 1498270
2003-04 439584.2 916477.8 236299.6 91990.42 53273.59 1707048 1760725
2004-05 509733.5 1071385 296690.5 105453.4 62945 2005815 2069155
2005-06 591077.3 1252475 372515.3 120886.8 74372.17 2356873 2431614
2006-07 685402.1 1464174 467718.6 138578.8 87873.87 2769372 2857565
2007-08 794779.4 1711655 587252.9 158860.1 103826.7 3254067 3358131
2008-09 921611.1 2000966 737336.5 182109.7 122675.6 3823593 3946383
2009-10 1068683 2339178 925776.8 208761.8 144946.4 4492797 4637679
2010-11 1239224 2734557 1162376 239314.6 171260.3 5279125 5450072
2011-12 1436981 3196763 1459444 274338.8 202351.3 6203076 6404774
2012-13 1666296 3737094 1832432 314488.9 239086.7 7288737 7526713
1992-2013
All SCBs All SCBs
SBG NBs PSB FBs RRBs (Excl. (Incl.
RRBs) RRBs)
352038.6 725081.1 167958.6 74948.94 41479.93 1340226 1382099
Intercept
(0.011) (0.020) (0.033) (0.021) (0.024) (0.010) (0.010)
1.159* 1.169* 1.255* 1.146* 1.181* 1.175* 1.175*
b
(0.001) (0.003) (0.005) (0.003) (0.003) (0.001) (0.001)
2
r 0.997 0.991 0.989 0.987 0.989 0.997 0.998
d.f. 20 20 20 20 20 20 20
F-Value 7131.635 2400.818 1826.097 1613.468 1810.377 9144.145 10231.32
Growth 15.95 16.90 25.55 14.63 18.15 17.50 17.51
Rate (%)
* Significant at the 0.01 probability level (2 tailed). Source and notes are same as in table 4.2.1
185
Table 4.2.3
Bank Group Wise Trend Values, Regression Coefficients and Growth Rate for Deposits
(1980-2013)
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1980 13419.58 28880.78 1548.214 1536.374 493.4365 44389.53 44926.31
1981 15618.44 33580.78 1925.069 1833.824 604.7712 52034.2 52705.96
1982 18177.6 39045.65 2393.657 2188.861 741.2265 60995.42 61832.76
1983 21156.1 45399.86 2976.305 2612.635 908.4703 71499.93 72540
1984 24622.63 52788.14 3700.778 3118.454 1113.449 83813.51 85101.36
1985 28657.17 61378.78 4601.597 3722.202 1364.678 98247.7 99837.89
1986 33352.8 71367.43 5721.687 4442.839 1672.592 115167.7 117126.3
1987 38817.82 82981.63 7114.423 5302.994 2049.981 135001.7 137408.4
1988-89 45178.32 96485.89 8846.168 6329.68 2512.521 158251.4 161202.7
1989-90 52581.02 112187.8 10999.44 7555.137 3079.424 185505.1 189117.2
1990-91 61196.69 130445 13676.86 9017.848 3774.238 217452.4 221865.6
1991-92 71224.08 151673.4 17005.99 10763.75 4625.824 254901.6 260284.9
1992-93 82894.5 176356.4 21145.47 12847.66 5669.555 298800.3 305357
1993-94 96477.19 205056.3 26292.56 15335.03 6948.783 350259.1 358234
1994-95 112285.5 238426.7 32692.52 18303.97 8516.645 410580 420267.4
1995-96 130684 277227.8 40650.32 21847.71 10438.27 481289.2 493042.8
1996-97 152097.3 322343.3 50545.15 26077.53 12793.46 564175.9 578420.4
1997-98 177019.2 374800.8 62848.52 31126.26 15680.07 661337.1 678582.3
1998-99 206024.7 435795.1 78146.69 37152.46 19217.98 775231.2 796088.7
1999-2000 239782.9 506715.5 97168.65 44345.36 23554.16 908740 933943
2000-01 279072.5 589177.4 120820.8 52930.84 28868.71 1065241 1095669
2001-02 324799.9 685058.9 150230.2 63178.51 35382.39 1248695 1285400
2002-03 378020.1 796544 186798.2 75410.17 43365.76 1463743 1507985
2003-04 439960.6 926172 232267.4 90009.95 53150.43 1715826 1769115
2004-05 512050.4 1076895 288804.4 107436.3 65142.82 2011322 2075463
2005-06 595952.4 1252147 359103.3 128236.5 79841.07 2357707 2434860
2006-07 693602.3 1455919 446513.9 153063.7 97855.71 2763747 2856491
2007-08 807252.6 1692852 555201.3 182697.6 119935 3239714 3351134
2008-09 939525 1968344 690344.7 218068.8 146996.1 3797651 3931431
2009-10 1093471 2288668 858383.9 260287.9 180163 4451674 4612216
2010-11 1272642 2661121 1067326 310681 220813.4 5218332 5410888
2011-12 1481171 3094186 1327127 370830.3 270635.8 6117023 6347862
2012-13 1723868 3597728 1650168 442624.9 331699.6 7170484 7447086
1980-2013
All SCBs All SCBs
RRBs) RRBs)
152097.3 322343.3 50545.15 26077.53 12793.46 564175.9 578420.4
Intercept
(0.010) (0.016) (0.037) (0.050) (0.054) (0.008) (0.008)
1.163* 1.162* 1.243* 1.193* 1.225* 1.172* 1.173*
b
(0.001) (0.001) (0.003) (0.005) (0.005) (0.001) (0.001)
r2 0.998 0.996 0.989 0.973 0.976 0.999 0.999
d.f. 31 31 31 31 31 31 31
F-Value 20328.33 7916.55 3023.844 1129.681 1287.003 31851.84 35780.16
Growth
16.38 16.27 24.34 19.36 22.56 17.22 17.31
Rate (%)
186
In the pre-reform period exponential trend values of deposits for different bank groups
was, for State Bank and its associates Rs. 12381.97 crores, for Nationalised Banks
Rs. 27394.92 crores, for Private Sector Banks Rs. 2378.905 crores ,for Foreign Banks
Rs. 997.737 crores, for Regional Rural Banks Rs. 259.09 crores, for all Scheduled
Commercial Banks excluding RRBs Rs. 43068.97 and for all Scheduled Commercial
Banks including RRBs Rs. 43281.56. The deposits increased to Rs. 65099.45 for State
Bank and its associates, Rs. 27394.92 for Nationalised Banks, Rs. 8808.27 for Private
Sector Banks, Rs. 9988.96 for Foreign Banks, Rs. 5716.30 for Regional Rural Banks,
Rs. 232065.5 for all Scheduled Commercial Banks excluding RRBs and Rs. 237138.4
for all Scheduled Commercial Banks including RRBs.
During this period, the regression coefficients ‗b‘ turned out to be significant for all
banks groups. It was maximum for Regional Rural Banks followed by Foreign Banks
and Nationalised Banks. The Regional Rural Banks registered highest growth rate of
36.25 percent followed by Foreign Banks 25.90 percent and Nationalised Banks 18.38
percent. The overall growth rate for all Scheduled Commercial Banks excluding
RRBs was 18.34 percent and 18.54 percent for all Scheduled Commercial Banks
including RRBs. The regression line has given a good fit to the observed data, since
this line explained 99.5 percent for State Bank and its associates, 99.9 percent for
Nationalised Banks, 98.0 percent for Private Sector Banks, 97.3 percent for Foreign
Banks, 99.3 percent for Regional Rural Banks, 99.9 percent for all Scheduled
Commercial Banks excluding RRBs and 99.9 percent also for all Scheduled
Commercial Banks including RRBs of the total variation of the ‗Y‘ values around
their mean. The Remaining variation, 0.5 percent for State Bank and its associates, 0.1
percent for Nationalised Banks, 2.0 percent for Private Sector Banks, 2.7 percent for
Foreign Banks, 0.7 percent for Regional Rural Banks, 0.1 percent for all Scheduled
Commercial Banks including RRBs was unaccounted for by the regression line and
attributed to the factors included in the disturbance variable ‗u‘.
In the post-reform period, the exponential trend values revealed that deposits touched
to Rs. 1666296 crores for State Bank and its associates, Rs. 3737094 crores for
Nationalised Banks, Rs. 1832432 crores for Private Sector Banks, Rs. 314488.9 crores
for Foreign Banks, Rs. 239086.7 crores for Regional Rural Banks, Rs.7288737 crores
187
for all Scheduled Commercial Banks excluding RRBs and Rs. 7526713 crores for all
Scheduled Commercial Banks including RRBs.
In this period also regression coefficients ‗b‘ turned out to be significant for all banks
groups. But it is maximum for Private Sector Banks and minimum for Foreign Banks.
The Private Sector Banks registered highest growth rate of 25.55 percent followed by
the Regional Rural Banks 18.15 percent and Nationalised Banks 16.90 percent. The
overall growth rate of all Scheduled Commercial Banks excluding RRBs declined to
17.51 percent from 18.34 percent in the pre reform period and rate of all Scheduled
Commercial Banks including RRBs declined to 17.50 percent from 18.54 percent as
compared to the pre reform period.
The regression line has given a good fit to the observed data, since this line explained
99.7 percent for State Bank and its associates, 99.1 percent for Nationalised Banks,
98.9 percent for Private Sector Banks, 98.7 percent for Foreign Banks, 98.9 percent
for Regional Rural Banks, 99.7 percent for all Scheduled Commercial Banks
excluding RRBs and 99.8 percent also for all Scheduled Commercial Banks including
RRBs of the total variation of the ‗Y‘ values around their mean. The Remaining
variation, 0.3 percent for State Bank and its associates, 0.9 percent for Nationalised
Banks, 1.1 percent for Private Sector Banks, 1.3 percent for Foreign Banks, 1.1
percent for Regional Rural Banks, 0.3 percent for all Scheduled Commercial Banks
RRBs is unaccounted for by the regression line and was attributed to the factors
included in the disturbance variable ‗u‘.
During the entire study period, the regression coefficients ‗b‘ turned out to be
significant for all banks groups at 1 % level of significance. But it is maximum for
Private Sector Banks and minimum for Nationalised Banks. The Private Sector Banks
registered highest growth rate of 24.34 percent followed by the Regional Rural Banks
22.56 percent and Foreign Banks 19.36 percent. The overall growth rate of all
Scheduled Commercial Banks excluding RRBs is 17.22 percent in the whole period
and rate of all Scheduled Commercial Banks including RRBs is 17.31 percent during
the whole period. The regression line for the entire period has given a good fit to the
observed data, since this line explained 99.8 percent for State Bank and its associates,
99.6 percent for Nationalised Banks, 98.9 percent for Private Sector Banks, 97.3
188
percent for Foreign Banks, 97.6 percent for Regional Rural Banks, 99.9 percent for all
Scheduled Commercial Banks excluding RRBs and for all Scheduled Commercial
Banks including RRBs of the total variation of the ‗Y‘ values around their mean. The
Remaining variation, 0.2 percent for State Bank and its associates, 0.4 percent for
Commercial Banks excluding RRBs and for all Scheduled Commercial Banks
including RRBs is unaccounted for by the regression line and attributed to the factors
The breakup of the post-reform period revealed that growth rate of deposits for State
Bank and its associates declined from 18.0 percent to 15.95 percent, Nationalised
Banks from 18.38 percent to 16.90 percent, Foreign Banks from 25.90 percent to
14.63 percent , Regional Rural Banks from 36.25 percent to 18.15 percent , all
Scheduled Commercial Banks excluding RRBs from 18.34 percent to 17.50 percent,
all Scheduled Commercial Banks including RRBs from 18.54 to 17.51 percent and for
Private Sector Banks increased to 25.55 percent from 13.98 percent in comparison to
the pre reform period. The reason for shrinking of the deposits growth rate of public
sector banks i.e., State Bank and its associates and Nationalised Banks was on
account of coming up of new competitors in the market and boom in the stock
exchange market in the early 1990s, the foreign banks were much successful in the
pre reform period registering very high growth rate in deposits mainly because of
their selected branch expansion and selected deposit mobilisation, which by and large
confined to metropolitan areas only. The quality of services provided by them was
also accountable to higher growth in deposits. The reason for steep fall in deposits
growth rate of foreign banks could be further assigned to high transaction costs in
comparison to public sector banks.
4.2.2 Total Advances
The growth of economic activities of a country is greatly determined by the loans and
advances provided by banks. So loans and advances of SCBs, get utmost importance
in the planning desk of Government and policy makers. Table 4.2.4, 4.2.5, 4.2.6
shows the advances provided by SCBs during the pre-reform, post-reform and total
period respectively.
189
Table 4.2.4
(Rs. in Crores)
All All
SCBs SCBs
Year SBG NBs PSB FBs RRBs
(Excl. (Incl.
RRBs) RRBs)
1980 8750.374 16812.05 1359.487 806.0982 324.8287 27685.11 28002.88
1981 10340.76 19711.43 1539.441 991.269 423.3739 32558.78 32992.72
1982 12220.19 23110.84 1743.214 1218.976 551.8153 38290.42 38871.69
1983 14441.21 27096.5 1973.961 1498.99 719.2228 45031.04 45798.23
1984 17065.9 31769.53 2235.252 1843.327 937.4176 52958.28 53959.02
1985 20167.63 37248.46 2531.129 2266.762 1221.808 62281.04 63573.98
1986 23833.1 43672.28 2866.171 2787.465 1592.474 73244.96 74902.22
1987 28164.77 51203.94 3245.562 3427.781 2075.593 86138.97 88249.04
1988-89 33283.72 60034.51 3675.173 4215.185 2705.278 101302.8 103974.1
1989-90 39333.04 70387.98 4161.65 5183.466 3525.994 119136.1 122501.3
1990-91 46481.83 82526.99 4712.522 6374.173 4595.695 140108.8 144329.8
1980-1991
All All
SCBs SCBs
SBG NBs PSB FBs RRBs
(Excl. (Incl.
RRBs) RRBs)
20167.63 37248.46 2531.129 2266.762 1221.808 62281.04 63573.98
Intercept 0.019 0.010 0.022 0.027 0.044 0.013 0.012
1.181* 1.172* 1.1323* 1.229* 1.303* 1.176* 1.178*
b 0.006 0.003 0.007 0.008 0.014 0.004 0.004
r2 0.987 0.995 0.970 0.983 0.975 0.994 0.994
d.f. 9 9 9 9 9 9 9
F-Value 724.156 2138.583 299.568 549.258 358.155 1512.293 1674.727
Growth
Rate 18.17 17.24 13.23 22.97 30.33 17.60 17.81
(%)
* Significant at the 0.01 probability level (2 tailed)
Source and notes are same as in table 4.2.1
190
Table 4.2.5
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1991-92 38717.85 61351.61 7379.678 9912.52 3453.15 116791.9 120223.5
1992-93 45661.95 73575.29 9514.136 11637.67 4100.667 140402.9 144484.7
1993-94 53851.48 88234.41 12265.95 13663.07 4869.604 168787.2 173641.9
1994-95 63509.81 105814.2 15813.69 16040.97 5782.728 202909.8 208683.1
1995-96 74900.38 126896.6 20387.55 18832.71 6867.077 243930.6 250795.7
1996-97 88333.86 152179.4 26284.34 22110.32 8154.757 293244.4 301406.6
1997-98 104176.7 182499.6 33886.68 25958.36 9683.897 352527.6 362230.9
1998-99 122860.9 218860.8 43687.88 30476.11 11499.77 423795.7 435329.6
1999-2000 144896.1 262466.6 56323.92 35780.12 13656.15 509471.6 523179.7
2000-01 170883.4 314760.3 72614.74 42007.23 16216.89 612467.9 628758.1
2001-02 201531.6 377473.1 93617.43 49318.09 19257.8 736286.4 755642.3
2002-03 237676.6 452680.7 120694.8 57901.32 22868.93 885136.3 908132
2003-04 280304.2 542872.6 155603.9 67978.36 27157.2 1064078 1091394
2004-05 330577.1 651034.4 200610 79809.20 32249.58 1279196 1311639
2005-06 389866.6 780746.3 258633.3 93699.04 38296.86 1537802 1576330
2006-07 459789.6 936302 333439 110006.26 45478.1 1848689 1894435
2007-08 542253.5 1122851 429881.1 129151.55 54005.93 2222425 2276735
2008-09 639507.4 1346567 554217.5 151628.85 64132.85 2671718 2736183
2009-10 754203.9 1614857 714516.3 178018.06 76158.73 3211840 3288349
2010-11 889471.4 1936600 921179.2 209000.01 90439.64 3861156 3951942
2011-12 1048999 2322448 1187616 245373.99 107398.4 4641739 4749450
2012-13 1237139 2785171 1531116 288078.44 127537.3 5580128 5707895
1992-2013
All SCBs All SCBs
RRBs) RRBs)
218859.2 413370 106297.4 53437.65 20985.83 807287.9 828385.7
Intercept
0.033 0.037 0.033 0.024 0.014 0.029 0.029
1.179 1.199 1.289 1.174 1.187 1.202 1.201
b
0.005 0.005 0.005 0.003 0.002 0.004 0.004
2
r 0.980 0.979 0.991 0.988 0.996 0.987 0.987
d.f. 20 20 20 20 20 20 20
F-Value 990.158 949.216 2341.101 1790.337 5501.879 1575.417 1612.099
Growth
17.93 19.92 28.92 17.40 18.75 20.21 20.18
Rate (%)
191
Table 4.2.6
(Rs. in Crores)
All
All SCBs
SCBs
Year SBG NBs PSB FBs RRBs (Excl.
(Incl.
RRBs)
RRBs)
1980 8770.922 15042.3 760.2041 998.9069 489.8811 24894.19 25422.51
1981 10204.51 17598.58 957.6634 1199.368 583.9193 29332.6 29960.82
1982 11872.41 20589.28 1206.412 1440.059 696.0093 34562.33 35309.28
1983 13812.93 24088.21 1519.771 1729.051 829.6161 40724.47 41612.52
1984 16070.62 28181.75 1914.525 2076.039 988.8702 47985.27 49040.99
1985 18697.33 32970.94 2411.813 2492.66 1178.695 56540.6 57795.56
1986 21753.36 38574.01 3038.27 2992.89 1404.959 66621.27 68112.94
1987 25308.9 45129.25 3827.446 3593.506 1674.657 78499.22 80272.14
1988-89 29445.58 52798.49 4821.606 4314.654 1996.126 92494.91 94601.93
1989-90 34258.39 61771.04 6073.995 5180.522 2379.305 108985.9 111489.8
1990-91 39857.84 72268.38 7651.685 6220.154 2836.039 128417.1 131392.4
1991-92 46372.51 84549.64 9639.173 7468.421 3380.449 151312.6 154848
1992-93 53951.99 98917.96 12142.9 8967.191 4029.364 178290.3 182490.7
1993-94 62770.31 115728 15296.96 10766.73 4802.846 210077.8 215068.1
1994-95 73029.97 135394.8 19270.27 12927.41 5724.806 247532.7 253461
1995-96 84966.55 158403.7 24275.63 15521.7 6823.747 291665.5 298707.6
1996-97 98854.13 185322.8 30581.11 18636.61 8133.643 343666.8 352031.5
1997-98 115011.6 216816.4 38524.4 22376.62 9694.987 404939.4 414874.5
1998-99 133810 253662.1 48530.93 26867.18 11556.05 477136.4 488935.9
1999-2000 155680.9 296769.3 61136.6 32258.91 13774.36 562205.4 576218.4
2000-01 181126.6 347202.1 77016.53 38732.66 16418.51 662441.4 679082.1
2001-02 210731.3 406205.5 97021.2 46505.57 19570.23 780548.6 800308.6
2002-03 245174.9 475235.8 122222 55838.35 23326.95 919713.2 943175.8
2003-04 285248.1 555997.1 153968.6 67044.04 27804.82 1083690 1111547
2004-05 331871.2 650483 193961.1 80498.5 33142.27 1276901 1309975
2005-06 386114.8 761025.8 244341.6 96653.02 39504.31 1504561 1543826
2006-07 449224.4 890354.1 307808.1 18636.61 47087.6 1772810 1819422
2007-08 522649 1041660 387759.8 139338.3 56126.6 2088886 2144216
2008-09 608074.8 1218680 488478.5 167300.9 66900.73 2461315 2526992
2009-10 707463.2 1425781 615358.4 200875 79743.08 2900145 2978098
2010-11 823096.4 1668078 775194.8 241186.8 95050.67 3417214 3509734
2011-12 957629.6 1951550 976547.9 289588.4 113296.7 4026471 4136275
2012-13 1114152 2283196 1230201 347703.2 135045.3 4744354 4874663
1980-2013
All
All SCBs
SCBs
SBG NBs PSB FBs RRBs (Excl.
(Incl.
RRBs)
RRBs)
98854.13 185322.8 30581.11 18636.61 8133.643 343666.8 352031.5
Intercept
0.028 0.037 0.047 0.031 0.034 0.029 0.029
1.163 1.169 1.259 1.200 1.191 1.178 1.178
b
0.002 0.003 0.004 0.003 0.003 0.003 0.003
r2 0.988 0.981 0.985 0.990 0.987 0.988 0.989
d.f. 31 31 31 31 31 31 31
F-Value 2626.16 1614.23 2148.481 3135.943 2381.159 2745.84 2856.83
Growth Rate 16.34 16.99 25.97 20.06 19.19 17.82 17.85
192
In the pre reform period exponential trend values of advances for different bank
groups was, for State Bank and its associates Rs. 46481.83 crores, for Nationalised
Banks Rs. 82526.99 crores, for Private Sector Banks Rs. 4712.522 crores ,for Foreign
Banks Rs. 6374.173 crores, for Regional Rural Banks Rs. 4595.695 crores, for all
Scheduled Commercial Banks excluding RRBs Rs. 140108.8 crores and for all
Scheduled Commercial Banks including RRBs Rs. 144329.8 crores at the end of
1990-91.
and State Bank and its associates. The Regional Rural Banks registered highest
growth rate of 30.33 percent followed by Foreign Banks 22.97 percent and
Nationalised Banks 18.17 percent. The overall growth rate for all Scheduled
Commercial Banks excluding RRBs was 17.60 percent and 17.81 percent for all
Scheduled Commercial Banks including RRBs. The regression line has given a good
fit to the observed data, since this line explained 98.7 percent for State Bank and its
associates, 99.5 percent for Nationalised Banks, 97.0 percent for Private Sector
Banks, 98.3 percent for Foreign Banks, 97.5 percent for Regional Rural Banks, 99.4
percent for all Scheduled Commercial Banks excluding RRBs and 99.4 percent also
for all Scheduled Commercial Banks including RRBs of the total variation of the ‗Y‘
values around their mean. The Remaining variation, 1.3 percent for State Bank and its
associates, 0.5 percent for Nationalised Banks, 3.0 percent for Private Sector Banks,
1.7 percent for Foreign Banks, 2.5 percent for Regional Rural Banks, 0.6 percent for
all Scheduled Commercial Banks excluding RRBs and 0.6 percent also for all
Scheduled Commercial Banks including RRBs was unaccounted for by the regression
line and was attributed to the factors included in the disturbance variable ‗u‘.
In the post-reform period, the exponential trend values revealed that advances touched
to Rs. 1237139 crores for State Bank and its associates, Rs. 2785171 crores for
Nationalised Banks, Rs. 1531116 crores for Private Sector Banks, Rs. 288078.44
crores for Foreign Banks, Rs. 127537.3 crores for Regional Rural Banks, Rs. 5580128
crores for all Scheduled Commercial Banks excluding RRBs and Rs. 5707895 crores
for all Scheduled Commercial Banks including RRBs at the end of the year 2012-13.
193
the Nationalised Banks 19.92 percent and Regional Rural Banks 18.75 percent. The
overall growth rate of all Scheduled Commercial Banks excluding RRBs increased to
Commercial Banks including RRBs increased to 20.18 percent from 17.81 percent as
excluding RRBs and for all Scheduled Commercial Banks including RRBs of the total
variation of the ‗Y‘ values around their mean. The Remaining variation, 2.0 percent
for State Bank and its associates, 2.1 percent for Nationalised Banks, 0.9 percent for
Private Sector Banks, 1.2 percent for Foreign Banks, 0.4 percent for Regional Rural
Banks, 1.3 percent for all Scheduled Commercial Banks excluding RRBs and also for
all Scheduled Commercial Banks including RRBs is unaccounted for by the
regression line and was attributed to the factors included in the disturbance variable
‗u‘.
Private Sector Banks and minimum for State Bank and its associates. The Private
Sector Banks registered highest growth rate of 25.97 percent followed by the Foreign
Banks 20.06 percent and Regional Rural Banks 19.19 percent. The overall growth rate
of all Scheduled Commercial Banks excluding RRBs is 17.82 percent in the whole
period and rate of all Scheduled Commercial Banks including RRBs is 17.85 percent
during the whole period.
The regression line for the entire period has given a good fit to the observed data,
since this line explained 98.8 percent for State Bank and its associates, 98.1 percent
for Nationalised Banks, 98.5 percent for Private Sector Banks, 99.0 percent for
194
Commercial Banks excluding RRBs and 98.9 percent for all Scheduled Commercial
Banks including RRBs is unaccounted for by the regression line and attributed to the
factors included in the disturbance variable ‗u‘.
The breakup of the post reform period revealed that growth rate of advances for State
Bank and its associates declined from 18.17 percent to 17.93 percent, Nationalised
Banks increased from 17.24 percent to 19.92 percent, Private Sector Banks increased
from 13.23 percent to 28.92 percent, Foreign Banks declined from 22.97 percent to
17.40 percent , Regional Rural Banks from 30.33 percent to 18.75 percent , all
Scheduled Commercial Banks excluding RRBs increased from 17.60 percent to 20.21
percent, all Scheduled Commercial Banks including RRBs increased from 17.81
percent to 20.18 percent in comparison to the pre reform period. The reason for rise
in advances growth rate of public sector banks is on account of lending policy of the
public sector banks which became more business oriented than welfare based in the
post-reform period. IBA Bulletin (1997-98) states that the outflow of money, in the
form of credit in the post-reform period became more restrictive, selective and based
on credit worthiness of the borrowers. Further efficient management and personalised
customer services have helped to register higher growth rate. The foreign banks
suffered lower growth rate in the post-reform period on account of their selected
branch expansion and too specific favoured locations coupled with tapping up of only
big clients. The growth rate of advances for the foreign banks lowered in the post-
reform period because of entry of new competitors and high cost of credit to the
borrowers in comparison to public sector banks.
4.2.3 Total Business
Total business is the sum of deposits and advances. The behaviour of the total
business is exhibited in the following tables 4.2.7, 4.2.8 and 4.2.9 during the pre-
reform, post-reform and total period respectively.
195
Table 4.2.7
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1980 21139.36 44204.13 3738.39 1801.30 580.30 70757.76 71287.45
1981 24966.54 52145.26 4251.23 2246.11 773.76 83535.43 84305.71
1982 29486.62 61513.00 4834.43 2800.76 1031.72 98620.54 99701.32
1983 34825.04 72563.62 5497.63 3492.37 1375.68 116429.78 117908.42
1984 41129.95 85599.45 6251.81 4354.76 1834.31 137455.06 139440.44
1985 48576.34 100977.13 7109.46 5430.11 2445.83 162277.16 164904.55
1986 57370.86 119117.36 8084.76 6771.00 3261.24 191581.72 195018.83
1987 67757.59 140516.42 9193.85 8443.01 4348.48 226178.19 230632.47
1988-89 80024.79 165759.76 10455.09 10527.89 5798.20 267022.22 272749.75
1989-90 94512.92 195537.99 11889.35 13127.62 7731.23 315242.00 322558.33
1990-91 111624.05 230665.78 13520.37 16369.31 10308.70 372169.46 381462.78
1980-1991
All SCBs All SCBs
RRBs) RRBs)
48576.34 100977.1 7109.458 5430.107 2445.835 162277.2 164904.5
Intercept
0.012 0.005 0.020 0.034 0.034 0.008 0.007
1.181 1.179 1.137 1.246 1.333 1.180 1.182
b
0.004 0.001 0.006 0.010 0.010 0.002 0.002
2
r 0.994 0.998 0.977 0.978 0.987 0.997 0.998
d.f. 9 9 9 9 9 9 9
F-Value 1648.761 8471.83 397.946 419.112 705.3226 4191.972 4509.844
Growth
Rate 18.10 17.96 13.71 24.69 33.33 18.05 18.26
(%)
* Significant at the 0.01 probability level (2 tailed) Source and notes are same as in table 4.2.1
196
Table 4.2.8
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1991-92 112805.82 200745.02 22647.53 27791.891 10700.53 361276.28 372078.08
1992-93 131700.54 236919.92 28731.096 32165.09 12662.59 428269.51 441048.7
1993-94 153760.09 279613.67 36448.826 37226.435 14984.42 507685.63 522804.13
1994-95 179514.56 330000.97 46239.688 43084.209 17731.98 601828.27 619714.23
1995-96 209582.84 389468.22 58660.565 49863.735 20983.34 713428.24 734588.16
1996-97 244687.5 459651.67 74417.93 57710.054 24830.88 845722.73 870755.82
1997-98 285672.11 542482.4 94408.03 66791.033 29383.9 1002549.2 1032164.3
1998-99 333521.54 640239.5 119767.86 77300.951 34771.78 1188456.9 1223492.5
1999-2000 389385.65 755612.76 151939.83 89464.66 41147.58 1408838.3 1450286.4
2000-01 454606.88 891776.65 192753.81 103542.39 48692.46 1670086 1719120.1
2001-02 530752.51 1052477.7 244531.23 119835.33 57620.77 1979778.3 2037786.5
2002-03 619652.36 1242137.6 310217.06 138692.04 68186.2 2346898.3 2415522.8
2003-04 723442.74 1465974.9 393547.38 160515.96 80688.92 2782095.1 2863278.5
2004-05 844617.78 1730148.4 499261.84 185773.99 95484.15 3297992.7 3394033
2005-06 986089.36 2041926.8 633373.25 215006.5 112992.3 3909555.6 4023171.2
2006-07 1151257.1 2409888.6 803509.6 248838.89 133710.7 4634523.7 4768930.3
2007-08 1344090.1 2844158.5 1019347.9 287994.99 158228 5493926.2 5652927.8
2008-09 1569222.2 3356685.1 1293164.5 333312.51 187241 6512691.9 6700788.2
2009-10 1832063.4 3961570.8 1640533.5 385760.97 221573.7 7720372.3 7942886.4
2010-11 2138929.9 4675458.8 2081212.7 446462.48 262201.8 9151998.8 9415227.4
2011-12 2497195.8 5517991.7 2640266.8 516715.68 310279.5 10849099 11160490
2012-13 2915470.5 6512351.9 3349493.6 598023.6 367172.8 12860900 13229265
1992-2013
All SCBs All SCBs
RRBs) RRBs)
573482.4 1143382 275422.9 128919.4 62681.27 2155537 2218630
Intercept
0.013 0.025 0.031 0.019 0.012 0.016 0.015
1.167 1.180 1.268 1.157 1.183 1.1854 1.1853
b
0.002 0.004 0.005 0.003 0.001 0.002 0.002
r2 0.996 0.988 0.991 0.991 0.997 0.995 0.995
d.f. 20 20 20 20 20 20 20
F-Value 5186.081 1693.746 2237.537 2348.433 7539.425 4216.226 4574.291
Growth
16.74 18.02 26.86 15.73 18.33 18.54 18.53
Rate (%)
197
Table 4.2.9
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1980 22205.43 43847.55 2295.257 2540.193 991.5472 69189.53 70275.59
1981 25845.07 51109.66 2868.749 3039.492 1200.928 81279.87 82602.23
1982 30081.28 59574.54 3585.534 2540.193 1454.522 95482.91 97091.02
1983 35011.82 69441.39 4481.415 4351.806 1761.666 112167.8 114121.2
1984 35011.82 80942.41 5601.141 5207.195 2133.669 131768.3 134138.5
1985 47429.84 94348.24 7000.641 6230.718 2584.225 154793.8 157667
1986 55203.95 109974.4 8749.819 7455.424 3129.923 181842.9 185322.5
1987 64252.3 128188.5 10936.05 8920.857 3790.854 213618.5 217828.9
1988-89 74783.73 149419.4 13668.53 10674.34 4591.351 250946.7 256037
1989-90 74783.73 174166.5 17083.74 12772.48 5560.885 294797.8 300946.9
1990-91 101308.1 203012.3 21352.28 15283.03 6735.15 346311.4 353734.3
1991-92 117913.2 236635.6 26687.36 18287.05 8157.379 406826.7 415780.8
1992-93 137240.1 275827.6 33355.46 21881.54 9879.934 477916.6 488710.6
1993-94 159734.8 321510.7 41689.65 26182.56 11966.23 561428.9 574432.5
1994-95 185916.5 374759.9 52106.22 31328.99 14493.08 659534.4 675190.4
1995-96 216389.7 436828.4 65125.47 37487 980923.8 774783 793621.7
1996-97 251857.6 509176.7 81397.71 44855.42 21260.21 910170.5 932826.4
1997-98 293138.9 593507.6 101735.7 53672.18 25749.63 1069216 1096448
1998-99 341186.6 691805.4 127155.4 64221.95 31187.05 1256053 1288770
1999-2000 397109.6 806383.5 158926.4 76845.37 37772.67 1475539 1514826
2000-01 462198.9 939938.3 198635.7 91950.05 45748.95 1733378 1780532
2001-02 537956.8 1095613 248266.8 110023.7 55409.53 2036273 2092845
2002-03 626131.9 1277070 310298.7 131649.9 67110.1 2392096 2459940
2003-04 728759.7 1488581 387829.9 157526.9 81281.42 2810097 2891423
2004-05 848208.9 1735123 484733.1 188490.3 98445.22 3301140 3398591
2005-06 987236.7 2022497 605848.4 225539.9 119233.4 3877989 3994719
2006-07 1149052 2357467 757225.5 269871.8 144411.4 4555638 4695410
2007-08 1337391 2747915 946425.8 322917.7 174906 5351701 5519005
2008-09 1556599 3203030 1182900 386390.2 211840.1 6286871 6487062
2009-10 1811737 3733522 1478459 462338.8 256573.4 7385454 7624920
2010-11 2108695 4351875 1847866 553215.8 310752.7 8676006 8962364
2011-12 2454326 5072641 2309574 661955.6 376372.9 10192072 10534401
2012-13 2856608 5912781 2886643 792069.2 455849.8 11973059 12382180
1980-2013
All SCBs All SCBs
RRBs) RRBs)
251857.6 509176.7 81397.71 44855.42 21260.21 910170.5 932826.4
Intercept
0.011 0.022 0.040 0.041 0.041 0.015 0.014
1.163 1.165 1.249 1.196 1.211 1.174 1.175
b
0.001 0.002 0.004 0.004 0.004 0.001 0.001
r2 0.997 0.992 0.988 0.982 0.984 0.996 0.997
d.f. 31 31 31 31 31 31 31
F-Value 15280.61 4198.257 2760.267 1699.042 1971.24 10013.69 11084.34
Growth
16.39 16.56 24.98 19.65 21.11 17.47 17.54
Rate (%)
198
In the pre-reform period exponential trend values of Total business for different bank
Scheduled Commercial Banks excluding RRBs Rs. 70757.76 and for all Scheduled
Commercial Banks including RRBs Rs. 71287.45 crores. The deposits increased to
Rs. 111624.05 crores for State Bank and its associates, Rs. 230665.78 crores for
Nationalised Banks, Rs. 13520.37 crores for Private Sector Banks, Rs. 16369.31
crores for Foreign Banks, Rs. 10308.70 crores for Regional Rural Banks, Rs.
372169.46 crores for all Scheduled Commercial Banks excluding RRBs and Rs.
381462.78 crores for all Scheduled Commercial Banks including RRBs.
and State Banks and its associates. The Regional Rural Banks registered highest
growth rate of 33.33 percent followed by Foreign Banks 24.69 percent and State
Banks and its associates 18.10 percent. The overall growth rate for all Scheduled
line and attributed to the factors included in the disturbance variable ‗u‘.
In the post-reform period, the exponential trend values revealed that total business
touched to Rs. 2915470.5 crores for State Bank and its associates, Rs. 6512351.9
crores for Nationalised Banks, Rs. 3349493.6 crores for Private Sector Banks, Rs.
598023.6 crores for Foreign Banks, Rs. 367172.8 crores for Regional Rural Banks,
199
Rs.12860900 crores for all Scheduled Commercial Banks excluding RRBs and Rs.
13229265 crores for all Scheduled Commercial Banks including RRBs.
the Regional Rural Banks 18.33 percent and Foreign Banks 15.73 percent. The overall
growth rate of all Scheduled Commercial Banks excluding RRBs increased to 18.54
percent from 18.05 percent in the pre reform period and rate of all Scheduled
Commercial Banks including RRBs increased to 18.53 percent from 18.26 percent as
RRBs of the total variation of the ‗Y‘ values around their mean. The Remaining
variation, 0.4 percent for State Bank and its associates, 1.2 percent for Nationalised
Banks, 0.9 percent for Private Sector Banks, 0.9 percent for Foreign Banks, 0.3
percent for Regional Rural Banks, 0.5 percent for all Scheduled Commercial Banks
RRBs was unaccounted for by the regression line and attributed to the factors
Private Sector Banks and minimum for State Banks and its associates. The Private
Sector Banks registered highest growth rate of 24.98 percent followed by the
Regional Rural Banks 21.11 percent and Foreign Banks 19.65 percent. The overall
growth rate of all Scheduled Commercial Banks excluding RRBs is 17.47 percent in
the whole period and rate of all Scheduled Commercial Banks including RRBs is
17.54 percent during the whole period.
200
The breakup of the post reform period revealed that growth rate of total business for
State Bank and its associates declined from 18.10 percent to 16.74 percent, Foreign
Banks from 24.69 percent to 15.73 percent, Regional Rural Banks from 33.33 percent
to 18.33 percent, all Scheduled Commercial Banks excluding RRBs from 18.34
percent to 17.50 percent. All Scheduled Commercial Banks including RRBs increased
from 18.05 to 18.54 percent and for Private Sector Banks increased to 26.86 percent
from 13.71 percent, Nationalised Banks from 17.96 percent to 18.02 percent in
comparison to the pre-reform period. The reasons for rise in total business growth rate
of Private sector banks is on account of professional customer oriented approach,
better branch network and removal of various financial controls which led to higher
growth in total business. The Foreign Banks registered a marked fall in the rate of
growth in post reform period in comparison to the State Bank group because of their
restricted branch expansion and their deposit policy discourages the smaller
depositors. In addition to this, the rate of growth is affected due to increased
competition from both public and private sector banks, and various other financial
intermediaries.
4.2.4 Total Assets
Total assets of the banks constitute advances issued by banks, fixed assets, other
assets etc. The size of the banks could be well predicted through the total assets. The
behaviour of the total assets of different bank groups is exhibited in tables 4.2.10,
4.2.11 and 4.2.12 during the pre-reform, post reform and total period respectively.
201
Table 4.2.10
(Rs. in Crores)
All All
SCBs SCBs
(Excl. (Incl.
RRBs) RRBs)
1980
18690.06 33992.09 3039.21 1964.19 507.0882 57573.78 58051.94
1981
22330.95 40312.5 3461.538 2454.098 673.0155 68499.81 69175.62
1982
26681.09 47808.12 3942.552 3066.198 893.2367 81499.33 82430.78
1983
31878.64 56697.45 4490.407 3830.968 1185.518 96965.82 98225.84
1984
38088.71 67239.65 5114.393 4786.487 1573.438 115367.5 117047.5
1985
45508.51 79742.03 5825.087 5980.331 2088.291 137261.3 139475.7
1986
54373.71 94569.09 6634.539 7471.943 2771.613 163310 166201.4
1987
64965.88 112153 7556.472 9335.592 3678.528 194302 198048.3
1988-89
77621.43 133006.5 8606.517 11664.07 4882.2 231175.6 235997.5
1989-90
92742.33 157737.5 9802.476 14573.32 6479.733 275046.8 281218.5
1990-91
110808.8 187066.8 11164.62 18208.19 8600.003 327243.7 335104.4
1980-1991
All All
SCBs SCBs
SBG NBs PSB FBs RRBs
(Excl. (Incl.
RRBs) RRBs)
45508.51 79742.03 5825.087 5980.331 2088.291 137261.3 139475.7
Intercept 0.019 0.006 0.018 0.030 0.030 0.010 0.009
1.194 1.185 1.138 1.249 1.327 1.189 1.191
b 0.006 0.001 0.005 0.009 0.009 0.003 0.003
r2 0.989 0.998 0.982 0.983 0.989 0.996 0.997
d.f. 9 9 9 9 9 9 9
F-Value 810.358 7304.407 513.734 541.893 843.517 2883.104 3090.281
Growth
19.48 18.59 13.89 24.94 32.72 18.97 19.16
Rate
202
Table 4.2.11
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1991-92 106115.3 164344.2 17955.18 24506.94 9867.251 309294.5 319313.1
1992-93 122163.7 192277.5 22787.51 28677.55 11606.11 363802.3 375578.5
1993-94 140639.2 224958.6 28920.38 33557.91 13651.41 427916.3 441758.2
1994-95 161908.9 263194.4 36703.8 39268.82 16057.14 503329.2 519599.3
1995-96 186395.4 307929.2 46581.99 45951.61 18886.81 592032.3 611156.6
1996-97 214585.1 360267.4 59118.74 53771.69 22215.15 696367.9 718847
1997-98 247038 421501.4 75029.53 62922.59 26130.03 819090.8 845513.2
1998-99 284399 493143.3 95222.44 73630.79 30734.81 963441.6 994499
1999-2000 327410.4 576962 120849.9 86161.32 36151.07 1133232 1169737
2000-01 376926.6 675027.3 153374.6 100824.3 42521.82 1332944 1375854
2001-02 433931.4 789760.5 194652.7 117982.7 50015.25 1567853 1618289
2002-03 499557.4 923994.8 247040.2 138061 58829.22 1844160 1903444
2003-04 575108.4 1081045 313526.8 161556.3 69196.43 2169162 2238845
2004-05 662085.4 1264788 397907.2 189050.1 81390.62 2551440 2633346
2005-06 762216.5 1479762 504997 221222.7 95733.73 3001087 3097362
2006-07 877491 1731275 640908.3 258870.5 112604.5 3529978 3643140
2007-08 1010199 2025536 813397.8 302925.3 132448.2 4152076 4285089
2008-09 1162977 2369813 1032310 354477.3 155789 4883808 5040153
2009-10 1338861 2772607 1310138 414802.5 183243 5744496 5928266
2010-11 1541345 3243862 1662739 485393.8 215535.1 6756865 6972871
2011-12 1774452 3795216 2110237 567998.4 253518 7947646 8201543
2012-13 2042813 4440282 2678171 664660.7 298194.3 9348283 9646716
1992-2013
All SCBs All SCBs
RRBs) RRBs)
465589.6 854245.1 219287.6 127627.6 54243.51 1700404 1755085
Intercept
0.011 0.020 0.037 0.022 0.021 0.011 0.011
1.151 1.169 1.269 1.170 1.176 1.176 1.176
b
0.001 0.003 0.005 0.003 0.003 0.001 0.001
2
r 0.996 0.991 0.987 0.989 0.991 0.997 0.997
d.f. 20 20 20 20 20 20 20
F-Value 6235.66 2415.67 1644.436 1894.13 2289.608 7590.974 8483.397
Growth
15.12 16.99 26.91 17.01 17.62 17.62 17.62
Rate (%)
203
Table 4.2.12
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1980 22018.88 35932.8 1874.226 2646.693 873.8061 60364.54 61307.68
1981 25385.22 41690.84 2340.22 3163.837 1056.826 70570.24 71721.83
1982 29266.22 48371.57 2922.075 3782.026 1278.179 82501.4 83904.99
1983 33740.56 56122.86 3648.599 4521.005 1545.896 96449.73 98157.68
1984 38898.96 65116.24 4555.759 5404.376 1869.685 112756.3 114831.4
1985 44846 75550.77 5688.47 6460.35 2261.293 131819.7 134337.5
1986 51702.25 87657.38 7102.809 7722.653 2734.924 154106.2 157157
1987 59606.7 101704 8868.798 9231.601 3307.757 180160.6 183852.7
1988-89 68719.63 118001.5 11073.87 11035.39 4000.571 210620 215083.2
1989-90 79225.78 136910.6 13827.2 13191.62 4838.496 246229.1 251618.8
1990-91 91338.15 35932.8 17265.09 15769.16 5851.924 287858.5 294360.5
1991-92 105302.3 184304.6 21557.75 18850.33 7077.617 336526.1 344362.6
1992-93 121401.4 213838.5 26917.71 22533.54 8560.033 393421.8 402858.4
1993-94 139961.7 248104.9 33610.33 26936.43 10352.94 459936.8 471290.7
1994-95 161359.7 287862.4 41966.96 32199.6 12521.38 537697.4 551347.4
1995-96 186029 333990.8 52401.31 38491.16 15144 628604.7 645003.1
1996-97 214469.9 387511 65429.99 46012.04 18315.93 734881.5 754567.8
1997-98 247259 449607.6 81698.02 55002.44 22152.22 859126.4 882743.9
1998-99 285061 521654.8 1874.226 65749.5 26792.03 1004377 1032693
1999-2000 328642.3 605247.2 127374 78596.46 32403.65 1174185 1208113
2000-01 378886.5 702234.8 159043.4 93953.61 39190.64 1372702 1413332
2001-02 436812.2 814764.1 198586.7 112311.4 47399.16 1604782 1653410
2002-03 503593.9 945325.7 247961.9 134256.2 57326.98 1876098 1934270
2003-04 580585.5 1096809 309613.3 160488.9 69334.18 2193286 2262838
2004-05 669347.9 1272567 386593.2 191847.2 83856.31 2564101 2647219
2005-06 771680.6 1476489 482712.9 229332.7 101420.1 2997608 3096894
2006-07 889658.4 1713088 602731.1 274142.5 122662.7 3504407 3622954
2007-08 1025673 1987601 752589.7 327707.9 148354.5 4096889 4238374
2008-09 1182482 2306104 939708 391739.6 179427.6 4789541 4958334
2009-10 1363265 2675644 1173350 468282.5 217008.9 5599299 5800591
2010-11 1571687 3104402 1465083 559781.3 262461.7 6545960 6785919
2011-12 1811973 3601866 1829351 669158.4 317434.6 7652672 7938622
2012-13 2088995 4179045 2284187 799906.8 383921.7 8946492 9287132
1980-2013
All SCBs All SCBs
RRBs) RRBs)
214469.9 387511 65429.99 46012.04 18315.93 734881.5 754567.8
Intercept 0.015 0.018 0.042 0.031 0.044 0.012 0.012
1.152 1.160 1.248 1.195 1.2094 1.169 1.169
b 0.001 0.001 0.004 0.003 0.004 0.001 0.001
r2 0.996 0.994 0.987 0.989 0.981 0.997 0.997
d.f. 31 31 31 31 31 31 31
F-Value 7799.187 5902.416 2515.243 2848.522 1644.917 13650.09 15091.96
Growth
15.28 16.02 24.86 19.53 20.94 16.90 16.98
Rate (%)
Source and notes are same as in table 4.2.1.
204
In the pre-reform period exponential trend values of total assets for different bank
Scheduled Commercial Banks excluding RRBs Rs. 57573.78 and for all Scheduled
Commercial Banks including RRBs Rs. 58051.94 crores at the end of the year 1980.
The total assets increased to Rs. 110808.8 crores for State Bank and its associates, Rs.
187066.8 crores for Nationalised Banks, Rs. 11164.62 crores for Private Sector
Banks, Rs. 18208.19 crores for Foreign Banks, Rs. 8600.003 crores for Regional
Rural Banks, Rs. 377243.7 crores for all Scheduled Commercial Banks excluding
RRBs and Rs. 335104.4 crores for all Scheduled Commercial Banks including RRBs
at the end of the year 1990-91.
and State Banks and its associates. The Regional Rural Banks registered highest
growth rate of 32.72 percent followed by Foreign Banks 24.94 percent and State
Banks and its associates 19.48 percent. The overall growth rate for all Scheduled
line and attributed to the factors included in the disturbance variable ‗u‘.
In the post-reform period, the exponential trend values revealed that total assets
touched to Rs. 2042813 crores for State Bank and its associates, Rs. 4440282 crores
for Nationalised Banks, Rs. 2678171 crores for Private Sector Banks, Rs. 664660.7
205
crores for Foreign Banks, Rs. 298194.3 crores for Regional Rural Banks, Rs.9348283
crores for all Scheduled Commercial Banks excluding RRBs and Rs. 9646716 crores
for all Scheduled Commercial Banks including RRBs.
groups. But it is maximum for Private Sector Banks and minimum for State Banks.
the Regional Rural Banks 17.62 percent and Foreign Banks 17.01 percent. The overall
growth rate of all Scheduled Commercial Banks excluding RRBs decreased to 17.62
percent from 18.97 percent in the pre reform period and rate of all Scheduled
Commercial Banks including RRBs decreased to 17.60 percent from 19.16 percent as
excluding RRBs and also for all Scheduled Commercial Banks including RRBs of the
total variation of the ‗Y‘ values around their mean. The Remaining variation, 0.4
percent for State Bank and its associates, 1.9 percent for Nationalised Banks, 1.3
percent for Private Sector Banks, 1.1 percent for Foreign Banks, 0.9 percent for
Regional Rural Banks, 0.3 percent for all Scheduled Commercial Banks excluding
RRBs and also for all Scheduled Commercial Banks including RRBs is unaccounted
for by the regression line and attributed to the factors included in the disturbance
variable ‗u‘.
Sector Banks registered highest growth rate of 24.86 percent followed by the
Regional Rural Banks 20.94 percent and Foreign Banks 19.53 percent. The overall
growth rate of all Scheduled Commercial Banks excluding RRBs is 16.90 percent in
the whole period and rate of all Scheduled Commercial Banks including RRBs is
16.98 percent during the whole period.
206
Commercial Banks excluding RRBs and for all Scheduled Commercial Banks
including RRBs of the total variation of the ‗Y‘ values around their mean. The
The breakup of the post reform period revealed that growth rate of total assets for
State Bank and its associates declined from 19.48 percent to 15.12 percent,
Nationalised Banks from 18.59 percent to 16.99 percent, Foreign Banks from 24.94
percent to 17.01 percent, Regional Rural Banks from 32.72 percent to 17.62 percent,
all Scheduled Commercial Banks excluding RRBs from 18.97 percent to 17.62
percent. All Scheduled Commercial Banks including RRBs decreased from 19.16 to
17.62 percent and for Private Sector Banks increased to 26.91 percent from 13.89
percent, in comparison to the pre reform period. The main reason behind this is the
introduction of new policy reforms of 1991, which exposed banks to more volume of
business, thereby showing decline in the growth rate of total assets in the post-reform
periods.
4.2.5 Total income
Total income of the banks comprises of interest income and non-interest income.
With the liberalisation and deregulation of interest rates, banks are finding tough to
earn steady income from their respective sources. The total income position of
different bank groups is exhibited in tables 4.2.13 for pre-reform period, 4.2.14 for
post-reform period and 4.2.15 for the entire study period.
207
Table 4.2.13
(Rs. in Crores)
All SCBs All SCBs
RRBs) RRBs)
1980 1345.848 2498.339 135.253 108.018 NA 4057.376 NA
1981 1618.736 3018.188 165.992 137.216 NA 4917.324 NA
1982 1946.957 3646.206 203.717 174.307 NA 5959.536 NA
1983 2341.728 4404.901 250.016 221.423 97.041 7222.641 7019.072
1984 2816.544 5321.463 306.838 281.276 134.008 8753.457 8608.072
1985 3387.636 6428.742 376.574 357.308 185.059 10608.726 10556.795
1986 4074.523 7766.420 462.158 453.892 255.557 12857.212 12946.675
1987 4900.687 9382.440 567.194 576.583 352.912 15582.258 15877.585
1988-89 5894.366 11334.718 696.102 732.439 487.354 18884.870 19472.003
1989-90 7089.527 13693.222 854.306 930.424 673.012 22887.460 23880.137
1990-91 8527.022 16542.478 1048.466 1181.926 929.397 27738.386 29286.199
1980-1991
All SCBs All SCBs
RRBs) RRBs)
3387.636 6428.742 376.573 357.3078 300.315 10608.73 14337.43
Intercept 0.022 0.019 0.016 0.044 0.101 0.020 0.025
1.202* 1.2080* 1.227* 1.270* 1.380* 1.211* 1.226*
b 0.007 0.006 0.005 0.013 0.044 0.006 0.011
2
r 0.986 0.990 0.994 0.972 0.897 0.990 0.982
d.f. 9 9 9 9 6 9 6
F-Value 652.613 917.265 1514.956 293.017 52.811 901.768 337.281
Growth
20.27 20.80 22.72 27.03 38.09 21.19 22.63
Rate (%)
208
Table 4.2.14
(Rs. in Crores)
All SCBs
All SCBs
Year SBG NBs PSB FBs RRBs (Incl.
(Excl. RRBs)
RRBs)
1991-92 11986.03 17979.43 1949.258 3253.852 919.4526 34813.3 35757.21
1992-93 13575.94 20708.53 2446.762 3722.961 1069.393 40305.22 41402.9
1993-94 15376.75 23851.89 3071.243 4259.703 1243.784 46663.51 47939.98
1994-95 17416.43 27472.38 3855.107 4873.827 1446.615 54024.85 55509.2
1995-96 19726.67 31642.42 4839.036 5576.489 1682.522 62547.45 64273.53
1996-97 22343.36 36445.44 6074.089 6380.454 1956.9 72414.53 74421.64
1997-98 25307.14 41977.51 7624.362 7300.328 2276.023 83838.18 86172.04
1998-99 28664.06 48349.3 9570.307 8352.82 2647.186 97063.94 99777.71
1999-2000 32466.26 55688.26 12012.91 9557.051 3078.877 112376.1 115531.6
2000-01 36772.81 64141.21 15078.93 10934.9 3580.966 130103.8 133772.8
2001-02 41650.62 73877.23 18927.49 12511.39 4164.933 150628.2 154894.1
2002-03 47175.45 85091.09 23758.3 14315.16 4844.132 174390.3 179350.3
2003-04 53433.13 98007.1 29822.06 16378.98 5634.09 201901 207667.8
2004-05 60520.88 112883.6 37433.46 18740.35 6552.872 233751.6 240456.4
2005-06 68548.8 130018.3 46987.5 21442.16 7621.484 270626.7 278422
2006-07 77641.59 149753.8 58979.99 24533.49 8864.361 313319 322381.9
2007-08 87940.52 172485 74033.29 28070.49 10309.92 362746.2 373282.6
2008-09 99605.57 198666.6 92928.6 32117.43 11991.21 419970.6 432220
2009-10 112818 228822.3 116646.5 36747.82 13946.69 486222.5 500463
2010-11 127782.9 263555.4 146417.9 42045.77 16221.05 562925.8 579480.9
2011-12 144733 303560.5 183787.7 48107.54 18866.3 651729.3 670974.9
2012-13 163931.4 349638.1 230695.3 55043.23 21942.93 754541.8 776914.8
1992-2013
All SCBs
All SCBs
SBG NBs PSB FBs RRBs (Incl.
(Excl. RRBs)
RRBs)
44327.04 79286.15 21205.77 13382.92 4491.713 162074.3 166674.2
Intercept
0.019 0.026 0.038 0.037 0.041 0.020 0.020
1.132 1.151 1.255 1.144 1.163 1.157 1.157
b
0.003 0.004 0.006 0.005 0.006 0.003 0.003
2
r 0.988 0.983 0.985 0.963 0.963 0.990 0.990
d.f. 20 20 20 20 20 20 20
F-Value 1656.393 1184.088 1404.7 521.737 534.621 2016.148 2064.885
Growth
13.26 15.17 25.52 14.41 16.30 15.77 15.78
Rate (%)
209
Table 4.2.15
(Rs. in Crores)
Year SBG NBs PSB FBs RRBs All SCBs All SCBs
(Excl. RRBs) (Incl. RRBs)
1980 1772.048 3094.617 123.134 176.117 NA 4994.948 NA
1981 2053.982 3596.774 156.1931 214.0754 NA 5865.597 NA
1982 2380.77 4180.416 198.128 260.2149 NA 6888.004 NA
1983 2759.552 4858.763 251.3215 316.2988 181.6873 8088.624 8813.592
1984 3198.597 5647.184 318.7964 384.4705 215.6718 9498.518 10318.31
1985 3707.494 6563.541 404.3871 467.3351 256.0132 11154.17 12079.94
1986 4297.358 7628.593 512.9572 568.0595 303.9003 13098.4 14142.31
1987 4981.068 8866.468 650.6762 690.4929 360.7447 15381.53 16556.8
1988-89 5773.557 10305.21 825.3702 839.3144 428.2218 18062.62 19383.5
1989-90 6692.131 11977.42 1046.966 1020.211 508.3205 21211.04 22692.79
1990-91 7756.851 13920.97 1328.056 1240.097 603.4016 24908.25 26567.08
1991-92 8990.968 16179.89 1684.613 1507.374 716.2676 29249.91 31102.81
1992-93 10421.43 18805.37 2136.9 1832.257 850.2451 34348.33 36412.92
1993-94 12079.48 21856.88 2710.616 2227.162 1009.283 40335.45 42629.61
1994-95 14001.33 25403.55 3438.363 2707.18 1198.069 47366.16 49907.65
1995-96 16228.95 29525.73 4361.497 3290.657 1422.167 55622.35 58428.27
1996-97 18810.98 34316.81 5532.475 3999.89 1688.183 65317.66 68403.58
1997-98 21803.81 39885.32 7017.837 4861.983 2003.957 76702.91 80081.96
1998-99 25272.8 46357.43 8901.99 5909.883 2378.796 90072.67 93754.15
1999-2000 29293.71 53879.76 11292 7183.636 2823.748 105772.9 109760.6
2000-01 33954.34 62622.71 14323.69 8731.919 3351.929 124209.7 128499.7
2001-02 39356.49 72784.37 18169.32 10613.9 3978.906 145860.2 150438.2
2002-03 45618.11 84594.93 23047.43 12901.51 4723.158 171284.5 176122.1
2003-04 52875.97 98321.97 29235.21 15682.16 5606.623 201140.3 206191
2004-05 61288.54 114276.5 37084.3 19062.13 6655.339 236200.3 241393.5
2005-06 71039.57 132819.9 47040.72 23170.58 7900.217 277371.4 282606
2006-07 82341.98 154372.3 59670.24 28164.51 9377.949 325718.8 330854.6
2007-08 95442.6 179421.9 75690.54 34234.79 11132.09 382493.5 387340.6
2008-09 110627.5 208536.4 96011.98 41613.39 13214.34 449164.4 453470.4
2009-10 128228.4 242375.1 121789.3 50582.29 15686.08 527456.4 530890.2
2010-11 148629.6 281704.8 154487.4 61484.26 18620.15 619395.1 621527.8
2011-12 172276.6 327416.5 195964.3 74735.92 22103.04 727359.3 727639.7
2012-13 199685.8 380545.7 248576.9 90843.69 26237.4 854142.3 851867.9
1980-2013
SBG NBs PSB FBs RRBs All SCBs All SCBs
Intercept 18810.98 34316.81 5532.475 3999.89 2183.347 65317.66 86648.81
0.030 0.023 0.030 0.073 0.056 0.023 0.023
b 1.159* 1.162* 1.268* 1.215* 1.187* 1.1743* 1.170*
0.003 0.002 0.003 0.007 0.006 0.002 0.002
r2 0.985 0.991 0.994 0.954 0.960 0.992 0.991
d.f. 31 31 31 31 28 31 28
F-Value 2075.266 3607.59 5351.15 647.967 688.572 4287.808 3399.429
Growth
15.91 16.22 26.84 21.55 18.70 17.43 17.07
Rate (%)
210
In the pre-reform period exponential trend values of total income for different bank
Banks Rs. 108.018 crores, for all Scheduled Commercial Banks excluding RRBs Rs.
4057.376 at the end of the year 1980. The total income increased to Rs. 8527.022
crores for State Bank and its associates, Rs. 16542.478 crores for Nationalised Banks,
Rs. 1048.466 crores for Private Sector Banks, Rs. 1181.929 crores for Foreign Banks,
Rs. 929.397 crores for Regional Rural Banks, Rs. 27738.386 crores for all Scheduled
Commercial Banks excluding RRBs and Rs. 29286.199 crores for all Scheduled
Commercial Banks including RRBs at the end of the year 1990-91.
and Private sector banks. The Regional Rural Banks registered highest growth rate of
38.09 percent followed by Foreign Banks 27.03 percent and Private sector banks
22.72 percent. The overall growth rate for all Scheduled Commercial Banks excluding
RRBs was 21.19 percent and 22.63 percent for all Scheduled Commercial Banks
including RRBs. The regression line has given a good fit to the observed data, since
this line explained 98.6 percent for State Bank and its associates, 99.0 percent for
Commercial Banks including RRBs of the total variation of the ‗Y‘ values around
their mean. The Remaining variation, 1.4 percent for State Bank and its associates, 1.0
percent for Nationalised Banks, 0.6 percent for Private Sector Banks, 2.8 percent for
Commercial Banks including RRBs was unaccounted for by the regression line and
attributed to the factors included in the disturbance variable ‗u‘.
In the post-reform period, the exponential trend values revealed that total assets
touched to Rs. 163931.4 crores for State Bank and its associates, Rs. 349638.1 crores
for Nationalised Banks, Rs. 230695.3 crores for Private Sector Banks, Rs. 55043.23
crores for Foreign Banks, Rs. 21942.93 crores for Regional Rural Banks, Rs.
211
754541.8 crores for all Scheduled Commercial Banks excluding RRBs and Rs.
776914.8 crores for all Scheduled Commercial Banks including RRBs.
groups. But it is maximum for Private Sector Banks and minimum for State Banks.
the Regional Rural Banks 16.30 percent and Nationalised banks 15.17 percent. The
overall growth rate of all Scheduled Commercial Banks excluding RRBs decreased to
Commercial Banks including RRBs decreased to 15.78 percent from 21.69 percent as
excluding RRBs and also for all Scheduled Commercial Banks including RRBs of the
total variation of the ‗Y‘ values around their mean. The Remaining variation, 1.2
percent for State Bank and its associates, 1.7 percent for Nationalised Banks, 1.5
percent for Private Sector Banks, 3.7 percent for Foreign Banks, 3.7 percent for
Regional Rural Banks, 1.0 percent for all Scheduled Commercial Banks excluding
RRBs and also for all Scheduled Commercial Banks including RRBs is unaccounted
for by the regression line and attributed to the factors included in the disturbance
variable ‗u‘.
Sector Banks registered highest growth rate of 26.84 percent followed by Foreign
Banks 21.55 percent and the Regional Rural Banks 18.70 percent. The overall growth
rate of all Scheduled Commercial Banks excluding RRBs is 17.43 percent in the
whole period and rate of all Scheduled Commercial Banks including RRBs is 17.07
percent during the whole period.
212
The breakup of the post-reform period revealed that growth rate of total income for
percent, in comparison to the pre-reform period. The reason for lowering of total
income growth could be assigned to frequent cuts in interest rates and competition
being posed by private sector banks and foreign banks. Further the growing level of
non-performing assets and market recession had added fuel to the fire by adversely
affecting the income of public sector banks.
4.2.6 Profitability
Profits represent the difference between income and expenditure. The difference
between total income and expenditure of any concern gives its net profit. Net profit
plus provisions and contingencies give operating profit. Table 4.2.16 gives data on
operating profit as percentage to total assets for different categories of banks.
213
Table- 4.2.16: Operating profit as percentage of total assets (1980-2013)
All SCBs All SCBs

RRBs) RRBs)
1980 0.04 0.11 NA NA NA NA NA
1981 0.04 0.09 NA NA NA NA NA
1982 0.04 0.1 NA NA NA NA NA
1983 0.04 0.09 NA NA NA NA NA
1984 0.04 0.07 NA NA NA NA NA
1985 0.04 0.07 NA NA NA NA NA
1986 0.04 0.14 NA NA NA NA NA
1987 0.04 0.16 NA NA NA NA NA
1988-89 0.08 0.18 NA NA NA NA NA
1989-90 0.07 0.19 0.03 1.46 0.11 0.39 0.2
1990-91 0.07 0.21 0.04 1.33 0.14 0.43 0.22
1991-92 1.41 1.57 0.29 6.36 -1.13 4.05 2
1992-93 0.95 0.48 0.21 2.35 -1.16 1.97 0.93
1993-94 0.76 0.88 0.32 4.49 -1.22 2.41 1.16
1994-95 0.86 1.34 0.46 3.97 -1.06 2.94 1.44
1995-96 1.09 1.44 0.58 3.37 -0.84 3.3 1.63
1996-97 1.08 1.6 0.65 3.43 -0.32 3.51 1.77
1997-98 1.02 1.7 0.73 3.48 0.3 3.55 1.82
1998-99 0.84 1.54 0.5 2.15 0.57 2.83 1.48
1999-2000 0.88 1.62 0.77 2.51 0.84 3.21 1.68
2000-01 0.74 1.56 0.72 2.34 0.96 2.94 1.55
2001-02 0.97 2.24 0.95 1.85 0.92 3.75 1.96
2002-03 1.08 2.88 1.32 1.81 0.8 4.61 2.39
2003-04 1.24 3.41 1.27 1.98 1.01 5.15 2.67
2004-05 1.14 2.65 0.98 1.57 0.65 4.19 2.16
2005-06 2.28 1.86 1.95 3.77 0.91 2.12 2.08
2006-07 1.91 1.92 2.08 4.06 1.24 2.11 2.09
2007-08 1.92 1.8 2.28 4.4 1.58 2.15 2.13
2008-09 2.04 1.92 2.46 4.97 1.51 2.32 2.3
2009-10 1.85 1.89 2.68 3.71 1.58 2.17 2.01
2010-11 2.19 1.99 2.58 3.52 1.3 2.26 2.05
2011-12 2.36 1.92 2.49 3.46 1.4 2.24 2.06
2012-13 2.08 1.79 2.64 3.38 1.4 2.13 1.97
Descriptive analysis
Minimum 0.04 0.07 0.03 1.33 -1.22 0.39 0.2
Maximum 2.36 3.41 2.68 6.36 1.58 5.15 2.67
Mean 0.95 1.25 1.21 3.15 0.47 2.78 1.74
Standard
0.79 0.95 0.93 1.25 0.95 1.14 0.61
Deviation
Skewness 0.31 0.15 0.47 0.52 -.072 -0.08 -1.34
Kurtosis -1.12 -0.8 -1.36 0.24 -0.82 0.39 1.80
214
The time period considered here is 1980 to 2012-13,for the year 1980 to 1988-89 data
is available only for public sector banks i.e., SBI and its associates and Nationalised
banks . Since operating profit is considered the magnitude will not get affected by
changes in the provisioning norms, however adoption of new income recognition
norms will show deterioration in the profitability as measured by operating profit.
Due to changes in classification related to Non Performing Assets (NPAs), the total
assets of the banks will also be affected.
Figure 4.2.1: Operating profit as percentage of total assets
7
6
5
4
3
2
1
0
-1
-2
State Bank of India & Its Associates Nationalised Banks

Private Sector Banks Foreign Banks
Regional Rural Banks All Scheduled Commercial Banks (Excl. RRBs)
All Scheduled Commercial Banks (Incl. RRBs)
From the figure 4.2.1 above, it is evident that after the financial sector reforms, the
profit position of all the categories of banks has substantially improved. All the curves
in the figure show a sharp jump in the immediate post-reforms period. They however
slide downwards in the year 1992-93 and once again in 1998-99. This is largely
attributable to the adoption of prudential income recognition norms. Despite this
however all banks groups except Regional Rural Banks are able to show positive
operating profits.
All public sector banks as a group (SBI & associates and Nationalised banks) show a
distinct jump in the post reform period. The operating profits which were nearly 0.1%
215
of total assets during 1980s were more than 1% in post reform years and in recent
years more than 2% i.e. increase by 10-20 times. For nationalised banks and State
banks it was less than 1% in 1992-93 and 1993-94 possibly due to the adoption of
prudential norms.
For all other categories substantial pre reform data is not available. The data that is
available for the other groups (as given in table 4.2.16) shows distinct improvement in
mid to late 1990‘s. For the private sector banks, the profit rose from 0.03 percent of
total assets in 1989-90 to 2.64 percent in the year 2012-13 and throughout sustained
itself close to 2% with some fluctuations during the 2005-6 to 2012-13. These profits
were higher in most years in relation to bank groups in the public sector. The foreign
bank shows profits much higher than both the public and the private sector banks for
all years. This is because of their presence predominantly in metropolitan areas
serving high end customers, providing a host of services and charging for them. As is
evident from the data in the post-reforms period profits for foreign banks also in
multiples to pre-reform profits but the multiple is substantial low in comparison to the
other banks groups i.e., public sector and other than foreign banks in the private
sector. This is due to high level of profits for the foreign banks right from inception.
From 1.46 percent of total assets in the years preceding liberalisation, it rose to more
than 3% in most years after the reforms and in few years more than 4% i.e., increase
by four times in 20 years.
As for the Regional Rural banks the profit in the first half of 1990‘s was throughout
negative. The poor profitability position can be attributed to the operations in the
areas where risk is substantially high, defaults are high, and a large proportion of
advances go towards concessional lending. The profits that were negative even before
the introduction of prudential accounting norms took time to recover from the jolt of
prudential accounting. The losses steadily fell after the reforms and by the closing of
decade the profits had risen to more than 1% of total assets. During the second half of
2000‘s the profit position further improved.
The data shows substantial improvement in profitability of all bank groups after the
reforms. All groups (except RRBs) could stand the prudential income recognition
norms without their operating profits becoming negative even for one year. After
announcement of the reforms in 1991, giving much autonomy to the banks in their
216
operations and freedom on fixing the interest rates, the profits for all groups show an
immediate jump as is evident in figure 4.2.1 next year i.e., 1992-93 when new
accounting norms were adopted, the profits for all the groups substantially came
down, but remained substantially higher than compared to the profits in years
preceding the reforms. One more jolt to profitability came when in 1998 NCR II made
the prudential norms more stringent. However, within 2 years the profit percentages
higher than those in 1998 were achieved.
Since all bank groups (except RRBs with a small share in total) shows similar trends
in profits, the average for all scheduled commercial banks as a group is bound to
move on the same pattern. Even when RRBs are included in the total, it does not
make any noticeable difference as can be seen from the two almost overlapping
curves in figure 4.2.1 and last two columns of table 4.2.16. The operating profits for
all SCBs in the aggregate including the RRBs increased from 0.20% of total assets
prior to liberalisation to more than 2% after the reforms in 1991.
4.2.7 Non Performing assets (NPA) / Advances
Once a loan is overdue and ceases to yield income, it becomes a NPA. In India, the
concept of NPAs in its present form came into existence with the recommendations of
the NCR-I implemented by RBI in 1992. In NCR-I i.e., the report of Narsimham
Committee presented in 1991, an asset was considered NPA if interest on such asset
was due for a period exceeding 180 days at the balance sheet date. The norm of 180
days was tightens to 90 days in NCR-II (recommendations of the second generation
reforms in 1998) to bring it at par with international standard practices.
Ever since liberalisation, the level of NPAs is constantly being referred to for
indicating the performance and the state of the health of all types of financial
institutions. NPAs derive importance from the fact that high levels of NPAs has effect
not only on profitability and other performance indicators of the concerned financial
institutions but has far reaching implications for the economy as a whole. Defaults
bring down the return accruing to them, reduce the effective rate of interest, the funds
re-circulation and increase their dependence on external sources thereby increasing
costs (Murty and Reddy, 1998). High level of NPAs affects the productivity of
banks by increasing the cost of funds and by reducing the efficiency of bank
employees. Cost of funds is increased partly because due to non-availability of
217
sufficient internal resources they have to rely on external sources to fulfil their future
financial requirements. Efficiency of employees is reduced because it keeps staff busy
with the task of recovery of over dues. instead of devoting time to plan for
development through more credit and mobilisation of resources the bank staff would
primarily be engaged in preparing a large volume of returns and statements relating to
sub-standard, doubtful and loss assets, proposals for filing suits, compromise,
waivement of legal action etc. High level of problem loans cause banks to increase
spending on monitoring, working out and or selling of these loans and possible
became more diligent administering the portion of their existing loans portfolios that
is currently performing (Berger and Robert (1997).
For sustainability of any bank, in order that it is able to meet its repayment liabilities
towards depositors, it is essential that the bank is also able to mobilise funds at low
cost and deploy them in high earning assets that continue to earn income. In case
funds get deployed in such assets, which do not yield income, the return on funds on
an average would come down without a corresponding decline in the average cost of
funds mobilised. The loan amount that is not received back by the bank is rendered
unavailable for further lending. Due to high level of NPAs and fear of default, banks
prefer to invest in zero risk government securities, even if they obtain a lower rate of
interest on them. Also, credit to industry suffers. Moreover with the presence of NPAs
beyond a reasonable level, banks find it difficult to adhere to capital adequacy
requirements. More weights are required to be assigned to these risky assets and
hence more capital requirement.
Besides these quantitative repercussions of high NPAs, there are important qualitative
aspects to it too which cannot be ignored. High incidence of loan defaults shakes the
confidence of general public in the soundness of banking set up and indirectly affects
the capacity of the banking system to mop up deposits. Inadequate recovery also
inhibits the banks to draw refinance from higher level agencies. Deterioration in the
quality of loan assets makes banks uncompetitive globally.
High levels of NPAs affect not only the banks, but also the economy as a whole.
Banks do not put enough resources in lending due to fear of default. Once credit to
different sectors slows down, it leads to slow down in the growth of industrial output
218
and GDP as a whole. Profit margins of the corporate fall and depression like situation
take grip in the economy.
In India, the concept of NPAs came up after the reforms of 1991. The default rate in
general, however, had always been quite high. Table 4.2.17 below gives the available
data on Net NPAs/ Net Advances from 1994-95 to 2012-13.
Table 4.2.17: Non Performing assets of scheduled commercial banks as

percentage of net advances
sector banks
Nationalised
All schedule
New private
commercial
Old private
Associates
SBI and
Foreign
Public
Banks
banks
banks
banks
banks
Year
1994-95 NA NA 10.7 NA NA NA NA
1995-96 6.88 10.14 8.9 NA NA NA NA
1996-97 7.7 10.07 9.2 6.6 2.0 1.9 8.1
1997-98 6.89 8.91 8.2 6.5 2.6 2.2 7.3
1998-99 7.74 8.35 8.1 9.0 4.5 2.9 7.6
1999-2000 6.77 7.8 7.4 7.1 2.9 2.4 6.8
2000-01 6.27 7.01 6.7 7.3 3.1 1.8 6.2
2001-02 5.45 6.01 5.8 7.1 4.9 1.9 5.5
2002-03 4.12 4.77 4.5 5.2 1.5 1.7 4.0
2003-04 2.71 3.13 3.1 3.8 1.7 1.5 2.8
2004-05 2.2 1.9 2.1 2.7 1.9 0.8 2.0
2005-06 1.6 1.2 1.3 1.7 0.8 0.8 1.2
2006-07 1.3 0.9 1.1 1.0 1.0 0.7 1.0
2007-08 1.4 0.7 1.0 0.7 1.2 0.8 1.0
2008-09 1.5 0.7 0.9 0.9 1.4 1.8 1.1
2009-10 1.5 0.9 1.1 0.8 1.1 1.8 1.1
2010-11 1.7 1.0 1.2 0.5 0.6 0.7 1.0
2011-12 1.8 1.4 1.5 0.6 0.4 0.6 1.3
2012-13 2.0 2.0 2.0 0.8 0.4 1.0 1.7
Source: Reports on Trend and progress of banking in India (different issues)
219
In 1994-95, the ratio was at reasonably high levels for public sector banks and old
private sector banks- higher in case of public sector banks i.e., 10.7 % of net
advances. Even since mid 1990s, it has shown a sharp decline as is evident from the
data in table 4.2.17 by 2006-07, it reached a level of just a little above 1% and this
continues till 2010-11. For the old private banks, the ratio initially increased in the
late 1990s but 2000 onwards it registered a sharp decline to reach 1.0 % of net
advances in 2006-07 and 0.8 % in 2012-13.
The trend for the foreign banks and banks established in the private sector after
liberalisation i.e., new private sector banks is somewhat different. In 1996-97, the
ratio for both groups was appreciably low at 2% for new private sector banks and 1.9
% for foreign banks. Right from inception these banks followed the prudential norms
and their recovery process were relatively more effective. The new private sector
banks recorded an increase for a couple of years but never went above 5%. After
2001-02, the ratio showed a steep decline and reached to 1% in 2006-07 and 0.4 % in
2012-13. The trend for foreign banks was on similar lines. Some increase in the
closing years of 1990s followed by a steep decline after 2001-02 to reach 1.0 % in
2012-13. The ratio itself was never 3 % or more in any of these years for which data
is available.
The data of table 4.2.17 is illustrated in figure 4.2.2 below. It clearly shows all the
bank groups converging to a low level of nearly 1% except for foreign banks, all other
curves take a sharp plunge after 2001-02. It is evident that magnitude for all years was
lowest in case of foreign banks among all the groups. The new private sector banks in
this regard occupied the next best position. Public sector banks fared the worst with
the NPAs being highest in relation to net advances for most of these years across all
banks groups. Overall trend is common to all groups of banks. All the bank groups
have registered a sharp decline in their net NPAs relative to net advances over these
years. In the year 1998-99, the position of all banks groups in this regard worsened
(for the public sector banks it does not worsen but no remarkable improvement was
shown either in this particular year). Reason for this worsening of the situation is to be
found in NCR-II, where in the norms for NPAs were made more stringent.
220
Figure 4.2.2: Non-performing assets of scheduled commercial banks
as percentage of net advances
12
10
8
6
4
2
0
SBI and Associates Nationalised Banks

Public sector banks Old private banks
New private banks Foreign banks
All schedule commercial banks
All the bank groups however quickly recovered and showed a sharp decline in the
opening years of 2000. By 2012-13 , all the bank groups could attain net NPAs to net
advances ratio close to 1%. The foreign banks and the banks in the private sector
could touch levels below1.0 %. Thus, in aggregate all scheduled commercial banks
showed a similar pattern. Starting from 8.1 % of net advances in 1996-97 the net
NPAs reached 1.7 % of net advance by 2012-13. Thus, it can be seen that with
regard to NPAs, a significant improvement has been made after the reforms. In
the mid nineties all bank groups on an average were operating with high level of
NPAs. The position at the beginning of 1990s can be expected to be much worse. By
2010-11 all the bank groups had reached a position where they stand very comfortable
even in comparison to the international benchmark of 2%. All this is made possible by
improvement in credit appraisal process, upturn of the business cycle, new initiatives
for the resolution of NPAs( including promulgation of securitization and
reconstruction of financial assets and enforcement of security interest act),and greater
provisioning and write offs enables by enhanced profitability.
221
4.2.8 Capital Adequacy
The capital base of commercial banks has become a subject of great attention since
past two decades. In India, it had progressively become very weak by the closing of
1980s. The ratio of paid up capital and reserves to deposits of scheduled commercial
banks in India declined from 6.7% in 1956 to 4.1 % in 1961,2.4 %in 1969 and 1.2 %
in 1984 ( Bhole,2004). In 1988 the base committee on banking supervision appointed
by the Bank of International Settlement (BIS) established a system in which capital
requirements based on the risk of bank assets were set up for the banks. It specified
the capital to risk weighted assets ratio (CRAR) of 8% as the capital adequacy norms.
The risk based capital standards have been adopted by many countries like India
where it came into force in 1992-93. Initially, while it was deemed to attain a CRAR
of 8% in a phased manner, NCR-II recommended it to be raised to 9% by 2000 and
10% by 2002. The CRAR was subsequently raised to 9% with effect from 1999-2000.
In order to achieve improved capitalisation a multipronged strategy has been

implemented. Initially substantial infusion of funds was made by the government to
recapitalise the public sector banks. Subsequently in order to mitigate the budgetary
impact and induce market discipline, public sector banks were allowed to raise funds
from the market through equity issuance subject to maintenance of 51% public
ownership. Ownership in public sector banks is now well diffused. At end march,
2005 holding by general public in 6 banks ranged between 40-49% and in 16 banks
between 30-49%. In only 4 banks, the government is holding more than 90%. The
overall capital position of commercial banks has witnessed marked improvement
during the post-reform period. Table 4.2.18 and 4.2.19 give data on capital base of the
banks in relation to risk weighted assets.
Data on CRAR on a regular basis is available starting from 1997-98. One thing is
clearly evident from the available data, all groups of banks on an average has CRAR
by more than 10% for all years after 1997-98. All banks average was in the range of
11-13% for all years considered.
222
Table 4.2.18: Capital Adequacy Ratio I (CRAR)
New All
Public Old private
private Foreign schedule
Year sector sector
sector banks commercial
banks banks
banks banks
1997-98 11.6 12.3 13.2 10.3 11.5
1998-99 11.3 12.1 11.8 10.8 11.3
1999-2000 10.7 12.4 13.4 11.9 11.1
2000-01 11.2 11.9 11.5 12.6 11.4

2001-02 11.8 12.5 12.3 12.9 12.0
2002-03 12.6 12.8 11.3 15.2 12.7
2003-04 13.2 13.7 10.2 15.0 12.9
2004-05 12.9 12.5 12.1 14.0 12.8
2005-06 12.2 11.7 12.6 13.0 12.3

2006-07 12.4 12.1 12.0 12.4 12.3
2007-08 12.5 14.1 14.4 13.1 13.0
2008-09 12.3 14.3 15.1 15.1 13.2
2009-10 12.1 13.8 17.3 18.1 13.6
2010-11 11.8 13.3 15.5 17.7 13.0
2011-12 11.9 12.5 14.9 17.3 12.9
2012-13 11.3 12.3 15.7 18.8 12.8

Source: Reports on Trend and progress of banking in India (different issues)
Table 4.2.19 gives data on the distribution of scheduled commercial banks by CRAR
of more than 10% over a given period of time CRAR is arrived at by dividing the
capital of the banks with aggregate risk weighted assets for credit risk, market risk
and operational risk. The higher the CRAR of a bank, the better capitalised it is.
223
Table 4.2.19: Capital Adequacy Ratio II
No. of scheduled commercial banks
Total No. of reporting

scheduled commercial
Year with CRAR above 10%
Capital adequacy
% of banks with
CRAR 10%
ratio %
banks
sector banks
sector banks
Nationalised
New private
Old private
State bank
banks *
Foreign
banks
group
Total
1995-96 4 2 12 8 16 42 92 45.65 8.7
1996-97 11 5 13 9 26 64 100 64.00 10.4
1997-98 12 7 15 7 30 71 103 68.93 11.5
1998-99 14 8 18 7 29 76 105 72.38 11.3
1999-2000 14 8 18 7 37 84 101 83.17 11.1
2000-01 15 8 16 7 38 84 100 84.00 11.4
2001-02 15 8 19 6 33 81 91 89.01 12
2002-03 18 8 20 6 36 88 93 94.62 12.7
2003-04 18 8 20 8 33 87 90 96.67 12.9
2004-05 18 8 15 7 30 78 88 88.64 12.8
2005-06 20 8 16 7 27 78 85 91.76 12.3
2006-07 20 8 14 8 29 79 82 96.34 12.4
2007-08 20 8 14 8 27 77 79 97.47 13
2008-09 20 7 15 7 31 80 80 100.00 13.2
2009-10 20 7 14 7 32 80 81 98.77 13.6
2010-11 20 6 14 7 34 81 81 100.00 14.2
2011-12 20 6 12 7 41 86 87 98.85 14.2
2012-13 20 6 13 7 43 89 89 100 13.88
Source :Handbook of Statistics on Indian economy, RBI.
* : Includes data for IDBI Bank Ltd.
Note : 1. Scheduled Commercial Banks (SCBs) had to comply with minimum Capital to Risk-weighted
Assets Ratio (CRAR) of 8 per cent up to end-March 1999 and 9 per cent from end-March 2000.
In 1995-96, less than half of the total scheduled commercial banks had CRAR above
10%. In the year to follow, the percentage of such banks in the total sharply increased.
After 2002-03 more than 90% banks had CRAR above 10% for all years. Only in
2004-05 the percentage was 88.6 % but, of the remaining 10 banks that had CRAR
less than 10%, 8 banks had CRAR above 9%. So 86 out of 88 i.e., close to 98% banks
have CRAR above 9%. By 2006-07 the percentage of banks with CRAR above 10%
had reached more than 95% and 100% in 2012-13.
224
4.2.9 Productivity
Broadly speaking productivity implies per unit of input. Conventional productivity

analysis for any productive unit is concerned with finding out the productivity of any
particular factor input and/or total factor productivity. Typically one finds labour
productivity, capital productivity and overall productivity i.e., total factor productivity
(Ahluwalia, 1991 & Farell, 1957).
In context of banking firms the outputs and inputs are distinctly different as compared
to any ordinary production unit. Banks accept deposits and give away credit in various
forms. But here, neither the deposits are inputs for the entity, nor is the credit output
in the conventional sense of the term. The inputs will be fixed assets, stationary etc.
Expenses paid as interest on deposits, other operational expenses. As for output,
banks generate no physical output. They provide some specialised services for which
they charge fees, commissions etc. Mainly they act as intermediary between savers
and investors; in the process earning interest incomes for themselves. The banking
business therefore consists primarily of making deposits and extending credit to
different segments of the economy. In case of banks there is no capital input in the
conventional sense. Capital and reserves is of entirely different nature and no
economic meaning can be attached to productivity of capital. Most studies on
productivity of banks (Berger and Humpherey, 1992) have been measured
productivity by the ratios of an output (such as deposits, loans, reserves) to an input
(labour and capital). One single ratio however fails to capture the multiproduct nature
of the banking activity. So, this study used multiple indicators of productivity and
efficiency to see if they all suggest a common trend.
4.2.9.1 Ratio of intermediation cost to total assets (ICR): Basic function of the
commercial banks is to act as intermediary between surplus and deficit units of the
economy. This ratio gives how efficiently banks are carrying the function of
intermediation of funds in the economy. Intermediation costs are identical to
operating expenses i.e., all expenses minus interest that is paid on deposits etc. by
banks. The data for 1988-89 has been deflated by a factor 12/15=0.8.
Ratio of intermediation cost to total assets=
225
Efficiency gains are reflected in containment of operating expenditure i.e.,
intermediation costs as a proportion of total assets as shown by table 4.2.20.
Table- 4.2.20: Ratio of intermediation cost to total assets of scheduled

commercial banks (1980-2013)
Percentages
All SCBs All SCBs
1980 1.4 3.08 NA NA NA NA NA
1981 1.36 3.02 NA NA NA NA NA
1982 1.27 2.94 NA NA NA NA NA
1983 1.27 3 NA NA NA NA NA
1984 1.41 3.25 NA NA NA NA NA
1985 1.43 3.2 NA NA NA NA NA
1986 1.38 3.15 NA NA NA NA NA
1987 1.35 3.08 NA NA NA NA NA
1988-89 1.7 3.39 NA NA NA NA NA
1989-90 1.26 2.9 0.37 3.74 2.3 4.61 2.42
1990-91 1.27 2.9 0.37 4.16 2.24 4.7 2.47
1991-92 1.27 3.32 0.42 2.91 2.59 5.07 2.69
1992-93 1.38 3.35 0.42 3.47 2.36 5.18 2.75
1993-94 1.4 3.32 0.44 3.15 2.48 5.14 2.73
1994-95 1.53 3.56 0.48 2.72 2.49 5.37 2.85
1995-96 1.61 3.7 0.62 2.85 2.18 5.69 3.01
1996-97 1.46 3.61 0.69 2.89 2 5.49 2.91
1997-98 1.34 3.4 0.69 2.64 1.78 5.07 2.69
1998-99 1.39 3.31 0.73 2.86 1.75 5.1 2.7
1999-2000 1.25 3.18 0.73 2.36 1.69 4.79 2.53
2000-01 1.38 3.36 0.77 2.35 1.54 5.08 2.68
2001-02 1.06 2.93 0.8 1.79 1.73 4.23 2.25
2002-03 1 2.87 1.08 1.58 1.86 4.32 2.3
2003-04 1.05 2.75 1.15 1.49 1.77 4.26 2.26
2004-05 1 2.66 1.1 1.52 1.69 4.12 2.18
2005-06 2.39 2.07 2.41 3.32 2.39 2.3 2.31
2006-07 2.13 1.84 2.33 3.27 2.71 2.12 2.14
2007-08 1.87 1.63 2.4 3.24 2.42 1.99 2
2008-09 1.75 1.58 2.21 3.04 2.31 1.87 1.89
2009-10 1.87 1.48 2.08 2.52 1.93 1.77 1.88
2010-11 1.94 1.6 2.17 2.71 2.27 1.86 1.97
2011-12 1.94 1.44 2.2 2.47 2.27 1.77 1.87
2012-13 1.93 1.41 2.2 2.36 1.96 1.75 1.84
Minimum 1.00 1.41 0.37 1.49 1.54 1.75 1.84
Maximum 2.39 3.7 2.41 4.16 2.71 5.69 3.01
Mean 1.48 2.79 1.20 2.72 2.11 3.90 2.38
Standard
0.33 0.71 0.79 0.68 0.33 1.48 0.36
Deviation
Skewness 0.86 -0.95 0.55 -0.16 -0.04 -0.55 -0.03
Kurtosis 0.44 -0.50 -1.52 -0.01 -1.24 -1.52 -1.26
226
Data for only public sector banks is available for the years 1980 to 1988-89, for all
other groups data is available starting from 1989-90. As is evident from the table the
intermediation costs in relation to total assets have gradually declined for all bank
groups except foreign banks, noticeably after 2000. For Foreign banks these costs
declined from around 3.74 % in opening 1990 to 2.36 in 2012-13, a decrease of nearly
36 % in 2 and half decades. The decline is more marked in the case of RRBs; from 2.3
to 1.96% during the same period i.e., nearly 15 % decline
Figure 4.2.3: Ratio of intermediation cost to total assets
6
5
4
3
2
1
0
SBG NBs PSB

FBs RRBs All SCBs (Excl RRBs)
All SCBs (Incl RRBs)
The high costs in case of regional rural banks can be expected due to the nature of
operating environment and clients in the rural areas, a high proportion of priority
sector lending and associated high default rate, greater efforts and therefore high costs
involved in recovery. These banks greatly benefitted from the changes brought by the
reforms. For all groups other than RRBs and private sector banks the ratios increased
somewhat before it started to decline after the mid 1990s. In case of foreign banks, the
decline came much later towards the end of 1990s, only for 4-5 years and was
marginal. All through mid 1990s to 2008-09, the foreign banks had highest
intermediation cost ratio among all bank groups. It fluctuated between 2.5 to 4%
during the period. This high level rather than inefficiency in operations is related to
high quantum and quality of services provided by foreign banks. These banks are
located largely in metropolitan areas provide a host of additional services and
227
facilities in relation to other scheduled commercial banks. For better services, they do
appropriately charge the customers and consequently, together with intermediation
costs their incomes are also high in relation to other bank groups. This is documented
in highest level of profits earned by foreign banks among all bank groups.
Inefficiency and higher profits do not go together in an environment of free price
competition. So, better quality of intermediation makes for high costs that do not go
down with the reforms measures.
Figure 4.2.3 also shows that for all other groups and for all scheduled commercial
banks as a whole, the overall trend after the reforms is for the intermediation cost ratio
to go downwards. The maximum and consistent decline is seen in case of nationalised
banks. All through 1980s the Intermediation Cost Ratio (ICR) was almost stagnant;
thereafter till mid 1990s it increases and reaches above 3%. This was largely because
of large expenses under voluntary pre-mature retirement of more than 10 % of their
total staff strength and other expenses on up gradation of technology etc.
Nevertheless, after mid 1990s it decline and by 2012-13 reached nearly 1.41%. Thus,
despite initially increased expenses necessitated in various ways in the process of
implementation of the reforms measures, the intermediation costs had overall falling
trend. For scheduled commercial banks as a whole it fell down from 2.42% in 1989-
90 to 1.84% in 2012-13, a fall of nearly 24% in over 2 decades. Even after the
decline, the intermediation cost continues to be high in relation to the developed
countries.
4.2.9.2 Operating profit to wage bill (in terms of Rs. 1000 spent on employees)
The ratio of operating profit to wage bill gives what is similar to labour productivity
in conventional accounting. It tells per thousand rupees spent on employees what the
extent of profit for each bank groups and all scheduled commercial banks in the
aggregate.
Operating profit to wage bill=
The data relating to the operating profit per employee is sown in the table 4.2.21 and
figure 4.2.4.
228
Table: 4.2.21 Operating profit per employee
In 1000s, Rs. units
All SCBs
All SCBs
(Incl. RRBs)
RRBs)
1980 37.5 47.9 NA NA NA NA NA
1981 39.7 43.1 NA NA NA NA NA
1982 44.2 47.1 NA NA NA NA NA
1983 44.0 41.5 NA NA NA NA NA
1984 36.5 31.4 NA NA NA NA NA
1985 41.2 32.8 NA NA NA NA NA
1986 45.2 64.6 NA NA NA NA NA
1987 46.1 77.9 NA NA NA NA NA
1988-89 67.9 76.3 NA NA NA NA NA
1989-90 79.9 95.5 94.42 1500 64.52 130.50 127.84
1990-91 86.5 106.3 146.15 1524.48 86.58 141.34 139.00
1991-92 1577.0 683.6 976.74 6716.58 -548.85 1188.97 1093.16
1992-93 958.1 205.4 710.06 2753.55 -614.80 569.65 505.26
1993-94 808.2 388.4 1116.09 4471.63 -642.03 721.66 646.93
1994-95 777.2 560.7 1515.34 4454.28 -541.91 827.64 756.70
1995-96 910.6 533.9 1621.75 3367.52 -462.81 832.42 771.44
1996-97 1024.1 610.1 1840.88 3376.69 -190.83 944.88 888.55
1997-98 1012.2 695.5 2138.99 4116.50 194.56 1037.46 995.68
1998-99 846.2 632.6 1433.43 2519.48 373.10 839.94 817.08
1999-2000 985.3 692.4 2150.44 3194.90 573.93 1001.25 981.12
2000-01 732.9 612.7 2215.40 3136.36 725.10 849.30 844.12
2001-02 1289.9 1052.0 2869.19 3128.23 613.01 1367.05 1325.78
2002-03 1514.2 1419.2 3396.20 3591.52 495.14 1718.51 1648.22
2003-04 1719.5 1785.0 3189.20 4155.83 695.07 2010.73 1939.38
2004-05 1689.6 1455.2 2611.28 3353.11 674.34 1730.45 1678.67
2005-06 1408.9 1372.6 2395.88 3320.70 491.32 1625.59 1575.22
2006-07 1365.0 1636.4 2603.15 3122.04 607.93 1825.19 1761.60
2007-08 1694.6 1789.3 2703.82 3360.53 888.56 2092.16 2033.21
2008-09 1898.5 1942.8 2837.79 4115.07 903.69 2311.61 2247.08
2009-10 1586.8 2043.2 3094.62 3463.88 1088.57 2214.29 2162.28
2010-11 1713.1 1875.9 2665.94 3019.43 710.53 2051.76 1985.12
2011-12 1877.8 2109.7 2628.16 3222.24 825.00 2227.07 2158.67
2012-13 1714.1 2007.5 2839.53 3395.88 923.08 2188.37 2134.26
Minimum 36.5 31.4 94.42 1500 -642.03 130.5 127.84
Maximum 1898.5 2109.7 3396.2 6716.58 1088.57 2311.11 2247.08
Mean 899.16 811.16 2074.77 3432.52 330.53 1351.99 1300.68
Standard
688.06 746.67 936.93 1013.87 553.88 679.48 667.43
Deviation
Skewness -0.09 0.52 -0.75 1.05 -0.66 -0.14 -0.11
Kurtosis -1.54 -1.30 -0.31 4.44 -0.93 -1.17 -1.23
Sources and notes are same as in table 4.2.1
229
Column 2 and 3 in the table above shows a sharp jump in the operating profits ( per
1000 rupees spent on employees) of the public sector banks immediately after the
reforms. Post liberalisation years marked by ups and downs; going above and below
1000 levels. After 2001, the ratio though fluctuating is sustained above 1000 i.e., Rs.
1000 operating profit per Rs. 1000 spent on employees. Some of the downturns i.e., in
1992-93,1998-99,2000-01 are partly due to dips in the operating profits as explained
earlier, caused by new prudential accounting norms and changes therein at times.
Some part of the downturn can also be explained by the increases in wage bill. In
1998-99 wage bill would have been substantially gone up with the implementation of
fifth pay commission report.
Figure 4.2.4: Operating profit per employee
8000
7000
6000
5000
4000
3000
2000
1000
0
-1000
-2000
SBG NBs PSB

FBs RRBs All SCBs (Excl. RRBs)
All SCBs (Incl. RRBs)
The figure above shows that the trend for RRBs and private sector banks is almost
steady in upward direction with somewhat constancy in recent years. For the private
sector banks, partly the new banks set up after liberalisation is causing the uptrend. As
in case of foreign banks, they have high profits per employee and when old and new
private banks are taken together as a single group, the overall ratio is increasing (with
new banks increasing in importance in relation to old banks). The ratio for foreign
banks is distinctly higher than all other bank groups for all years. Over the years, the
differential falls with the ratio slightly falling for foreign banks and increasing for
other groups. The average for all scheduled commercial banks (both including and
230
excluding RRBs) is almost steadily increasing. On the whole, the overall picture on
operating profits per employee is that of an uptrend in the post- reform years
(except foreign banks where relative values were substantially high in early
1990s).
4.2.9.3 Business per employee/ labour inputs (in monetary terms)
Bank‘s basic function is accepting deposits and making credit. So the sum of deposits
and loans and advances has been taken to represent business. Employee measure is
taken in monetary terms (i.e., per rupee spent on payment and provisions to
employees) for two reasons. First, consistent data is not available on the number of
employees. Second wage rate increases may not always be accompanied by an
increase in productivity. So it will be the amount spent on hiring of labour force rather
than the number of employees that will reflect a truer measure of productivity.
Business per employee/ labour inputs =
In case of business per employee table 4.2.22 and figure 4.2.5 shows the overall
picture is similar in that in uptrend is noted over the entire period of around one and
half decade after liberalisation. The important difference lies in the years after 2000
where operating profit (relative to wage bill) is almost stagnant or slightly falling for
all bank groups, but business per employee registered a jump for all groups except
foreign banks. The trend for RRBs and private sector banks is almost continuously
upward, the uptrend being very sharp in case of private banks mainly due to entry of
new private banks and greater relative increase in their business. Foreign banks that
had highest business per employee in the initial years registered a downtrend and by
2008-09, they had gone below the other groups (except RRBs). The overall trend for
public sector banks groups (SBI & associates and nationalised banks) all through
1980s is that of almost constancy and till mid 1990s somewhat decline. The trend
thereafter is upward, being moderate in second half of 1990s and a sharp uptrend
thereafter till 2008-09. The average for all scheduled commercial banks as a group
(whether including or excluding the RRBs) fall gradually till the first half of 1990s
,recovers gradually in the second half and thereafter increases sharply
231
Table 4.2.22: Business per employee
In 1000s, Rs. units
All SCBs
All SCBs
(Incl. RRBs)
RRBs)
1980 59 74.64 NA NA NA NA NA
1981 64 76.43 NA NA NA NA NA
1982 67 78.25 NA NA NA NA NA
1983 68 78.99 NA NA NA NA NA
1984 61 71.22 NA NA NA NA NA
1985 58 71.86 NA NA NA NA NA
1986 60 75.11 NA NA NA NA NA
1987 61 78.19 NA NA NA NA NA
1988-89 49 64.25 NA NA NA NA NA
1989-90 68 77.42 51.79 115.03 39.82 73.87 72.50
1990-91 66 76.86 55.31 131.85 36.97 73.65 72.07
1991-92 65 72.21 62.28 142.32 28.47 71.31 68.94
1992-93 61 70.63 69.11 151.26 29.17 69.70 67.49
1993-94 61 69.40 78.92 133.00 32.08 69.43 67.38
1994-95 53 66.74 91.97 127.61 33.39 65.38 63.73
1995-96 48 57.41 89.68 113.60 35.09 57.93 56.85
1996-97 53 60.29 109.29 108.36 38.29 62.80 61.58
1997-98 58 65.44 123.60 116.77 42.47 68.72 67.42
1998-99 60 64.89 125.58 99.95 44.00 68.54 67.34
1999-2000 65 67.47 136.29 98.54 48.91 72.77 71.64
2000-01 59 61.74 159.20 103.22 53.13 67.99 67.38
2001-02 76 75.81 177.23 100.75 49.36 84.74 82.81
2002-03 78 80.49 163.72 117.04 48.97 88.69 86.40
2003-04 78 85.74 170.53 117.21 54.15 93.12 91.00
2004-05 87 93.02 182.10 118.47 61.80 101.37 99.43
2005-06 86 108.58 181.85 105.39 70.67 110.02 108.28
2006-07 107 133.77 183.65 89.93 65.49 129.42 126.08
2007-08 133 157.01 167.76 84.28 76.22 145.09 141.72
2008-09 142 163.07 153.85 77.69 80.60 147.23 144.17
2009-10 126 173.86 154.37 84.01 87.75 149.21 146.49
2010-11 117 152.05 146.19 80.73 93.01 136.39 134.78
2011-12 121 174.24 145.06 87.92 97.97 147.79 145.91
2012-13 129 176.71 148.16 91.69 102.69 152.48 150.67
Minimum 48 57.41 51.79 77.69 28.47 57.93 56.85
Maximum 142 176.71 183.65 151.26 102.69 152.48 150.67
Mean 77.09 92.53 130.31 108.19 56.26 96.15 94.25
Standard
27.19 38.14 43.61 19.88 22.93 33.75 33.31
Deviation
Skewness 1.23 1.37 -0.55 0.36 0.70 0.67 0.67
Kurtosis 0.18 0.32 -1.06 -0.49 -0.70 -1.27 -1.25
232
Figure 4.2.5 Business per employee
200
180
160
140
120
100
80
60
40
20
0
SBG NBs PSB

FBs RRBs All SCBs (Excl. RRBs)
All SCBs (Incl. RRBs)
The figure above shows that the overall trend for all banks is almost steady in upward
direction with somewhat ups and downs. Overall measures of productivity discussed
above have shown a positive trend. These improvements in general could be driven by
two factors. Technology improvements, which expand the range of production
possibilities and a catching up effect, as peer pressure amongst banks compel them to
raise productivity levels. The role of new business practices, new approaches and
expansion of business that has been introduced by new private and foreign banks has
been of utmost importance.
From the above analysis of various banking statistics it is clear that after financial
sector reforms; the banks in all groups have substantially improved their position in
terms of efficiency, productivity and profitability. The maximum gain in performance
has been in case of RRBs in terms of all indicators examined. From high level of
losses, they have turned into profitable entity as a group and the profit levels do not
compare badly with other banks groups and all bank averages. The indictors for
efficiency and productivity have also shown dramatic improvement. Next in line are
the banks in private sector as a group. This is majorly because addition of newly set
up private sector banks to the group with higher profitability and predictability right
from inception. Public sector banks groups (SBI & associates and nationalised banks)
have also shown remarkable improvement in the post- reform period.
233
It is only in case of foreign banks that one does not find any improvement in
productivity indicators and lesser gains in profitability as compared to other bank
groups. Major reasons lie in the fact that these banks had high levels of profitability
and productivity right from the inception. In the environment that has become
competent consequent upon deregulations of interest rates and free entry of new units,
it is not possible to maintain the high differential in profit rates that existed in 1990s.
Nevertheless, profits did increase in relation to total assets, but only at rates lower
than other groups so that there was convergence among profit rates of different bank
groups. Reasons for high intermediation costs also were in the better quality of service
provided. As for productivity, they have much better technology and efficient
working methods, so that their productivity levels are very high in relation to other
bank groups. The salaries paid by these banks are also high. Despite this, productivity
indicators are at higher levels to other groups. One other reason for falling values of
productivity indicators can be higher increases in salaries given by foreign banks.
The all bank averages increased significantly during the post-reform years for
profitability indicators and moderately for the productivity indicators. The poor
performance of RRBs, on both aspects in initial years did not pull down the average
performance because they were in very small proportion in relation to the entire
banking industry. In term of profitability the Indian scheduled commercial banks
stand at a competitive international position. Internationally, a return of 1% on assets
is considered as outstanding. India‘s banking system in 2002 was the second most
profitable in world after US. (Mohan, 2005)
4.2.10 Competition
Theoretically one defines competition as a market structure where exists a large

number of market players selling an identical product so that no one is influential
enough to affect the price that is itself determined by the market forces. All firms are
price takers; there is free entry and exit, absence of any regulations, no transportation
costs or location differences, no communication gaps on relevant information and so
on. In such a scenario efficiency prevails and supernormal profits are absent.
In context of Indian banking system, data clearly shows existence of a large number
of banks branches located throughout the country even prior to the reforms. There
were no hindrances to flow of relevant information. The Indian banking system was,
234
however one of complete absence of competition. The reason lies in administered
rates of interest (both borrowing and lending) that prevailed in the pre liberalisation
period and restrictions on entry of new banks. The banks that existed, though
numerous, were operating in a highly controlled and regulated environment most of
them were in fact in the public sector. Throughout 1980s and in the initial years of
1990s, the public sector banks in aggregate accounted for nearly 90% of total assets of
the banking system. Other financial institutions were also either in the public sector
itself or even otherwise operating in highly controlled and regulated environment. The
situation in the Indian financial system was therefore that of government monopoly.
The governmental policies were such that rather than any monopoly profits; a number
of banks were making negligible or negative profit. If one looks at net profits rather
than operating profits, the situation will be worse. So despite of lack of competition,
there was no exploitation of consumers on account of high rates of interest. The rates
were rather kept low and in fact many segments of the economy were getting
concessional credit.
After liberalisation, the situation has dramatically changed, with deregulation of

rate of interest, there now exists active price competition among different
financial players. With removal on restrictions on entry and exist, a numbers of
private and foreign banks have come on the scene.
The public sector banks share in total assets has declined dramatically although they
still dominate the financial scene. From around 90 % of the total bank assets in the
beginning of 1990s, their share has come down to nearly two third of the total by
2012-13. Moreover even public sector banks are free to access capital market. They
have significantly more freedom in internal decision making and operational
flexibility in management. Apart from high level of competition within the banking
system, there also now exists competition between banks and other financial
institutions. Now SCBs are also increasingly providing term finance and a number of
development banks have started meeting the working capital requirement of business
concern. In addition a number of non-bank financial institutions/companies have also
come up on the scene. Thus post liberalisation period is that of active competition
(closely resembling monopolistic competition), all conditions of competition being
fulfilled. There exists a number of players in the financial market providing (not
235
identical but) similar services. The price i.e., rate of interest is largely determined by
market conditions. Although RBI can substantially affect the interest rate in an
indirect way via changes in bank rate, CRR, repo rate, or other tools at its disposal, its
actions are also largely dictated by market conditions. Of course, there does not
prevail one single rate of interest charged by different banks on loans (or given on
deposits) but the rate always moved in a narrow range. Private and foreign banks
often are able to charge somewhat higher rates, but it is because of the additional
facilities and/or services provided by them to their customers or due to location
advantage enjoyed by them. Free entry and exit prevails. In fact, after liberalisation a
number of unremunerative branches have been closed, amalgamated or taken over by
profitable ones. Ownership is now relatively much more diversified and interference
is minimum. There are no communication gaps in the system and bank branches are
spread across the entire country. All this is not to say that the banking industry has
been entirely left to itself. It is under close supervision of the relevant authorities and
when the situation so requires appropriate corrective measures is also taken.
With active price competition being prevalent, one would expect profit and net
interest margin (spread) to fall and efficiency to increase. However, as discussed
earlier, there were no monopoly profits to be wiped out. In fact, banks had poor
profitability and due to impact of reforms profitability levels have substantially
improved. As for net interest margin, data is presented in table 4.2.23 below. Net
interest margin or spread is the difference between interest earned and interest spent
expressed as percentage to total assets. Prior to liberalisation, both lending and deposit
rates were administered. There was no single lending /deposit rate. The rate structure
was highly complex; a number of concessional rates prevailed; in fact around 3/4 th of
total available finance was to be compulsorily put on concessional terms under CRR,
SLR and priority sector lending. So, on the whole, interest margin was low and
there was no scope for a further fall after liberalisation despite competition.
236
Table 4.2.23: Net interest margin /total assets
All scheduled
All scheduled
State bank of
(incl. RRBs)
sector banks
Nationalised
(excl. RRBs)
Rural banks
commercial
commercial
India & its
associates
Regional
Foreign
Private
banks
banks
banks
banks
Year
1980 0.83 2.37 NA NA NA NA NA

1981 0.81 2.35 NA NA NA NA NA
1982 0.76 2.35 NA NA NA NA NA
1983 0.83 2.43 NA NA NA NA NA
1984 0.93 2.70 NA NA NA NA NA
1985 0.99 2.62 NA NA NA NA NA
1986 0.92 2.53 NA NA NA NA NA
1987 0.90 2.44 NA NA NA NA NA
1988-89 1.17 2.68 NA NA NA NA NA
1989-90 0.88 2.25 0.29 3.13 1.39 3.48 1.81
1990-91 0.88 2.16 0.30 3.46 1.56 3.47 1.82
1991-92 1.94 3.54 0.57 4.98 1.30 6.44 3.33
1992-93 1.58 2.53 0.45 4.57 1.03 4.88 2.52
1993-94 1.41 2.73 0.53 4.99 1.07 4.94 2.56
1994-95 1.69 3.52 0.65 4.24 1.17 5.85 3.02
1995-96 1.74 3.72 0.78 3.83 1.07 6.10 3.16
1996-97 1.73 3.76 0.86 3.92 1.42 6.21 3.24
1997-98 1.57 3.57 0.79 3.50 1.80 5.68 3.00
1998-99 1.47 3.50 0.74 2.95 2.04 5.36 2.85
1999-2000 1.40 3.32 0.84 2.91 2.20 5.24 2.79
2000-01 1.43 3.53 0.96 2.79 2.18 5.47 2.91
2001-02 1.36 3.35 0.87 1.92 2.21 4.96 2.64
2002-03 1.31 3.68 1.06 1.90 2.18 5.35 2.83
2003-04 1.35 3.83 1.24 1.87 2.10 5.52 2.92
2004-05 1.44 3.65 1.27 1.76 2.17 5.48 2.89
2005-06 3.22 2.92 2.74 4.05 2.86 3.04 3.04
2006-07 2.79 2.80 2.54 4.36 3.41 2.86 2.87
2007-08 2.49 2.33 2.67 4.36 3.44 2.54 2.86
2008-09 2.39 2.32 2.86 4.33 3.26 2.62 2.61
2009-10 2.36 2.28 2.91 3.97 3.03 2.55 2.47
2010-11 2.84 2.74 3.10 3.86 3.06 2.91 2.83
2011-12 3.25 2.55 3.09 3.89 3.18 2.90 2.82
2012-13 2.98 2.39 3.22 3.89 2.83 2.79 2.71
Minimum 0.76 2.16 0.29 1.76 1.03 2.54 1.81
Maximum 3.25 3.83 3.22 4.99 3.44 6.44 3.33
Mean 1.62 2.89 1.47 3.56 2.16 4.44 2.77
Standard
0.75 0.56 1.06 0.96 0.80 1.38 0.36
Deviation
Skewness 0.86 0.42 0.64 -0.61 0.13 -0.20 -1.39
Kurtosis -0.33 -1.50 -1.41 -0.51 -1.29 -1.69 2.62
237
The data in the above table is shown graphically in the following figure 4.2.6
Figure 4.2.6: Net interest margin / Total assets

8
State bank of India & its associates Nationalised banks

Private sector banks Foreign banks
Regional Rural banks All scheduled commercial banks (excl. RRBs)
All scheduled commercial banks (incl. RRBs)
The rate of RRBs, private sector banks and foreign banks was lot better, near to 3%.
The spread was highest in case of foreign banks in the years preceding liberalisation.
After liberalisation it increased maximum, all through remaining above all other bank
groups. The other bank groups with noticeable increase are SBI & associate where the
spread increased from 0.83 to 2.98. In case of private sector banks the spread
fluctuates above and below 3% and ended little above 3 %. For the RRBs, the spread
fluctuated and ended at 2.83% in 2012-13. The average for all SCBs moved to above
3% by mid 1990s but then declined to around 3%.
Thus in case of spread there is no marked upward or downward trend. There were
both up and down movements for most bank groups. Overall trend is
predominantly upward, though not marked. One thing worth noting is that by
2008-09 the spread for all bank groups had reached around 3 %. This convergence
indicates competition. The only exception was the foreign banks where it was
substantially higher. The high interest rate differential that these banks could maintain
was because of quality and quantity of services provided by them. It was not lack of
competition but other facilities provided by these banks that they could get deposits at
relatively lower rates and lend at relatively higher rates. Moreover, they are not
concerned with maximising business as is evident in their falling business per
employee ratio.
238
4.3 Relationship between Banking Sector Development and Economic Growth
The importance of financial institutions in generating growth within the economy has
been widely discussed in the literature. Early economists such as Schumpeter in 1911
identified banks‘ role in facilitating technological innovation through their
intermediary role. He believed that efficient allocation of savings through
identification and funding of entrepreneurs with the best chances of successfully
implementing innovative products and production processes are tools to achieve this
objective. Several scholars thereafter (McKinnon 1973, Shaw 1973, Fry 1988, King
& Levine 1993) have supported the above postulation about the significance of banks
to the growth of the economy.
According to the work done by Bayoumi & Melander (2008), a 2½% reduction in
overall credit causes a reduction in the level of GDP by around 1½%. Similarly,
findings have also revealed that economic growth can also be a causal factor for
financial development. This often occurs when the level of development within the
economy is responsible for prompting the growth of the financial system (a reverse
case to the situation earlier described above). Situations with bi-directional causality
have also been observed too. One such study was by Demetriades & Hussein (1996)
who studied 13 countries and observed all three situations described above. They
concluded that the issue of causality is country specific rather than general as earlier
postulated. Several studies like Odedokun (1998) and Ghirmay (2004) lend support
to this postulation.
The above discovery has made it rather important to examine the relationship between
banks and the economy with a view to determining the direction of causality that
exists amongst them. This study will help us to critically assess whether banks
through their role of intermediation can be relied on to stimulate the growth of the
Indian economy. With some research work reporting reverse causality in their study,
it will be necessary also to examine the direction of causality for this study relative to
India.
4.3.1 Variables and methodology
The study employed advanced time series techniques such as Johansen‘s multivariate
cointegration, Vector Error Correction Model (VECM) to examine the short run and
239
long run relationship between banking sector indicators and economic growth of
India. The variables included in the analysis are Economic Growth (EGFC), Gross
Domestic Capital Formation (GDCF) and Institutional Credit to the Private Sector
(CR). All the variables are transformed into natural logarithm form to remove the
problem of heteroscedasticity. The annual time series data for the time span of 1968
to 2013 is analysed.
4.3.2 Results for the Total period (1968-2013)
This section deals with descriptive statistics, line graph and unit root test (Stationarity
test) results, lag selection criteria, co-integration test, long run and short run
relationship, diagnostic test results and stability test of the variables included in the
study.
Descriptive statistics
In order to understand the behaviour of data series included in the study , mean,
median, standard deviation, Skewness, kurtosis and Jarque –Bera are measured and
presented in the table 4.3.1 . It is found that all variables have positive mean value and
positive skewness. Jarque –bera test value and the probability show that the data
series are normal.
Table no. 4.3.1 : Descriptive Statistics of variables (1968-2013)

LNEGFC LNCR LNGDCF
Mean 14.15878 3.075367 3.117980
Median 14.08830 3.054921 3.114109
Maximum 15.51700 4.007432 3.640572
Minimum 13.14971 2.191841 2.570713
Std. Dev. 0.712517 0.556482 0.285435
Skewness 0.349782 0.172977 0.196913
Kurtosis 1.918868 2.139521 2.252033
Jarque-Bera 3.178284 1.648540 1.369561
Probability 0.204101 0.438555 0.504201
Sum 651.3039 141.4669 143.4271
Sum Sq. Dev. 22.84561 13.93524 3.666279
Observations 46 46 46
Notes: LNEGFC- Natural Lag of Economic Growth at Factor Cost, LNCR- Natural
Log of Credit, LNGDCF – Natural Log of Gross Domestic Capital Formation.
240
Line Graph
The basic movement and characteristics of variables can also be understood through
line graph presented below in figure 4.3.1. LNEGFC and LNCR both move in the
same upward direction with some fluctuation while LNGDCF variables show more
fluctuations in the upward trend.
LNEGFC
16.0
15.5
15.0
14.5
14.0
13.5
13.0
70 75 80 85 90 95 00 05 10
LNCR
4.5
4.0
3.5
3.0
2.5
2.0
70 75 80 85 90 95 00 05 10
LNGDCF
3.8
3.6
3.4
3.2
3.0
2.8
2.6
2.4
70 75 80 85 90 95 00 05 10
Figure 4.3.1: Line graph of the variables (1968-2013)
Stationarity Test (Unit Root)
Since many macroeconomic series appear to be non stationary, as Nelson and Plosser
(1982) affirm, so first need to check for the stationarity of the series. Several unit root
tests exist to check for stationarity of the series. In order to proceed for the
cointegration analysis, one must establish that the variables possess the same order of
integration. A variable is called integrated order of ‗d‘, I (d), if it has to be differenced
‗d‘ times to become stationary (Kennedy, 1998). Augmented Dickey-Fuller (ADF)
241
(1981) test and Philips Perron test were used to examine the stationarity
characteristics of the series. Considering the low power of the ADF test, the Phillips
Perron (PP) test (1988), which takes account of the serial correlation and
heteroscedasticity, as an alternative test is also used. Table no.4.3.2 shows the Test
Statistics (TS) and the corresponding Critical Values (CV) at the 5% levels of
significance. The null hypothesis for the presence of a unit root is rejected if the TS
value is bigger (in absolute terms) than the corresponding CV statistic. Rejection of
the null hypothesis implies that the series is stationary. The ADF unit-root test and
Philips Perron test results are shown below:
Table no. 4.3.2: Results of Unit Root Test for the entire period (1968-2013)
ADF
Level/first Calculated–
Variables critical Stationarity
difference test statistics
value 5 %
Economic Growth
Level -0.890539 -3.513075 Not stationary
(LNEGFC)
First
-5.384625 -3.523623 Stationary
difference
Credit(LNCR) Level -1.654093 -3.513075 Not stationary
First
-5.381222 -3.515523 Stationary
difference
Gross domestic Capital
Formation(LNGDCF)
First
-8.721242 -3.515523 Stationary
difference
Level/first Calculated – PP critical
Variables Stationarity
difference test statistics value 5 %
Economic Growth
(LNEGFC)
First
-10.00531 -3.515523 Stationary
difference
First
-5.435418 -3.515523 Stationary
difference
Gross Domestic Capital
Formation(LNGDCF)
First
-8.930198 -3.515523 Stationary
difference
The results in Table 4.3.2 show that the null hypothesis for unit root at the level of all
variables is accepted. The observed CV values are higher than TS in ADF and PP
tests with constant and trend. However, the null hypothesis of the unit root for the first
difference for the LNEGFC, LNCR and LNGDCF is rejected because the TS values
242
of ADF and PP tests are higher than the corresponding critical values (CV). It means
that all the variables are integrated of order I(1) means that all the series are non-
stationary at level but stationary at first difference.
Lag Selection Criteria
The variables are integrated of the same order, so there may be long run cointegration
equation. The step of discovering the long run relationship among explanatory
variable requires an adequate lag length of them in order to remove any serial
correlation. The optimum lag length is usually selected based on AIC, SIC and HQ
test statistic. The reason for using information criterion is to determine the optimal
lags that can balance the risk resulting from the bias when a lower order is selected
and the risk resulting from the increase of variance when a higher order is selected
(Hsiao 1979).
Table no. 4.3.3: VAR Lag order Selection Criteria for the entire period
(1968-2013)
Lag LR AIC SIC HQ

0 NA -2.275900 -2.150517 -2.230243
1 302.2125 -10.00478* -9.503247* -9.822150*
2 9.474718 -9.844424 -8.966741 -9.524820
3 9.306102 -9.705597 -8.451764 -9.249020
4 6.757384 -9.507907 -7.877924 -8.914357
5 17.02361* -9.749828 -7.743694 -9.019305
* indicates lag order selected by the criterion
LR: sequential modified LR test statistic (each test at 5% level),
AIC: Akaike information criterion
SIC: Schwarz information criterion
HQ: Hannan-Quinn information criterion
AIC,SIC and HQ tests indicate that lag order of 1 year should be selected, but LR test
suggest that lag order of 5 year should be selected for the data analysis. It is common
procedure to estimating the model with large number of lags and then reducing down
by re-estimating the model for one lag less until we reach zero lag. In each of the
models, values of the AIC and the SIC criteria, as well as the diagnostics concerning
autocorrelation, heteroscedasticity, possible Autoregressive Conditional
Heteroscedasticity (ARCH) effects and normality of the residuals inspected. Finally
the lag order of 4 years is selected as this model minimizes AIC and SIC value. The
lag order values at lag 1 are closely followed by the lag order values at lag 4.
243
Theoretically it seems that where the impact of finance and capital is involved, lag
order of 1 year is too small time span to obtain meaningful results. Moreover with lag
order 1, the model did not yield theoretically expected signs of coefficients. So lag
order 4 is chosen.
Testing for co-integration
Given that the variables are non-stationary in levels, it was necessary to determine
whether they are cointegrated, in order to support the argument of a long-run
equilibrium and the application of an Error Correction Model (ECM). According to
Engel and Granger (1987), it is always of interest to test whether a set of variables
are cointegrated because of the economic recommendations such as whether the
system is in equilibrium in the long run. E-Views, the statistical package used in this
analysis, implements a Vector Autoregressive (VAR) based cointegration test using
the methodology developed by Johansen (1988). Johansen's method is to test the
restrictions imposed by cointegration on the unrestricted dynamic VAR model
involving the series, and compute both the Trace Statistic and Max-Eigened estimator
in a multivariate relationship.
Table 4.3.4: Trace Cointegration Rank Test (1968-2013)
Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.497475 40.25073 29.79707 0.0022
At most 1 0.167764 12.03820 15.49471 0.1551
At most 2 0.104143 4.508972 3.841466 0.0337
Trace test indicates 1 cointegration at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
Table 4.3.5: Maximum Eigenvalue Cointegration Rank Test (1968-2013)
Hypothesized Max-Eigen 0.05

None * 0.497475 28.21253 21.13162 0.0043
At most 1 0.167764 7.529231 14.26460 0.4286
At most 2 0.104143 4.508972 3.841466 0.0337
Max-eigenvalue test indicates 1 cointegration at the 0.05 level
244
Table 4.3.4 and 4.3.5 presents the results of the cointegration test and show rejection
of the hypothesis of no cointegrating vectors under both the trace and maximal eigen-
value forms of the test. In the case of the trace test, the null hypothesis of no
cointegrating vectors is rejected since the test statistic of 40.25 is greater than 5%
critical value of 29.79. Moving on to test the null of at most 1 cointegrating vectors,
the trace statistic 12.03 is smaller than 5% critical value of 15.49., so the null
hypothesis is accepted. In the case of the Max test, the null hypothesis of no
cointegrating vectors is rejected at 5% critical value since the Max statistic of 28.21 is
greater than 5% critical value of 21.13. Moving on to test the null of at most 1
cointegrating vectors, the Max statistic 7.52 is smaller than 5% critical value of 14.26,
so the null hypothesis is accepted. Therefore, the null hypothesis of no cointegrating
vectors is rejected by the trace test and by the Max test at 5% level. On the basis of
the results it is concluded that there is 1 cointegrating equation among the variables.
Long run relationship
The acceptance of cointegration in the statistic regression meant that the parameter
cointegrating vector contained the long-run equilibrium of the relationship between
economic growth and the respective independent variables. The results of the long-run
equilibrium function are summarised below:
Table no. 4.3.6 : Long Run Relationship (1968-2013)
Dependent variable is LNEGFC ( lag 4)

Independent Variables Coefficient T- ratio
LNCR 4.185928 3.6721*
LNGDCF 2.636587 2.6523*
* indicates 1% level of significance
Table no. 4.3.6 shows that Credit (CR) and Gross Domestic Capital Formation
(GDCF) have positive and significant impact on the economic growth at 1% level of
significance in the long run. An increase of 1 % in credit leads to 4.18% increase in
the level of economic growth. Likewise an increase of 1% in Gross domestic Capital
Formation leads to 2.63 % increase in the economic growth.
245
Short run relationship
The empirical investigation regarding the short run dynamics is important for policy
makers because the signs and magnitudes of the short run dynamics provide the
direction and movements of variables. Thus short run dynamics are estimated through
Vector Error Correction Model (VECM).
Table 4.3.7: Short run relationship (1968-2013)
Variable D(LNEGFC)
Coefficient T- ratio
CointEq1 -0.018785 -4.734748*
D(LNEGFC(-1)) -0.265958 -1.597730***
D(LNEGFC(-2)) -0.443830 -2.471600**
D(LNEGFC(-3)) -0.254875 -1.444958
D(LNEGFC(-4)) -0.585623 -3.482036*
D(LNCR(-1)) 0.038287 0.457023
D(LNCR(-2)) -0.056736 -0.662679
D(LNCR(-3)) -0.046004 -0.556472
D(LNCR(-4)) -0.168254 -2.008895**
D(LNGDCF(-1)) -0.075097 -1.231596
D(LNGDCF(-2)) 0.036321 0.562752
D(LNGDCF(-3)) 0.011938 0.182114
D(LNGDCF(-4)) 0.139211 2.267415**
Constant 0.142839 5.478506*
R-squared 58%, F-stat 2.88 , prob (0.009)
DW-statistic 2.006
*, ** and ***denotes 1%, 5% and 10% level of significance
Table 4.3.7 illustrates the results in which EGFC is the dependent variable. Since the
optimal lag length was four, the short-run results are also presented for four lags of
each variable. The coefficient of the lagged error correction term, representing the
speed of adjustment between the short and the long-run periods, had a coefficient of
- 0.02, being statistically highly significant at 1%. This indicates that deviations from
the short run to the long run are corrected by 0.02 per cent per year. The negative sign
246
is an indicator of model consistency both in the short and long run, and the model
actually converges to long-run equilibrium (Harris and Sollis, 2003).
The past levels of economic growth had a negative impact on current levels of
economic growth as shown by the table at 1year lag is significant at 15 % level, at 2
year lag significant at 5% level and at 4 years lag it is significant at 1 % level of
significance. In the short period all the lag levels of economic growth are negatively
affecting the economic growth. The past levels of credit (CR) for the 4 year lag in the
short run had negative impact on economic growth and statistically significant at 5%
level of significance. This implies that a 1 % increase in the credit (CR) generates
nearly 0.17 % decrease in economic growth.
The past level of Gross Domestic Capital formation(GDCF) for the 4 year lag in the
short run had positive impact on economic growth and statistically significant at 5%
level of significance. This implies that a 1 % increase in the Gross Domestic Capital
formation (GDCF) generates nearly 0.14 % increase in economic growth. This result
supported the Harrod-Domar model which proved that the economic growth will
directly or positively be related to saving ratio and capital formation (i.e. the more an
economy is able to save-and invest, the greater will be the growth of that GDP). In
other words the Harrod-Domar model is applicable to India‘s situations.
Diagnostic and Stability test of the model
The results, in the lower part of table 4.3.7 and table 4.3.8, which relate to the whole
model, are explained below, in order to support the assumption that the estimated
long-run equation indeed represents a cointegrating relationship, and that CointEq1 or
Error Correction Term (ECT) can appropriately be used in the estimation of the short-
run model.
Using the F-statistic to test the null hypothesis that all of the slope coefficients
excluding the constant in a regression are zero, the associated probability value (p =
0.009), rejected the hypothesis of zero coefficients. The entire model is, therefore,
relevant and statistically significant. The value of R-squared is 58% indicates an
appropriate measure of the model's success in predicating the values of the dependent
variable (EGFC) within the sample. The inference is that the explanatory variables are
jointly able to explain up to 58 % of the variation in Economic growth. The study also
247
applied the Durbin-Watson test for checking the autocorrelation among the variables.
The value is 2.006 which is very near to the standard value of 2, so it can be said that
there is no autocorrelation among the variables.
The diagnostic tests are largely intended to establish the strength of the model and its
ability to offer correct and reliable inferences. To ensure that models are not miss
specified, the test for serial correlation, normality and hetroscadasticity are conducted.
The LM (Lagrange Multiplier) test, adopted in this study, is a general test for error
autocorrelation and allows for cases with higher orders or more complex forms of
error correlation (Asteriou and Hall, 2006). The null hypothesis of the LM test is that
there is no serial correlation up to lag order ‗p‘, where ‗p‘ is a pre-specified integer.
The results, indicated in Table no. 4.3.8, show that the test did not reject the null
hypothesis of no serial correlation in the residuals. The null hypothesis of the test is
that there is no serial correlation in the residuals up to the specified order. The
Probability of Chi-Square is 18.34 %, which is greater than 5 %. So we accept the null
hypothesis that there is no serial correlation in the residuals. The implication is that
the model had valid standard errors and could be used for making inferences and valid
economic policy suggestions.
Table no. 4.3.8: Diagnostic Test Result of Economic Growth and Financial
Development
Dependent variable LNEGFC

Test Statistics
Obs*R-squared Prob. Chi-Square
A:Serial Correlation 6.218430 0.1834

B:Heteroscedasticity 1.407234 0.8429
C:Normality Jarque-Bera Probability
0.740264 0.690643
248
It is also necessary to test for heteroscedasticity, which arises when the variance of the
computed standard errors, as the Ordinary Least Squares (OLS) estimates would still
be consistent. White (1980) describes a general test for model mis-specification, since
and independent of the regressors and that the linear specification of the model is
correct (Asteriou and Hall, 2006). The ARCH test is used to test of the null
hypothesis of no heteroscedasticity. In this case, as can be seen from table no. 4.3.8
the Obs*R-squared statistic value of 1.40 had a probability of 84.29 % such that it did
not reject the null hypothesis of no heteroscedasticity.
The histogram Normality Test is used to test the null hyphothesis that residuals are
normally distributed. It can seen from the jarque- Bera value is 0.74 and Probability
is 69.06 % . The probability value is more than 5 %, so the null hypothesis is accepted
that the residuals are normally distributed. The results of the diagnostic test reveal that
the model is well specified, indicating that the estimated Error Correction Model
performs well.
To confirm, it is important to investigate whether the above shown long run

relationship is stable during the study period. In other words researchers have to test
for parameter stability. The methodology used here is based on the cumulative sum
(CUSUM) and cumulative sum of squares (CUSUMSQ) test proposed by Brown et.
al.(1975). Unlike chow test that requires break points to be specified, the CUSUM test
can be used even if we do not know the structural break point. The CUSUM test uses
the cumulative sum of recursive residuals based on the first N observations and is
updated recursively and plotted against break point. The CUSUMSQ makes use of the
squared recursive residuals and follows the same procedure. If the plots of CUSUM
and CUSUMSQ statistics study with in the critical bounds at 5% level of significance
the null hypothesis of all co-efficient in the given regression are stable and cannot be
rejected. If however either the parallel lines are crossed then the null hypothesis of
parameter stability is rejected at the 5% significance level. .
249
As the model helped to find the relationship between variables, it is necessary to
check the stability of the model applied in the study. In addition to testing for the
stability of individual coefficients, Cumulative sum of Recursive Residuals Test
(CUSUM) and Cumulative Sum of Squares of Recursive Residuals test (CUSUMSQ)
test was computed to provide an examination stability of the model.
Figure 4.3.2: Plot of Cumulative Sum of Recursive Residuals (1968-2013)

40
30
20
10
-10
-20
1975 1980 1985 1990 1995 2000 2005 2010
CUSUM 5% Significance
Figure 4.3.3 : Plot of Cumulative Sum of Squares of Recursive Residuals
(1968-2013)
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
1975 1980 1985 1990 1995 2000 2005 2010
CUSUM of Squares 5% Significance
250
Figure 4.3.2 and figure 4.3.3 evidently shows that CUSUM and CUMSUMSQ plots
lie outside the bound. Thus it is providing evidence that parameter of the model suffer
from structural instability over the period. It shows that there is a structural break in
the data series used for the study.
4.3.2.1 Existence of Structural Break
Table 4.3.9: Chow Test Result (1968-2013)

Null hypothesis F-statistics Probability Conclusion
No breaks at specified breakpoints 30.80225 0.0000 Rejected
Note: year 1991 is taken as a break period
The chow test result shown in table 4.3.9 confirms the structural break in the data
during the year 1991. The null hypothesis of no break at specified break point (1991)
is rejected at 1% level. By considering the structural break, for studying the
relationship between banking sector development and economic growth in India, it is
necessary to check the pre-reform and post- reform period performance. Therefore the
study period is divided in to two periods that is pre-reform period (1968-1991) and
post-reform period (1992-2013).
4.3.3 Pre financial sector reform period (1968-1991)

study i.e., economic growth, gross domestic capital formation and credit during the
pre financial sector reform period ( 1968-1991).
In order to understand the behaviour of data series included in the study, mean,
median, standard deviation, Skewness, kurtosis and Jarque-Bera are measured and
presented in the table 4.3.10. It is found that all variables have positive mean value
and negative skewness except economic growth. Jarque-bera test value and the
probability show that the data series are normal.
251
Table 4.3.10: Descriptive Statistics of variables (1968-1991)
LNEGFC LNCR LNGDCF
Mean 13.57791 2.658511 2.909144
Median 13.54796 2.772388 2.922321
Maximum 14.11405 3.131669 3.259335
Minimum 13.14971 2.191841 2.570713
Std. Dev. 0.287697 0.321119 0.171043
Skewness 0.287467 -0.131150 -0.041485
Kurtosis 1.959823 1.481621 2.506433
Jarque-Bera 1.412518 2.374275 0.250493
Probability 0.493487 0.305093 0.882280
Sum 325.8699 63.80427 69.81946
Sum Sq. Dev. 1.903694 2.371705 0.672879
Line Graph
line graph presented below in the figure 4.3.4. The entire variables move in the same
direction with minor fluctuation but there is much fluctuation in the GDCF and CR.
Figure 4.3.4: Line graph of variables (1968-1991)

LNEGFC
14.2
14.0
13.8
13.6
13.4
13.2
13.0
68 70 72 74 76 78 80 82 84 86 88 90
LNGDCF
3.4
3.2
3.0
2.8
2.6
2.4
68 70 72 74 76 78 80 82 84 86 88 90
LNCR
3.2
3.0
2.8
2.6
2.4
2.2
2.0
68 70 72 74 76 78 80 82 84 86 88 90
252
Augmented Dickey-Fuller (ADF) (1981) test and Philips Perron test are used to
examine the stationarity characteristics of the series. Table no. 4.3.11 shows the test
statistics (TS) and the corresponding critical values (CV) at the 5% levels of
value is bigger (in absolute terms) than the corresponding CV statistic. Rejection of
Philips Perron test results are as below:
Table no. 4.3.11: Results of unit root test for pre reform period (1968-1991)
ADF
Calculated
Level/first critical
Variables –test Stationarity
difference value
statistics
5%
LNEGFC Level -1.667027 -3.622033 Not stationary
First
-6.142974 -3.632896 Stationary
difference
LNCR Level -1.597274 -3.622033 Not stationary
First
-3.447723 -3.632896** Stationary
difference
LNGDCF Level -2.674795 -3.622033 Not stationary
First
-6.220959 -3.632896 Stationary
difference
Calculated
Level/first PP critical
difference value 5 %
statistics
First
-9.336802 -3.632896 Stationary
difference
First
-3.421178 -3.632896 Stationary
difference
First
-6.426900 -3.632896 Stationary
difference
** At 1 % otherwise at 5% level of significance
The results of the above table show that the null hypothesis for unit root at the level of
all variables is accepted. The observed CV values are higher than TS in ADF and PP
253
stationary at level but became stationary at first difference.
lag length is usually selected based on AIC, SIC and HQ test statistic. The entire test
indicates that 1 lag order should be selected for the data analysis as shown by the table
4.3.12 below.
Table no. 4.3.12: VAR Lag order Selection Criteria (1968-1991)
Lag LR AIC SIC HQ
0 NA -4.184514 -4.036406 -4.147265
1 117.8991* -9.607120* -9.014688* -9.458125*
LR: sequential modified LR test statistic (each test at 5% level)
Table 4.3.13 and 4.3.14 presents the results of the cointegration test and show
rejection of the hypothesis of no cointegrating vectors under both the trace and
maximal eigenvalue forms of the test. In the case of the trace test, the null hypothesis
of no cointegrating vectors is accepted since the test statistic of 20.39 is smaller than
5% critical value of 29.79. In the case of the Max test, the null hypothesis of no
cointegrating vectors is accepted at 5% critical value since the Max statistic of 10.63
is smaller than 5% critical value of 21.13. Therefore, the null hypothesis of no
cointegrating vectors is accepted by the trace test and by the Max test at 5% level of
significance.

None 0.383318 20.39970 29.79707 0.3961
At most 1 0.284581 9.764858 15.49471 0.2993
At most 2 0.103243 2.397336 3.841466 0.1215
Trace test indicates no cointegration at the 0.05 level
254
Max-
Hypothesized Eigen 0.05
None 0.383318 10.63484 21.13162 0.6836
At most 1 0.284581 7.367522 14.26460 0.4466
At most 2 0.103243 2.397336 3.841466 0.1215
Max-eigenvalue test indicates no cointegration at the 0.05 level
On the basis of the results shown by the tables above, it is concluded that there are no
cointegrating equation among the variables.
It is clear from the cointegration test that no cointegrating vectors are there by the
trace test and by the Max test at 5% level of significance. If there is no cointegration
then there is no long term relationship among the variables. So the VAR with the
difference data is analysed for the short term relationship among the variables. The
empirical investigation regarding the short run dynamics is important for policy
direction and movements of variables. the results are shown in the table 4.3.15 below:
Table 4.3.15: Short run relationship during pre reform period (1968-1991)
Variable D(LNEGFC)
D(LNEGFC(-1)) -0.273990 -1.317829
D(LNCR(-1)) -0.270175 -1.770720**
D(LNGDCF(-1)) -0.135414 -1.400080
Constant 0.068692 5.15549*
R-squared 32 % F-stat 2.78 prob (0.07)
DW-statistic 1.87
*,**and*** denotes 1% , 5% and 10% level of significance
Table no. 4.3.15 illustrates the results in which EGFC is the dependent variable. Since
the optimal lag length is one, the short-run results are also presented for one lags of
each variable. The past levels of credit (CR) for the 1 year lag in the short run had
255
negative impact on economic growth and statistically significant at 5% level of
significance. This implies that a 1 % increase in the credit (CR) generates nearly 0.27
% decrease in economic growth. The past level of Gross Domestic Capital
formation(GDCF) for the 1 year lag in the short run had negative impact on economic
growth but not statistically significant at 5 % level of significance.
The results, in the lower part of the table 4.3.15, which relate to the whole model, are
explained here. Using the F-statistic to test the null hypothesis that all of the slope
coefficients excluding the constant in a regression are zero, the associated probability
value (p = 0.07), rejected the hypothesis of zero coefficients. The entire model is,
therefore, relevant and statistically significant at 10 % level of significance. The value
of R-squared is 32% indicates an appropriate measure of the model's success in
predicating the values of the dependent variable (EGFC) within the sample. The
inference is that the explanatory variables are jointly able to explain up to 32 % of the
variation in Economic growth. The study also applied the Durbin-Watson test for
checking the autocorrelation among the variables. The value is 1.87 which is near to
the standard value of 2, so it can be said that there is no autocorrelation among the
variables.
the model has valid standard errors and could be used for making inferences and valid
Table 4.3.16: Diagnostic Test Result (1968-1991)

Test Statistics

0.2800 0.8693
256
The ARCH test is used to test of the null hypothesis of no heteroscedasticity. In this
case, as can be seen from table 4.3.16, the Probability of Chi-Square is 98.19 %,
which is greater than 5 % that it did not reject the null hypothesis of no
heteroscedasticity.
The Histogram Normality Test is used to test the null hyphothesis that residuals are
normally distributed. It can be seen from the jarque- Bera value is 0.28 and
Probability is 86.93%. The probability value is more than 5%, so the null hypothesis
is accepted that the residuals are normally distributed. The results of the diagnostic
test reveal that the model is well specified, indicating that the estimated Model
performs well.

(CUSUM) and cumulative sum of squares (CUSUMSQ) test proposed by Brown et al
(1975). If the plots of CUSUM and CUSUMSQ statistics study with in the critical
bounds at 5% level of significance the null hypothesis of all co-efficient in the given
regression are stable and cannot be rejected. If however either the parallel lines are
crossed then the null hypothesis of parameter stability is rejected at the 5%
significance level.
15
10
-5
-10
-15
1974 1976 1978 1980 1982 1984 1986 1988 1990
257
Figure 4.3.6: Plot of Cumulative Sum of Squares of Recursive Residuals
(1968-1991)
1.6
1.2
0.8
0.4
0.0
-0.4
1974 1976 1978 1980 1982 1984 1986 1988 1990
Figure 4.3.5 and figure 4.3.6, evidently shows that CUSUM and CUMSUMSQ plots
lie inside the bound. Thus it is providing evidence that parameters of the model are
free from structural instability over the period.
4.3.4 Post financial sector reform period (1992-2013)
test) results, lag selection criteria ,co-integration test ,long run and short run
study i.e., economic growth, gross domestic capital formation and credit during the
post financial sector reform period ( 1992-2013).
presented in the table. It is found that all variables have positive mean value. Jarque -
bera test value and the probability show that the data series are normal.
258
Table 4.3.17: Descriptive statistics of variables during post reform period
(1992-2013)
LNEGFC LNCR LNGDCF
Mean 14.79246 3.530120 3.345802
Median 14.74076 3.444859 3.261837
Maximum 15.51700 4.007432 3.640572
Minimum 14.12825 3.038350 3.081925
Std. Dev. 0.436984 0.367973 0.195770
Skewness 0.162024 0.176852 0.249583
Kurtosis 1.827702 1.432336 1.366356
Jarque-Bera 1.356015 2.367455 2.674796
Probability 0.507627 0.306136 0.262528
Sum 325.4341 77.66264 73.60763
Sum Sq. Dev. 4.010064 2.843481 0.804843
Line Graph
line graph presented below figure 4.3.7. The entire variables move in the same
direction with minor fluctuation but there is much fluctuation in the Gross Domestic
Capital Formation.
259
LNEGFC
15.6
15.2
14.8
14.4
14.0
92 94 96 98 00 02 04 06 08 10 12
LNCR
4.2
4.0
3.8
3.6
3.4
3.2
3.0
92 94 96 98 00 02 04 06 08 10 12
LNGDCF
3.8
3.6
3.4
3.2
3.0
92 94 96 98 00 02 04 06 08 10 12
examine the stationarity characteristics of the series. Table 4.3.18 shows the test
statistics (TS) and the corresponding critical values (CV) at the 5% levels of
value is bigger (in absolute terms) than the corresponding CV statistics. Rejection of
260
Philips Perron test results are as below:
Table 4.3.18: Results of Unit Root Test for post-reform period (1992-2013)
Calculated ADF critical

Level/first
Variables –test value Stationarity
difference
statistics 5%
First difference -3.832045 -3.658446 Stationary
First difference -3.498957 -3.268973*** Stationary
Calculated PP critical
Level/first
difference
statistics 5%
First difference -3.518874 -3.268973*** Stationary
* **indicates 10 % level of significance
The results of the above table show that the null hypothesis for unit root at the level of
all variables is accepted. The observed CV values are higher than TS in ADF and PP
stationary at level but becomes stationary at first difference.
Lag order selection
lag length is usually selected based on AIC, SIC and HQ test statistic. All the test
indicates that 1 lag order should be selected for the data analysis. Here lag order 2 is
261
selected as the values are not so different from the lag suggested by the criterion and
the results are more authentic at lag order 2. The results are shown in following table:
Table no. 4.3.19: VAR Lag order Selection Criteria(1992-2013)
Lag LR AIC SIC HQ

0 NA -4.066211 -3.916851 -4.037054
1 130.8385* -11.34362* -10.74618* -11.22699*
2 11.55892 -11.33277 -10.28725 -11.12867
Testing for cointegration
Table 4.3.20 and 4.3.21 presents the results of the cointegration test and show
rejection of the hypothesis of no cointegrating vectors under both the trace and
of no cointegrating vectors is rejected since the test statistic of 32.40 is greater than
5% critical value of 29.79. Moving on to test the null of at most 1 cointegrating
vectors, the trace statistic 11.03 is smaller than 5% critical value of 15.49, so the null
greater than 5% critical value of 21.13. Therefore, the null hypothesis of no
cointegrating vectors is rejected by the trace test and by the Max test at 5% level of
significance.

None * 0.675255 32.40035 29.79707 0.0245
At most 1 0.440251 11.03076 15.49471 0.2096
At most 2 0.000299 0.005683 3.841466 0.9392
262

None * 0.675255 21.36959 21.13162 0.0463
At most 1 0.440251 11.02507 14.26460 0.1530
At most 2 0.000299 0.005683 3.841466 0.9392
Therefore, the null hypothesis of no cointegrating vectors is rejected by the Trace test
and by the Max test at 5% level of significance. On the basis of the results it is
concluded that there is 1 cointegrating equation among the variables.
equilibrium relationship are presented as below:
Table 4.3.22: Long Run Relationship (1992-2013)
Dependent variable is LNEGFC ( lag 2)

LNCR 0.707726 2.14249**
LNGDCF 1.436522 1.81050
**indicates 5 % level of significance
Notes are same as in the table 4.3.1
Table no. 4.3.22 shows that Credit (CR) has positive and significant impact on the
economic growth at 5% level of significance in the long run. An increase of 1 % in
credit leads to 0.70% increase in the level of economic growth. Likewise an increase
of 1% in Gross domestic Capital Formation leads to 1.44 % increase in the economic
growth but it is not statistically significant at 5 % level.
263
direction and movements of variables. Thus, short run dynamics are estimated
through Vector Error Correction Model (VECM) and the results are shown as below.
Variable D(LNEGFC)
Coefficient t-Statistic
CointEq1 -0.131850 -3.96817*
D(LNEGFC(-1)) -0.569990 -2.13536**
D(LNEGFC(-2)) -0.705412 -2.77481*
D(LNCR(-1)) 0.004647 0.07060
D(LNCR(-2)) 0.000692 0.01138
D(LNGDCF(-1)) -0.018062 -0.35351
D(LNGDCF(-2)) 0.063071 1.45047
Constant 0.152197 5.31761*
R-squared 76 % F-statistic 5.03 Prob. (0.008)
Durbin-Watson stat 2.54
*,**and*** denotes 1%,5% and 10% level of significance
optimal lag length is two, the short-run results are also presented for two lags of each
variable. The coefficient of the lagged error correction term, representing the speed of
adjustment between the short and the long-run periods, has a coefficient of - 0.13,
being statistically highly significant at 1% level. This indicates that deviations from
actually converges to long-run equilibrium (Harris and Sollis, 2003). The past levels
of economic growth had a negative impact on current levels of economic growth as
shown by the 1 and 2 year lag periods at 5 % and 1% level of significance
respectively. The past level of Gross Domestic Capital formation (GDCF) and credit
(CR) for the 1 year lag and 2 year lag in the short run had no statistically significant
impact on economic growth at 1% level of significance.
264
The results, in the lower part of the table 4.3.23, which relate to the whole model, are
explained here. Using the F-statistic to test the null hypothesis that all of the slope
coefficients excluding the constant in a regression are zero, the associated probability
value (p = 0.008), rejected the hypothesis of zero coefficients. The entire model is,
therefore, relevant and statistically significant at 1% level of significance. The value
of R-squared is 76% indicates an appropriate measure of the model's success in
inference is that the explanatory variables were jointly able to explain up to 76 % of
the variation in Economic growth. The study also applied the Durbin-Watson test for
variables.
Table no. 4.3.24: Diagnostic Test Result (1992-2013)

Test Statistics

1.009020 0.603802
case, as can be seen from table no. 4.3.24, the Probability of Chi-Square is 67.38 %,
which is greater than 5% that it did not reject the null hypothesis of no
heteroscedasticity. The histogram Normality Test is used to test the null hyphothesis
that residuals are normally distributed. It can be seen from the jarque- Bera value is
265
1.01 and Probability is 60.38%. The probability value is more than 5 %, so the null
hypothesis is accepted that the residuals are normally distributed. The results of the
diagnostic test reveal that the model is well specified, indicating that the estimated
Model performs well.

(1975). If the plots of CUSUM and CUSUMSQ statistics study with in the critical
bounds at 5% level of significance the null hypothesis of all co-efficient in the given
regression are stable and cannot be rejected. If however either the parallel lines are
crossed then the null hypothesis of parameter stability is rejected at the 5%
significance level. .

10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
-7.5
-10.0
03 04 05 06 07 08 09 10 11 12 13
266
(1992-2013)
1.6
1.2
0.8
0.4
0.0
-0.4
03 04 05 06 07 08 09 10 11 12 13
Figures 4.3.8 and figure 4.3.9 evidently shows that CUSUM and CUMSUMSQ plots
4.4 Direction of Causality
To take policy decision it is important to know which way banking sector

development and economic growth cause each other and therefore an attempt is made
to find out the causality between banking sector development and economic growth in
Indian Context with the help of Toda Yamamoto test. To inspect the causality
between the different variables of the model, the short run and the long run causality
is determined. The first test reveals the significance of the sum of lagged terms of
each explanatory variable by the mean of Chi-square test and the second test indicates
the significance of the error correction term by the mean of the T-test. Table 4.4.1
below illustrates the results of all these causality tests during the total period i.e.,
1968-2013.
267
Table 4.4.1
VAR Granger Causality/Block Exogeneity Wald Tests Result (1968-2013)
Independent variable
ECTt-1
Dependent Chi-sq -statistics
Coefficient
variable (p-value)
[t-ratio]
LNEGFC LNCR LNGDCF All
LNEGFC 0.309656 0.862569 0.890122 -0.018785
(0.5779) ( 0.3530) (0.6408) [-4.73475]*
LNCR 2.597033 0.354779 3.794993 0.007861
( 0.1071) ( 0.5514) (0.1499)**** [ 0.92124]
LNGDCF 3.780728 4.276212 6.958203 -0.004234
(0.0418)** (0.0386)** ( 0.0308)** [-0.34217]

*,**and**** denotes 1% , 5% and 15% level of significance
The Chi-square statistics for the short run dynamics reveals that the null hypothesis of
GDCF does not cause EGFC is not rejected at 1% level of significance and CR not
cause EGFC is not rejected at 1% level of significance. It means that there is no
causality runs from GDCF and CR to Economic Growth in the short run. When EGFC
is dependent variable and all other independent variables are taken together then the
null hypothesis is also not rejected at 1% level of significance means all the variables
taken together cannot cause EGFC. No variable is found that can significantly cause
CR in the short run period, even all the variables when taken together cannot cause
CR at 1% level of significance however at 15 % level it is significant. In the short run
EGFC and CR can cause GDCF at 5 % level of significance. It means that there is
unidirectional causality running from EGFC and CR to GDCF. The causality is also
running from these two variables taken together as independent variable to the GDCF
at 5% level of significance.
In the long run, the error correction term coefficients show that there is long run
causality from the two independent variables such as GDCF and CR to EGFC
meaning that GDCF and CR have influence on dependent variable EGFC in the long
run at 1% level of significance.
268
To inspect the causality between the different variables of the model during the pre-
reform period i.e., 1968-1991, the short run causality is determined as there is no long
run causality among the variables. The short run test reveals the significance of the
sum of lagged terms of each explanatory variable by the mean of Chi-square test.
Table 4.4.2 below illustrates the results of all the causality tests.
Table 4.4.2
Dependent variable Chi-sq -statistics (p-value)
LNEGFC 5.212691 1.003036 9.147961
(0.0224)** ( 0.3166) ( 0.0103)*
LNCR 2.400451 1.138291 4.444202
(0.1213) (0.2860) (0.1084)
LNGDCF 2.850867 0.097768 2.858647
( 0.0913)*** (0.7545) ( 0.2395)

GDCF does not cause EGFC is not rejected at 1% level of significance means that
there is no causality runs from GDCF to Economic Growth in the short run. The null
hypothesis of CR not cause EGFC is rejected at 5% level of significance. It means
that there is unidirectional causality runs from CR to Economic Growth in the short
run. When EGFC is dependent variable and all other independent variables are taken
together then the null hypothesis is also rejected at 1% level of significance means all
the variables taken together can cause EGFC. No variable is found that can
significantly cause CR in the short run period, even all the variables when taken
together cannot cause CR at 1% level of significance. In the short run EGFC can
cause GDCF at 10 % level of significance. It means that there is unidirectional
causality running from EGFC to GDCF.
To inspect the causality between the different variables of the model, the short run
and the long run causality is determined during the post-reform period. The first test
269
reveals the significance of the sum of lagged terms of each explanatory variable by
the mean of Chi-square test and the second test indicates the significance of the error
correction term by the mean of the T-test. Table 4.4.3 below illustrates the results of
all these causality tests during the total period i.e., 1992-2013.
Table 4.4.3
ECTt-1
Coefficient
variable (p-value)
[t-ratio]
LNEGFC 4.737538 1.273156 22.17090 -0.131850
(0.0936)*** (0.5291) (0.0002)* [-3.96817]*
LNCR 0.246588 2.126997 3.405628 0.163337
(0.8840) (0.3452) (0.4924) [ 1.21121]
LNGDCF 1.021458 7.637068 11.61631 -0.050065
(0.6001) ( 0.0220)** (0.0204)** [-0.22547]

GDCF does not cause EGFC is accepted at 1% level of significance and CR not cause
EGFC is rejected at 10% level of significance. It means that there is unidirectional
causality runs from CR to Economic Growth in the short run. When EGFC is
dependent variable and all other independent variables are taken together then the null
hypothesis is also rejected at 1% level of significance means all the variables taken
together can cause EGFC. CR is found that can significantly cause GDCF at 5 % level
of significance in the short run period, even all the variables when taken together can
cause GDCF at 5 % level of significance. Overall results show that in the short run
period, there is unidirectional causality running from CR to EGFC and GDCF.
causality from the two independent variables such as GDCF and CR to EGFC
meaning that GDCF and CR have influence on dependent variable EGFC in the long
run at 1% level of significance.
270
The direction of causality does not change in the pre-reform period and post-reform
period. Supply leading hypothesis is followed in Indian context means that the
development of financial sector may help to improve and lead economic growth by
increasing savings and improving borrowing options and capital formation. Results
are in line with the studies of Bhattacharya and Sivasubramaniyam (2003) and
Amenounve et.al (2005).
4.5 Conclusion
The above analysis shows that the Indian financial sector has developed substantially
in terms of the quantum of deposits and credit, contribution to increased savings and
investment in the economy and with regard to numerous changes in the structure of
the financial sector. In terms of the most of the indicators discussed the developments
subsequent to the reforms have been of much higher magnitude in relation to the
period prior to the reforms. The changes discussed above relate to general
developments of the financial institutions.
The performance of these institutions in particular shows that the commercial banks in
India had experienced strong balance sheet growth and have substantially improved
their profit position in the post reforms period. The profitability is at distinctly higher
levels for all post reform years in comparison to years prior to reforms. Improvement
in the financial health of the banks, as reflected in significant improvement in capital
adequacy and improved asset quality is distinctly visible. All indicators of
productivity that are examined stand at a much higher level today in comparison to
the years prior to the reforms. It is noteworthy that this progress has been achieved
along with adoption of international best practices in prudential norms. Technology
deepening and flexible HRM has largely enabled competitiveness and productivity
gains. The direction of causality does not change in the pre-reform period and post-
reform period. Supply leading hypothesis is followed in Indian context means that the
development of financial sector may help to improve and lead economic growth.
271
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274
CHAPTER- 5
STOCK MARKET DEVELOPMENT AND ECONOMIC GROWTH
In the preceding chapters, the focus of attention had been the financial institutions.
This chapter is devoted to a detailed study of the financial markets. Starting with the
importance of financial markets in an economy, it then brings out the organisation and
the structure of these markets in India and in what way they have been affected by the
reforms undertaken in the financial sector. In the next section relationship and
direction of causality between stock market development and economic growth is
analysed.
5.1 Importance of Financial Markets
It is necessary to have a financial system whereby both financial institutions and

financial markets play an important role from the financial stability perspective. Stock
market is an important and growing ingredient of the financial market, more so in
developing countries. Well developed stock markets may be able to offer different
impetus to investment and growth (Levine and Zervos, 1998). Increasing Stock
Market Capitalisation (SMC) may improve an economy‘s ability to mobilise capital
and diversify risk. On one hand ,there are models that emphasis the tension between
bank based and market based systems (Levine,2002), on the other there exists a
number of studies on financial development and economic growth focussing on
complementarity hypothesis (Demirguc-Kunt and Levine, 2001).
One such study suggests that the stock markets and financial intermediaries have
grown hand in hand in the emerging market economies. Some other studies also find
that the levels of banking developments and stock market liquidity exert a positive
influence on economic growth. Levine and Zervos (1998) shows that initial level of
stock market liquidity and banking developments are positively and significantly
correlated with future rates of economic growth, capital accumulation and
productivity growth.
The capital market fosters economic growth in various ways such as by augumenting
the quantum of savings and capital formation and through efficient allocation of
275
capital that in turn raises the productivity of investment. It also enhances the
efficiency of a financial system as diverse competitors vie with each other for
financial resources. It adds to the financial deepening of the economy by enlarging the
financial system and promoting the use of innovative, sophisticated, and cost effective
financial instruments, which ultimately reduce the cost of capital. Well functioning
capital markets also impose discipline on firms to perform (Beck and Levine, 2002).
Equity and debt markets can also diffuse stress on the banking sector by diversifying
credit risk across the country. While capital markets provide both equity and debt
finance, banks and other financial institutions as intermediaries specialise in providing
debt finance only. Industry level studies have also found a positive relationship
between financial development and economic growth (Rajan and Zingales, 1996),
but an increase in financial development disproportionately boosts the growth of these
companies that are naturally heavy users of external finance.
While considering the role of financial markets, especially the stock market in
economic development, the associated problems and limitations cannot be ignored.
Quite often, the benefits of stock markets are more from the point of view of
maximising speculative returns for the individual investors and market operators. The
efficient market hypothesis mostly does not hold. Actually the stock market
valuations are often incorrect because they are less related to fundamentals and more
to speculative activity and trading. The corporate financing system based on equity
finance displayed a tendency to discourage long term riskier investment in productive
physical cap as companies become preoccupied with short term financial return
considerations to please shareholders and to avoid possible takeovers. The stock
market induced liquidity may encourage investor‘s myopia and weaker investor‘s
commitment. It may reduce investor incentive to exert corporate control and monitor
company‘s performance, which can hurt economic growth. In today‘s liberalised and
globalised economics, stock markets can easily act as conduit for spreading
speculative pressures all over the world (Bhole, 1995 and 2002).
Singh (1997) argues that stock market expansion is not a necessary natural
progression of a country‘s financial development and stock market development may
not help in achieving quicker industrialisation and foster long term economic growth
in most developing countries for several reasons. First because of inherent volatility
276
and arbitrariness of the stock market, the resulting pricing process is a poor guide to
efficient investment allocation. Second in the wake of unfavourable economic shocks,
the interactions between the stock and currency markets may exacerbate macro
economic instability and reduce long term economic growth. Third, stock market
development is likely to undermine the role of existing banking systems in developing
countries.
5.2 The Stock Market in India: Organisation and Structure
The stock markets in India consist of 20 stock exchanges spread all over the country
in 2013. The number increased from 9 in 1979-80 to 22 in 1993-94 and remained
almost constant thereafter. In the year 2007-08 it declined to 19. Two of these
exchanges opened up to derivate trading i.e., futures and options contract in 1999-
2000 and the number of these exchanges increases to 3 in 2013.
India has now the largest number of organised and recognised stock exchanges in the
world. All of them are regulated by Securities and Exchange Board of India (SEBI).
They are organised either as voluntarily non profit making associations or public
limited companies or companies limited by guarantee. There are number of brokers
(including corporate brokers and sub brokers), besides these there are Foreign
Institutional Investors (FIIs) depository participants, portfolio managers, merchant
bankers and so on. Numerous underwriters, debenture trustees, venture capital funds,
registrars to issue and mutual funds support these.
All stock exchanges have two parts
 The New Issue Market (NIM) or Primary Market (PM) and

 The Secondary Market(SM).
New issue market supplies additional capital to companies, the secondary market does
not directly supply fresh capital, but encourages investors to invest more in industrial
securities by making them more liquid. It provides facilities for continuous and
regular trading in these securities.
The Bombay Stock Exchange (BSE) is the apex stock exchange in India. It is the
oldest market and has been recognised permanently, while recognition for other
exchanges is renewed every five years. It is biggest in terms of size and amount of
277
fresh capital raised, secondary market turnover and capitalisation and the total listed
companies. Its business is no longer confined to Mumbai alone; there are 100 other
cities in which it had set up its business.
Apart from BSE, there are two other stock exchanges in Mumbai, Viz the National
Stock Exchange (NSE) of India Ltd. and Over The Counter Exchange of India
(OTCE). The NSE has a fully automated electronic screen based trading system. It
has two separate segments .First is the Wholesale Debt Market Segment (WDMS)
that caters to banks, financial institutions and other institutional participants and deals
in public sector government bonds, units, treasury bills, government securities, call
money, Commercial Paper (CP) etc. Second is the Capital Market Segment (CMS)
which deals in equities, convertible debentures etc. The NSE allows its members to
trade from their offices through a communication network.
OTCE was set up in 1992. It is the first stock exchange in India to introduce screen
based automated ring less trading system. The securities that are traded on OTCE
cannot be traded on other stock exchanges. However they can be bought and sold at
any of the OTCE counters all over India. It has an online trading cum-depository
quote driven and transparent system of trading. It provides liquid cash markets for
retail investors. The existence of market makers and the modern trading and
settlement system on it ensures deliveries vs payment on time. There are no problems
of bad deliveries or short deliveries because the system allows the execution of trades
only on the basis of electronic inventory of scripts. It encourages domestic and foreign
institutional investors also to trade on it by offering them netting facilities for both
intra-custodian and inter-custodian transactions. The trading on the OTCE is based on
the roll over concept that means all trading done on any day is settled on the same day
itself. Netting with previous day or subsequent day transactions is not permitted. Thus
OTCE is a cash and retail market for small investors and small companies. With time
however, the focus of its activity is shifting to bigger permitted scripts.
A part from the above stock exchanges in Mumbai there are 17 other national and
regional exchanges located in metropolitan centres and other cities in India. After mid
1990s, the turnover of these exchanges has gone down drastically. The relative
position of BSE has also goes down over the years although it is still is the premier
institution. It is the NSE that has gained in importance, together BSE and NSE
278
account for more than 95% of the total turnover. Thus, at present stock market in
India is mostly co-existent with only NSE and BSE.
In addition to the official stock exchanges, there are about more than 40 unofficial
stock exchanges operating as brokers associations. They are not recognised by SEBI,
but some of them transact considerable amount of business. In addition there are kerb
and illegal badla markets doing the securities trading business.
5.3 Objectives of Stock Market Reforms
Although the capital market in India has a long history, during most part, it remained
on the periphery of the financial system. Various reforms undertaken since the early
1990s by the SEBI and the government of India have brought about a significant
structural transformation in the Indian capital market. The reforms have been
implemented in a gradual and sequential manner, based on international best
practices; modify to suit the country‘s needs. The reform measures were aimed at:
 Creating growth enabling institutions.

 Boosting competitive conditions in the equity market through improved price
discovery mechanism.
 Putting in place an appropriate regulatory framework.
 Reducing the transaction cost.
 Reducing information asymmetry, thereby boosting the investor confidence.
The significance of a well functioning of domestic capital market has also increased
as the banks need to raise necessary capital from the market to sustain their growing
operations.
5.4 Reforms in Indian Stock Market
Since the initiation of the financial liberalisation programme in 1991, there have been
substantial regulatory, structural, institutional and operational changes in the
securities market of the country. These reforms were carried out with the objective of
improving market efficiency, enhancing transparency, preventing unfair trade
practices and bringing the Indian securities market up to international standards.
Major reform measures undertaken were the following.
279
SEBI as a Statutory Body
The Securities and Exchange Board of India (SEBI) set up as an administrative body
in April 1988, was given statutory status on November 1992 by the promulgation of
the SEBI Ordinance. The objective of setting up of SEBI is to protect the interest of
investors in securities, and to promote the development of securities market and to
regulate it. Its regulatory jurisdiction extends over corporate bodies in the issuance of
capital and transfer of securities and to all the intermediaries and persons associated
with securities market. After the repeal of the Capital Issues (Control) Act 1947 in
1992, SEBI has vested with the powers so far exercised by Controller of Capital
Issues. SEBI has the responsibility of prohibiting fraudulent and unfair trade practices
relating to securities market and of regulating substantial acquisition of shares and
takeover of companies. SEBI also has the powers to impose monetary penalties and to
levy fees from market intermediaries. In a recent amendment to the SEBI Act, the
regulator has also been given search and seizure powers.
Introduction of Screen-Based Trading
Prior to 1990‘s, the trading on stock exchanges in India used to take place through
floor-based open outcry system, which was inaccessible to users. This system neither
allowed immediate matching or recording of trades, nor did it provide price-time
priority, which made it difficult to ensure that a trade was executed at the best
possible price. Besides, this system was time consuming and resulted in high
transaction costs. In order to provide efficiency, liquidity and transparency in
securities trading, fully automated screen based trading system was introduced in
most of the stock exchanges. The NSE pioneered this system of trading by launching
the automated trading system NEAT (National Exchange for Automated Trading)
in1993. Following NSE, BSE introduced BSE Online Trading Platform (BOLT) in
1995 and many other exchanges followed suit. In on-line trading system orders are
electronically matched on price-time priority and hence cut down on time and cost. It
enables market participants to see the full market on real-time, making the market
transparent. It also allows a large number of participants, irrespective of their
geographical locations, to trade with one another simultaneously, improving the depth
and liquidity of the stock market.
280
Entry of Foreign Institutional Investors
As part of a move towards global integration, Foreign Institutional Investors (FIIs),

were allowed to invest in the Indian securities market from September, 1992.
However, investments by them were first made in January 1993. Each FII need to be
registered with SEBI initially for a period of five years and it can operate through
opening an office in India or through a sub-account with a local company. All FIIs are
required to buy or sell only for delivery and they are not allowed to offset a deal or to
sell short. FIIs are permitted to trade in exchange traded derivatives from June 1998.
As per the original policy of 1992, registered FIIs could individually invest in a
maximum of five per cent of a company‘s issued capital and all FIIs together up to a
maximum of 24 per cent. The five per cent individual FII limit was raised to ten per
cent in June 1998. As of March 2001, FIIs as a group were allowed to invest in excess
of 24 per cent and up to 40 per cent of the paid up capital of a company with the
approval of the general body of the shareholders granted through a special resolution.
It was further enhanced to sectoral FDI limit in September 2001. Now, investments by
the FIIs have become a crucial factor in the movement of share prices in India. They
also have an impact on stock market behaviour mainly through effects on interest
rates and asset prices. Their investments enjoy full capital account convertibility.
Introduction of Depository Receipts
The process of integration received a major impetus when the Indian corporate was
allowed to go global with the issue of Global Depository Receipts (GDR)/ American
Depository Receipts (ADR)/Foreign Currency Convertible Bonds (FCCB) from
November 1993. While bunching of Depository Receipts (DRs) issues took place in
view of the pent-up overseas demand for Indian securities, it was primarily motivated
by the costly procedure of floatation in the domestic market (Patil, 1994). Initially,
companies seeking to float DRs were required to obtain prior permission from the
Department of Economic Affairs. To be eligible, companies should have a consistent
track record of good performance for a minimum of three years. The infrastructure
companies were exempted from the latter requirement in June 1996. The restrictions
on number of DRs issued were also removed along with it. The end-use restrictions
on Euro issues were removed in May 1998. In December 1999 Indian software
companies, in March 2000 other knowledge-based companies, and in April 2001 all
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types of companies were permitted to undertake overseas business acquisition through
ADR/GDR stock swaps. In January 2000, companies were made free to access the
GDR/ADR market through an automatic route operated by the RBI, without the prior
approval of the Government of India or the track record condition. Similarly,
companies were allowed in phases to utilise, without any prior approval, part of the
DRs proceeds for overseas investment and finally upto 100 per cent of the proceeds
from February 2001.
DRs can be redeemed at the price of the corresponding shares of the issuing company
ruling on the BSE or NSE on the date of redemption. Similar norms apply to
conversion of FCCBs. The ordinary shares and FCCB issued against the DRs are
treated as Foreign Direct Investment (FDI). The aggregate of foreign equity
participation directly or indirectly through the DR mechanism should not exceed 51
per cent of the issued and subscribed capital of the issuing company. Two-way-
fungibility in DR issues of Indian companies has been introduced from February 13,
2002 whereby converted local shares could be reconverted into DRs subject to
sectoral caps on FDI. Interest payments and dividend on these instruments are subject
to tax deduction at source at the rate of 10 per cent. Capital gains on account of
transactions among non-resident investors outside India are free from any income tax
liability in India.
Introduction of Depository System
For modernising the settlement system the Depositories Act was passed in 1996,
which provided for the establishment of depositories in securities. The objective of
this Act is to reduce settlement risk arising out of bad delivery, the time taken for
settlement and due to the physical movement of paper. It aims at de-materialisation of
securities in the depository mode and providing for maintenance of ownership records
electronically in a book entry form. The Act also envisages transfer of ownership of
securities electronically by book entry with making securities move from person to
person. Accordingly two depositories were set up in the country, viz. the National
Securities Depository Limited (NSDL) and the Central Depository Services Limited
(CDSL), to provide instantaneous electronic transfer of securities. It has been now
made mandatory that all new securities issued should be compulsorily traded in de-
materialised form. The admission to a depository for de-materialisation of securities
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has been made a pre-requisite for making a public or rights issue or an offer for sale.
It has also been made compulsory for public limited companies making Initial Public
Offer of any security for Rs. 10 crores or more only in dematerialised form.
Derivatives Trading
The suggestion to introduce derivative trading in Indian securities market was first
made by the L.C. Gupta committee (1998). It suggested the introduction of
derivatives in order to assist market participants to manage risks better through
hedging, speculation and arbitrage. Accordingly, the Securities Contracts (Regulation)
Act was amended in 2001 to introduce derivative trading in NSE and BSE. The
market presently offers index futures and index options on S&P CNX NIFTY, CNX
IT Index, CNX Bank NIFTY Index, and BSE 30 Index. Stock futures and stock
options on individual stocks and futures in interest rate products like T-bills and
bonds are also introduced.
Demutualisation of Stock Exchanges
Traditionally, stock exchanges were organised in the form of clubs, with the
ownership and control vested with the brokers. In case of disputes, often the interests
of the brokers alone are protected, leaving the investors at the losing end. Therefore to
reduce the dominance of trading members in the management of stock exchanges, the
Government proposed to corporatize the stock exchanges by which ownership,
management and trading membership would be segregated from one another. Out of
the total stock exchanges of the country, only two stock exchanges, i.e. OTCEI and
NSE are de-mutualised. A few exchanges have started the de-mutualisation process.
Risk Management Mechanism
With a view to avoid any kind of market failures, the stock exchanges have developed
a comprehensive risk management system, which is constantly monitored and
upgraded. It encompasses capital adequacy of members, adequate margin
requirements, limits on exposure and turnover, indemnity insurance, on-line position
monitoring and automatic disablement. To eliminate the counter-party risk that arises
from electronic trading, the NSE set up a clearing corporation, the National Securities
Clearing Corporation Ltd. (NSCCL) in 1996. The NSCCL assured the counter-party
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risk of each member and guaranteed financial settlement. NSCCL established a
Settlement Guarantee Fund to provide a cushion for any residual risk and operated
like a self-insured mechanism wherein members contribute to the Fund. In the event
of failure of a member to meet his obligations, the fund is utilised to the extent
required for the successful completion of the settlement. This has eliminated counter-
party risk of trading on the exchange.
Investor Protection Measures
Investors in securities market have been facing serious problems in view of market
disturbances arising out of the inefficiencies of the system. Hence, the SEBI Act
entrusted SEBI with the primary objective of protecting the interests of investors in
securities and empowered it to achieve this objective. The Central Government has
established a fund called Investor Education and Protection Fund in October 2001, for
the promotion of awareness amongst investors and protection of the interest of the
investors. Department of Economic Affairs (DEA), Department of Company Affairs
(DCA), the SEBI and the stock exchanges have set up investor grievance cells for
redressal of investor grievance. The exchanges maintain investor protection funds to
take care of investor claims. The DCA has also set up an investor education and
protection fund for the promotion of investors‘ awareness and protection of interest of
investors. All these agencies and investor associations are organizing investor
education and awareness programmes. In January 2003, SEBI launched a nation-wide
Securities Market Awareness Campaign that aims at educating investors about the
risks associated with the market as well as the rights and obligations of investors.
Introduction of Rolling Settlement
Indian stock market in the early nineties used ‗future-style settlement‘ with fortnightly
settlement cycle. Often, this cycle was not adhered to and on several occasions led to
defaults and risks in settlement. Besides, a peculiar market practice called ‗badla‘
allowed brokers to carry positions across settlements. In other words, even open
positions at the end of the fortnight did not always get settled. In order to reduce large
open positions, SEBI over a period reduced the trading cycle to a week. Stock
exchanges, however, continued to have different weekly trading cycles, which
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enabled shifting of positions from one exchange to another. Rolling Settlement was
introduced by SEBI for the first time in 1998 by making it optional for demat scrips.
Rolling settlement on T+5 bases was introduced in 2000 with respect of specified
scrips reducing the trading cycle to one day. All scrips moved to rolling settlement
from December 2001. The settlement period has been reduced progressively fromT+5
to T+3 days. Currently, T+2 day rolling settlement with one day trading cycle is being
followed, i.e. trades taking place over a day are settled together after two working
days.
Reduction of Transaction Costs
In the pre-reforms period transaction costs in the Indian securities market was high
due to high order processing and brokerage related costs, which are caused by entry
barriers into the brokerage industry and costs of clearing and settlement. With
increased competition and free entry in the post-liberalisation period, brokerage
related costs went down. Similarly, costs relating to clearing and settlement also went
down thanks to the dematerialisation of shares and adoption of rolling settlement
system. For those who use the services of NSDL, transaction costs have come down
to one-tenth of previous levels, which is comparable to those seen on the best markets
overseas.
5.5 Recent reforms
In the overall context of the evolving macroeconomic situation in the country and
global financial developments, the government in close collaboration with the RBI
and SEBI has recently taken a number of initiatives to meet the growing capital needs
of the Indian economy. Some of the initiatives are as follows:
2010-2011
 The Government in its Budget 2010-11 announced the setting up of the
Financial Sector Legislative Reforms Commission (FSLRC) with a view to
rewriting and cleaning up financial-sector laws to bring them in tune with
current requirements. The Commission will review, simplify, and rewrite
legislation focusing on broad principles. It will evolve a common set of
principles for governance of financial-sector regulatory institutions. The
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Commission will also examine the case for greater convergence of regulation
and will streamline the regulatory architecture of financial markets.
 With a view to strengthening and institutionalizing the mechanism for
maintaining financial stability and development, the Government set up an
apex-level body—the Financial Stability and Development Council (FSDC).
 A prospective borrower can access External Commercial Borrowings (ECBs)
under two routes, automatic and approval routes. As per extant norms,
infrastructure finance companies (IFCs), i.e. NBFCs categorized as IFCs by
the RBI were permitted to avail of ECBs for on-lending to the infrastructure
sector, as defined in the extant ECB policy, under the approval route. As per
the extant policy, using ECBs to refinance domestic rupee loans was not
permitted. At present, entities in the services sectors, namely hotels, hospitals,
and software are allowed to avail of ECBs up to US$ 100 million per financial
year under the automatic route, for foreign currency and/or rupee capital
expenditure for permissible end-uses.
 It was decided to increase the limit of FII investment both in Government
securities and corporate bonds by US $ 5 billion each, raising the cap to US$
10 billion and US$ 20 billion respectively. The incremental limit of US$ 5
billion has, however, to be invested in securities with residual maturity of over
five years and corporate bonds with residual maturity of over five years issued
by companies in the infrastructure sector.
 The Financial Action Task Force (FATF) is an inter-Governmental body,
responsible for setting global standards on Antimony Laundering (AML) and
Combating the Financing of Terrorism (CFT). On 25 June, 2010 admitted
India as 34th Country Member of the FATF.
 On 15 December, 2010 India gained membership of the Eurasian Group On
Anti-money Laundering And Combating The Financing Of Terrorism (EAC)
which is an FATF-style regional body, responsible for enforcing global AML
and CFT standards. The support for India‘s membership was unanimous. India
is the ninth member of the group.
2011-2012
 Guidelines on Credit Default Swaps (CDS) for Corporate Bonds were issued
by the RBI on 23 May 2011, outlining broad norms including the eligible
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participants and other requirements. It was also indicated that market
participants would have to follow the capital adequacy guidelines for CDS
issued by their respective regulators.
 Trading in Interest Rate Futures (IRF) contracts on 91-day Government of
India (GOI) Treasury Bills (T-Bill) was introduced at the NSE on 4 July 2011.
 Qualified Foreign Investors (QFIs) were allowed to directly invest in the
Indian equity market in January 2012. This was done to widen the class of
investors, attract more foreign funds, reduce market volatility, and deepen the
Indian capital market.
 SEBI-registered MFs to accept subscriptions for equity schemes from foreign
investors who meet the Know Your Customer (KYC) requirements.
 In November 2011, the government reviewed the policy in the context of
India‘s evolving macroeconomic situation and the need for enhancing capital
flows and making available additional financial resources for the corporate
sector and decided to (i) increase the current limit of FII investment in
government securities by US $ 5 billion, raising the cap to US $ 15 billion (the
incremental limit of US $ 5 billion can be invested in securities without any
residual maturity criterion); and (ii) increase the current limit of FII
investment in corporate bonds by US $ 5 billion, raising the cap to US $ 20
billion (the incremental limit of US $ 5 billion can be invested in listed
corporate bonds).
 The investment limit in long-term infrastructure corporate bonds, however,
has been kept unchanged at US$ 25 billion. With this, overall limit for FII
investment in corporate bonds and government securities now stands at US$
60 billion.
 In November 2011, ECB policy was modified keeping in view the
developments in global financial markets and macro-economic conditions.
The all-in-cost ceiling was enhanced and the proceeds of ECBs raised abroad
for Rupee expenditure in India should be brought immediately.
 In December 2011, Moody‘s has upgraded the rating on long-term
government bonds denominated in domestic currency from Ba1 to Baa3 (from
speculative to investment grade). The long-term country ceiling on foreign
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currency bank deposits has been upgraded from Ba1 to Baa3 (from speculative
to investment grade).
2012-2013
 SEBI (Alternative Investment Funds) Regulations, 2012 introduced With a

view to extending the reach of regulation to unregulated funds, ensuring
systemic stability, increasing market efficiency, encouraging new capital
formation, and providing investor protection, SEBI has notified new
regulations covering Alternate Investment Funds (AIFs) under three broad
categories.
 With the objective of promoting financial education in a synergistic manner,
under the aegis of the Financial Stability and Development Council (FSDC)
Sub-Committee a draft National Strategy on Financial Education has been
formulated and public consultation on the same has been undertaken.
 Pursuant to the budget announcement of 2012-13, the Ministry of Corporate
Affairs (MCA) on 1 October 2012, the RBI and SEBI on 28 August 2012 have
carried out amendments to the existing legal framework to facilitate two-way
fungibility in Indian depository receipts.
 On 23rd November 2012, the government notified a new tax saving scheme
called the Rajiv Gandhi Equity Savings Scheme (RGESS), exclusively for
first-time retail investors in the securities market. This scheme provides 50 per
cent deduction of the amount invested from taxable income for that year to
new investors who invest up to 50,000 and whose annual income is below 10
lakh. The operational guidelines were issued by SEBI on 6 December 2012
 As mandated in the Union Budget 2012-13 for top listed companies to offer
electronic voting facility to their shareholders, SEBI has come out with the
necessary amendments in this regard on 13 July 2012, to be incorporated in
the equity listing agreement by stock exchanges.
 Separate trading platforms for Small and Medium Enterprises (SMEs) were
launched and became functional at the BSE and NSE in March 2012 and
September 2012 respectively. As on 14 January 2013, the number of equities
listed on the BSE and NSE, SME platforms is 12 and 2 respectively.
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 Following the announcement in Union Budget 2012-13, the rate of the
Securities Transaction Tax (STT) has been revised downwards by 20 per cent
to 0.1 per cent from 0.125 per cent for delivery-based transactions in the cash
market, effective 1 July, 2012.
 Based on the recommendations of the Dr. Bimal Jalan Committee, new
Securities Contracts (Regulation) (Stock Exchanges and Clearing
Corporations) Regulations 2012 were notified on 20 June 2012 to regulate
recognition, ownership, and governance in stock exchanges and clearing
corporations.
 In Budget 2011-12, the government, for the first time, permitted Qualified
Foreign Investors (QFIs), who meet the Know-Your-Customer (KYC) norms,
to invest directly in Indian Mutual Funds (MFs). In January 2012, the
government expanded this scheme to allow QFIs to directly invest in Indian
equity markets. Taking the scheme forward, as announced in Budget 2012- 13,
QFIs have also been permitted to invest in corporate debt securities and MF
debt schemes subject to a total overall ceiling of US$ 1 billion. In May 2012,
QFIs were allowed to open individual noninterest- bearing rupee bank
accounts with authorized dealer banks in India for receiving funds and making
payment for transactions in securities they are eligible to invest in.
 In June 2012, the FII limit for investment in G-Secs (government securities)
was enhanced by US $ 5 billion, raising the cap to US $ 20 billion.
 The important steps taken in the arena of external commercial borrowings
(ECB) policy liberalization include: Enhancing the limit for refinancing rupee
loans through ECB from 25 per cent to 40 per cent for Indian companies in the
power sector, Allowing ECB for capital expenditure on the maintenance and
operation of toll systems for roads and highways so long as they are a part of
the original project subject to certain conditions, and also for low cost housing
projects. Reducing the withholding tax from 20 per cent to 5 per cent for a
period of three years (July 2012- June 2015) on interest payments on ECBs
Introducing a new ECB scheme of US $10 billion for companies in the
manufacturing and infrastructure sectors. Permitting the Small Industries
Development Bank (SIDBI) as an eligible borrower for accessing ECB for on-
lending to the Micro, Small and Medium Enterprises (MSME) sector subject
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to certain conditions. Permitting the National Housing Bank (NHB)/ Housing
Finance Companies to avail themselves of ECBs for financing prospective
owners of low cost / affordable housing units.
2013-14
 Various policy reform measures were implemented in consultation with all

market regulators and the Ministry of Corporate affairs (MCA) to improve the
regulatory regime and stimulate the growth of the corporate bond market:
Strengthening of the legal framework for regulation of corporate debt by
amendments in rules/regulations formulated by the MCA, Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFESI) Act, and Income Tax Act., Amendment in definition of deposit in
Companies (Acceptance of Deposits) Rules 1975. Development of securitized
debt market by ensuring clarity in taxation policy for securitized debt,
Rationalization of Withholding Tax (WHT) on FIIs for G-Secs and corporate
bonds, Encouragement of public issuance of corporate bonds for raising Tier II
capital by banks, especially since banks are viewed as more reliable by public
investors, Setting up of Central Counter Party (CCP) and creation of trade
guarantee fund for trading in corporate bonds in stock exchanges, New trading
platform and risk management system for corporate bonds including a
centralized database on outstanding amount, settlement value, and traded
volume to eliminate fragmentation of information.
 The Securities Contracts (Regulation) Rules (SCRR) 1957 provide for non-
promoter, public shareholding for all listed companies to be 25 per cent
(except for government-owned public sector enterprises where the threshold is
10 per cent).
 A framework to permit small and medium enterprises, including start-up
companies, to list on the SME exchange without being required to make an
IPO, was announced in the Union Budget 2013-14.
 The Securities Transaction Tax (STT) has been reduced for equity futures
from 0.017 per cent to 0.01 per cent in 2013-14. At the same time the
Commodities Transaction Tax (CTT) rate on non-agricultural commodities
futures contracts has been harmonized at the same rate as on equity futures.
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 Following the K. M. Chandrasekhar Committee recommendations, SEBI has
notified new Foreign Portfolio Investor (FPI) regulations on 7 January 2014 to
put in place a framework for registration and procedures with regard to foreign
investors who propose to make portfolio investment in India.
 The portfolio investor registered in accordance with SEBI guidelines shall be
called Registered Foreign Portfolio Investor (RFPI). The existing portfolio
investor class, namely FII and Qualified Foreign Investor (QFI) registered
with SEBI shall be subsumed under RFPI. An RFPI may purchase and sell
shares and convertible debentures of an Indian company through a registered
broker on recognized stock exchanges in India as well as purchase shares and
convertible debentures which are offered to public in terms of relevant SEBI
guidelines/ regulations. An RFPI shall be eligible to invest in government
securities and corporate debt and all exchange-traded derivative contracts on
the stock exchanges subject to limits prescribed by the RBI and SEBI. This
move is expected to streamline the foreign investment process in India for all
FPIs.
 A committee was set up to review the American Depository Receipt
(ADR)/Global Depository Receipt (GDR) scheme of 1993 keeping in view the
new company law and the recent legislations in the financial markets; the
needs of the Indian companies and foreign investors; and the need for
simplification and legal clarity of the Scheme. The Committee submitted its
report on 27 November 2013. The government has accepted the report and the
new scheme suggested by the Committee would be notified at a later stage
after the necessary tax-related amendments are made.
 International Finance Corporation [IFC(W)], a member of the World Bank
Group, launched a US$1 billion offshore bond programme-the largest of its
kind in the offshore rupee market-to strengthen India‘s capital markets. Under
the programme, the IFC will issue rupee-linked bonds and use the proceeds to
finance private-sector investment in the country. The IFC‘s offshore bond
programme will help bring depth and diversity to the offshore rupee market
and pave the way for an alternative source of funding for Indian companies.
 The GoI in consultation with the RBI has progressively enhanced the limits for
FII investments in the domestic debt (G-Sec as well as corporate debt) market
291
keeping in view India‘s evolving macroeconomic scenario. The FII debt limits
have now been enhanced to US$ 81 billion (corporate bond US$ 51 billion
and G-Secs US$ 30 billion) from the earlier US$ 66 billion.
 With a view to revamping financial-sector laws to bring them in tune with
current requirements, the GoI set up the Financial Sector Legislative Reforms
Commission (FSLRC) on 24 March 2011. The Commission submitted its
Report on 22 March 2013. The FSLRC has given wide-ranging
recommendations on the institutional, legal, and regulatory framework, and
operational changes in the Indian financial sector. Broadly, the
recommendations of the Commission can be divided into two parts, legislative
and non-legislative aspects. The legislative aspects of the recommendations
relate to revamping the legislative framework of the financial-sector
regulatory architecture through a non-sectoral, principle-based approach and
by restructuring existing regulatory agencies and creating new agencies
wherever needed. The Commission has recommended a seven-agency
structure for the financial sector. The non-legislative aspects of the FSLRC
recommendations are broadly in the nature of governance-enhancing
principles for enhanced consumer protection, greater transparency in the
functioning of financial-sector regulators in terms of their reporting system,
greater clarity on their interface with the regulated entities, and greater
transparency in the regulation making process by means of mandatory public
consultations, incorporation of cost-benefit analysis, etc.
 The Financial Stability Board (FSB) was established in 2009 under the aegis
of the G20 bringing together the national authorities, standard-setting bodies,
and international financial institutions to address vulnerabilities and to develop
and implement strong regulatory, supervisory, and other policies in the interest
of financial stability. India is an active Member of the FSB. The FSDC
Secretariat in the Department of Economic Affairs coordinates with the
various financial-sector regulators and other relevant agencies to represent
India‘s views with the FSB. As a member of the FSB, Basel Committee on
Banking Supervision (BCBS), and International Monetary Fund (IMF), India
actively participates in post-crisis reforms of the international regulatory and
supervisory framework under the aegis of the G20. India remains committed
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to adoption of international standards and best practices, in a phased manner
and calibrated to local conditions, wherever necessary.
The most significant reform in respect of the primary capital market was the
introduction of free pricing. All companies are now able to price issues based on the
market conditions. The norms of the public issues were made stringent in April, 1996
to prevent fraudulent companies from accessing the market. Greater disclosure now
required has enhanced transparency, thereby improving the level of investor
protection. Trading infrastructure in stock exchanges has been modernised and trading
and settlement cycles successively shortened. This greatly reduces the risk associated
with unsettled trades to market fluctuations.
The setting up of NSE as an electronic trading platform set a benchmark of operating

efficiency for other stock exchanges in the country. The establishment of National
Securities Depository Ltd. (NSDL) in 1996 and Central Depositing Services India
Ltd. (CSDL) in 1999 has enabled paperless trading in exchanges. This has also
facilitated electronic transfer of securities and eliminated the risks to the investors
arising from bad deliveries in the market, delays in share transfer, fake and forged
shares, and loss of scripts. The Electronic Fund Transfer (EFT) facility combined with
dematerialisation of shares has created a conducive environment for reducing the
settlement cycle in stock markets.
The improvement in clearing and settlement system has brought about a substantial
reduction in transaction costs. Several measures are also undertaken to enhance the
safety and integrity of the market. These include capital requirements, trading and
exposure limits, daily margins and setting up of trade/settlement guarantee fund to
ensure smooth settlement of transactions in case of default by any member. Some of
other important reforms include introduction of trading in derivatives, move towards
corporatization and demutualisation of stock exchanges, system of redressal of
investor grievances, opening up of mutual funds industry to the private sector,
allowing foreign institutional investors (FII) to invest in all type of securities,
allowing Indian corporate sector to access the international capital markets etc.
As a result of various measures, the Indian equity market has become modern and
transparent. However, its role in the capital formation continues to be limited. The
private corporate debt market is active mainly in the form of private placements,
293
while the public issues market for corporate debt is yet to pick up. It is the primary
equity and debt markets that link the issuers of securities and investors and provide
resources for capital formation. In some advanced countries, especially the US, the
new issues market has been quite successful in financing new companies and spurring
the development of new technology companies. A growing economy requires risk
capital and long term sources in the form of debt for enabling the corporate firms to
choose an appropriate mix of debt and equity. Long term resources are also important
for financing infrastructure projects. Therefore, in order to sustain India‘s high growth
path, the capital market needs to play a major role.
5.6 Impact of reforms
Ever since the reforms process began in early 1990s, the Indian capital market has
witnessed significant qualitative and quantitative changes. Substantial improvement in
terms of various parameters as size of the market, liquidity, transparency and
efficiency has taken place. The changes in regulatory and governance framework have
brought about an improvement in investor confidence. Together with these
developments on the positive front it also needs to be noted that with opening up to
the foreign sector the stock market has become much more volatile and vulnerable to
foreign disturbances.
The studies related to the stock markets often evaluate the developments with regard
to size, liquidity and volatility. This study has examined the trends in these indicators
on the basis of available data. The data is obtained from ‗The Handbook of statistics
on the Indian securities market, 2013. Where any other data source is used it has
specifically been mentioned. In most cases the pre-reform data is not available.
Therefore rather than comparing the pre and post- reform trends, the study has
examined the trends after reform period. This gives the picture of stock market after
the reforms.
5.6.1 Size of the market
Stock market development is the most commonly expressed in terms of its size and
liquidity. The indicators for size commonly used are:
I. Number of listed companies and
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II. Marker Capitalisation Ratio (MCR) i.e., the ratio of stock market
capitalisation to Gross Domestic Product (GDP).
Table 5.6.1 represents data on the number of listed companies on India‘s two premier
stock exchanges. On BSE, in the first half of 1990‘s the number of listed companies
more than doubled and then remained constant for nearly a decade. In 2004-05 the
number took a sharp downturn and has increased only slightly after that.
Table 5.6.1: Number of listed companies
Year BSE NSE Year BSE NSE

1991-92 2601 - 2003-04 5528 909
1992-93 2861 - 2004-05 4731 970
1993-94 3585 - 2005-06 4781 1069
1994-95 4702 135 2006-07 4821 1228
1995-96 5603 422 2007-08 4887 1381
1996-97 5832 550 2008-09 4929 1432
1997-98 5853 612 2009-10 4975 1470
1998-99 5849 648 2010-11 5067 1574
1999-00 5815 720 2011-12 5133 1646
2000-01 5869 785 2012-13 5211 1666
2001-02 5782 793
2002-03 5650 818
Descriptive Statistics
Minimum 2861 135 Mean 5117 896
Maximum 5869 1666 Median 5133 818

Standard 769.78 516.92 -1.43 -0.14
Skewness
Deviation
4.97 2.08 Jarque- 0.01 0.67
Kurtosis
Bera Prob
Source: The Handbook of statistics on the Indian securities market (Various issues).
The NSE started its functioning in the financial year 1994-95 with 135 companies on
its list. In little more than a decade the number of listed companies has increased by
more than a multiple of 10 and the number reaches to 1666 in the year 2012-13.
Descriptive statistics are used to describe the basic features of the data in the study.
The commonly used measures to describe a data set are measures of central tendency
and measures of variability or dispersion. The mean is a measure of central tendency
and represents a whole data set with one single number. Standard deviation is a
measure of variability or dispersion and represents average deviation of a data from
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its mean. The table 5.6.1 also provide the minimum, maximum, mean, median,
standard deviations, skewness, kurtosis and jarque-bera probability for each of the
variables in the study.
The mean number of listed companies on BSE is 5117 with a minimum of 2861 and
maximum of 5869. The mean number of listed companies on NSE is 896 with a
minimum of 135 and maximum of 1666. BSE is more volatile than NSE in the
number of listed companies. Both the data series are negatively skewed. BSE data
series is not normally distributed but NSE data is normally distributed.
The picture is presented clearly by the line graph. The curve corresponding to NSE in
figure 5.6.1 below shows a steady increase in the number of listed companies. In case
of BSE there is increasing trend but sharp decline is observed in the year 2004-05 due
to the delisting of securities. After that again the trend is increasing and the number of
listing companies are 5211 in the year 2012-13.
Figure 5.6.1: Number of listed companies
7000
6000
5000
4000
3000
2000
1000
0
2001-02
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
BSE NSE
5.6.2 Marker Capitalisation Ratio (MCR)
Market Capitalisation Ratio (MCR) at all India level will give a true picture of the
change in the size of the Indian stock market but complete data is not available. So
together with the data at all India level the data for the BSE has also been used in this
study. In the years before the liberalisation, the MCR though low, was steadily
increasing. Post-reform values show ups and downs, at times sharply, of course the
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magnitudes are much above the pre-reform levels. Amidst lots of fluctuations, the
ratio has significantly increased in the recent years. Apart from the new listings the
ratio in early years of 21st century have gone up due to substantial increases in stock
prices. In view of the sharp up turns and down turns noted in the data any attempt to
obtain any average rates of growth over the time period using the regression analysis
would give grossly misleading results. Data on MCR (All India and BSE) is presented
in table 5.6.2.
Table no. 5.6.2: Market Capitalisation Ratio
Year BSE All India Year BSE All India

1991-92 47.99 52.55 2002-03 22.56 21.18
1992-93 24.29 29.54 2003-04 42.27 39.45
1993-94 41.29 44.88 2004-05 52.38 48.90
1994-95 41.65 45.27 2005-06 81.83 76.17
1995-96 42.92 46.65 2006-07 82.54 78.41
1996-97 32.69 34.41 2007-08 103.03 97.41
1997-98 35.64 37.51 2008-09 54.81 51.44
1998-99 30.24 31.83 2009-10 95.18 92.77
1999-00 45.12 30.35 2010-11 87.73 85.98
2000-01 26.25 30.21 2011-12 69.25 67.93
2001-02 25.99 27.03 2012-13 63.75 62.26
Minimum 22.56 21.18 Mean 52.24 51.46
Maximum 103.03 97.41 Median 44.02 45.96

Standard 24.45 22.62 0.67 0.67
Skewness
Deviation
2.25 2.26 Jarque- 0.33 0.34
Kurtosis
Bera Prob.
Note: 1. Market capitalisation data upto 1987-88 represent calendar year (January-December) and from
1988-89 onwards financial year (April-March).2. the compilation of the data on the All-India market
capitalisation was discontinued by the Stock Exchange, Mumbai (BSE) since 1999-2000. Data on All
India Market Capitalisation from 1999-2000 are taken from NSE Publications
Source: The Handbook of statistics on the Indian securities market, 2013.
The mean value of MCR in the case of BSE is 52.24 with a minimum of 22.56 and
maximum of 103.03. The mean value of MCR in the case of All India is 51.46 with a
minimum of 21.18 and maximum of 97.41. BSE is more volatile than All India in the
297
case of Market Capitalisation Ratio (MCR). Both the data series are positively skewed
and normally distributed during the time period under study.
The trend in the growth of MCR is presented with the help of line graph as presented
in the figure 5.6.2.
Figure 5.6.2: Market Capitalisation Ratio
120
100
80
60
40
20
2010-11
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2011-12
2012-13
BSE All India
It is evident from the data and figure 5.6.2 that the basic trend of MCR is similar in
both the series i.e., BSE and All India. There is sharp increase in the MCR in 2005-06
and 2007-08 on account of an improvement in macro-economic fundamentals and a
rise in new listings.
5.6.3 Liquidity
This measures the frequency of trading and frictionlessness in trading proxied by low
transaction cost. Two commonly used measures of liquidity are
 The Turnover Ratio = Total value of share traded on a country‘s stock

exchange/ Stock Market Capitalisation
 The Value Traded Ratio = Total value of Domestic stock traded on a countries
exchanges relative to GDP. This ratio measures the trading activity relative to
the size of the economy.
Liquidity measures are presented in table 5.6.3 and illustrated in figure 5.6.3. Both
ratios fluctuated with small variations in the first half of 1990‘s. In the second half,
298
however, they registered a sharp increase. This increase was similarly driven by sharp
rise in stock prices due to IT boom. It must however be remembered here that an
increase in stock prices may lead to an increase in liquidity ratio even without an
increase in actual number of transactions or a fall in transaction costs. Further
liquidity may be concentrated among large stocks.
It may be noted here ,that of the two liquidity measures , the turnover ratio being the
ratio of value traded to value listed, will be less affected by the increase in stock
prices . This is so because both values are a function of stock prices. To the extent
higher priced shares are more frequently traded, the turnover ratio will show an
upward bias. In the light of this observation, the two liquidity ratios can be more
closely examined.
Table 5.6.3 Liquidity ratios

Value Value
Turnover Turnover
Year traded Year traded
ratio ratio
ratio ratio
1991-92 20.3 11 2002-03 162.9 37.9
1992-93 20 6.1 2003-04 133.4 57.9
1993-94 21.1 9.8 2004-05 97.7 53.1
1994-95 14.7 6.9 2005-06 79.8 66.9
1995-96 20.5 9.9 2006-07 81.8 70.7
1996-97 85.5 30.6 2007-08 73.1 71.2
1997-98 98 38 2008-09 95.0 49.3
1998-99 126.5 41.7 2009-10 68.9 63.2
1999-00 167 78.1 2010-11 53.4 49.2
2000-01 409.3 111.3 2011-12 46.1 49.9
2001-02 134 36 2012-13 43.4 45.9
Minimum 14.7 6.1 Mean 93.29 45.20
Maximum 409.3 111.3 Median 80.8 47.55
Standard
84.40 26.66 Skewness 2.44 0.32
Deviation
Jarque-
Kurtosis 10.02 3.01 0.00 0.82
Bera Prob
Source: SEBI Handbook of Statistics, Various issues.
The mean value of Turnover ratio is 93.29 with a minimum of 14.70 and maximum of
409.30. The mean of value traded ratio is 45.20 with a minimum of 6.10 and
maximum of 111.30. Turnover ratio is more volatile than value traded ratio. Both the
data series are positively skewed but data series of Turnover ratio is not normally
299
distributed and value traded ratio is normally distributed during the time period under
study. The data is illustrated in figure 5.6.3 that gives clear picture of the trend of
liquidity ratios growth during 1991-92 to 2012-13.
Figure 5.6.3: Liquidity Ratios
450
400
350
300
250
200
150
100
50
0
2009-10
2012-13
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2010-11
2011-12
Turnover ratio Value traded ratio
In 1991-92, turnover ratio falls around by 40% to 20.3 % and fluctuates around the
same level till 1995-96.during the same time period Stock Market Capitalisation
(SMC) also fluctuates in a narrow range after increasing more than two folds in 1991-
92. This indicates that after announcement of the reforms, SMC greatly increased in
hope of higher rates of economic growth and improved institutional and infrastructure
facilities. A large number of companies got listed on stock exchanges. So value of
listed shares i.e., SMC showed a substantial increase. Trading in new stock and earlier
listed stocks however, lagged behind. This makes for a lower turnover ratio. As for
the Value Traded Ratio (VTR), it fluctuated sharply during these years. A sudden
jump of over 70 % in 1991-92 can at least in part be explained by the very low rate of
growth of GDP during the years. For the years that followed, GDP growth rated
steadily increased. This indicates fluctuations in trading volumes. During rest of the
decade both liquidity ratios steeply increased. Opening of the next century saw fall in
both liquidity measures although at varying rates. On the whole liquidity measures
show higher magnitude and higher rates of growth after reforms as compared to the
pre-reform period. India is among the least transaction cost countries. Automation in
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trading of stock exchanges has increased the number of trades and number of shares
traded per day. This has greatly helped in reducing transaction costs.
Share markets are unprecedently buoyant due to liberalisation measures announced by

the government to attract the investors and investment. Some important proposals
announced in the union budget 1992-93,such as the abolition of wealth tax on
financial assets, free pricing era and permission for Indian companies to raise funds
abroad triggered the volume in BSE. Irregularities in the securities transactions of
banks and financial institutions also added to the speculative pressure in the stock
markets. In 1996-97, the turnover of BSE rose to 85.5. ‗badla‘ was revived, which led
to a massive rise in turnover. Moreover the extension of trading terminals and rapid
progress in trading in demat paperless form are some of the reasons for an increase in
the turnover witnessed from 1996-97 to 1998-99. In 2000-01 the BSE turnover
witnessed a sharp increase because market was driven by large FII inflows, improved
corporate performance, sound macro-economic fundamentals and upgrading of
India‘s international credit rating from stable to positive by international credit rating
agencies.
After that increase in turnover was slow due to slowdown in FII inflows, large sell off
of new economy stock on NASDAQ, an increase in international oil prices, payment
crises of some stock exchanges and liquidity problem with some cooperative banks.
5.6.4 Volatility
The study of volatility is important to academics, policy makers, and financial market
participants for several reasons. First, prediction of financial market volatility is
important to economic agents because it represents a measure of risk exposure in their
investments. Second, a volatile stock market is a serious concern for policy makers
because instability of the stock market creates uncertainty and thus adversely affects
growth prospects. Recent evidence shows that when markets are perceived as highly
volatile, it ―may act as a potential barrier to investing‖ (Poshakwale and Murinde,
2001).
Third, the stock market volatility causes reduction in consumer spending. Garner
(1990) found that the stock market crash in 1987 brought about a reduction in the
consumer spending in the U.S.. Fourth, pricing of derivative securities and pricing of
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call option is a function of volatility. Finally, stock return forecasting is in a sense
volatility forecasting, and this has created new job opportunities for the professionals
those who are experts in volatility forecasting. Thus it can be seen that the study of
stock market volatility is very important and can be helpful for the formulation of
economic policies and framing rules and regulations related to stock market volatility.
Volatility in equity market has become a matter of mutual concern in recent years for
investors, regulators and brokers. Stock return volatility hinders economic
performance through consumer spending (Garner, 1988). Stock Return Volatility
may also affect business investment spending (Gertler and Hubbard, 1989). Further
the extreme volatility could disrupt the smooth functioning of the financial system and
lead to structural or regulatory changes.
However, increase in volatility per se is not a problem but increased volatility reflects
underlying problems in fundamental forces affecting economic activities and
expectations about them. In fact the more quickly and accurately prices reflect the
available information; the more efficient would be pricing of securities and thereby
allocation of resources. A market in which prices fully reflect available information is
called ―efficient‖ where share prices fluctuate randomly around their ―intrinsic‖
values.
The stock market in India has had its fair share of crisis engendered by excessive
speculation resulting in excessive volatility. Undoubtedly, the confidence of investors
in the early 1990‘s to some extent has been eroded by excessive volatility of the
Indian Stock Markets. The wide spread concern of the exchange management, brokers
and investors alike has realised the importance of being able to measure and predict
stock market volatility.
Volatility of stock exchange is measured by the standard deviation of daily returns.

NSE started its operations in 1994 so the starting year for which the data is available
is 1995. No pre reform data is available on volatility. BSE index was very high in the
year 1992 at 3.5 %. The possible reason for this can be found in the drastically
changes and therefore uncertain economic environment in the immediate post- reform
period.
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Table 5.6.4: Volatility Index
Year BSE NSE Year BSE NSE
1991-92 3.5 - 2002-03 1.1 1.1
1992-93 3.3 - 2003-04 1.2 1.3
1993-94 1.8 - 2004-05 1.6 1.8
1994-95 1.4 - 2005-06 1.1 1.1
1995-96 1.3 1.3 2006-07 1.6 1.7
1996-97 1.5 1.5 2007-08 1.9 2.0
1997-98 1.6 1.7 2008-09 2.8 2.7
1998-99 1.9 1.8 2009-10 1.9 1.9
1999-00 1.8 1.8 2010-11 1.1 1.1
2000-01 2.2 2 2011-12 1.3 1.3
2001-02 1.7 1.6 2012-13 0.8 0.9
Minimum 0.8 0.9 Mean 1.74 1.58
Maximum 3.5 2.7 Median 1.6 1.4
Standard
0.68 0.44 Skewness 1.24 -0.56
Deviation
Jarque-
Kurtosis 4.00 2.66 0.03 0.53
Bera Prob
The mean value of volatility in case of BSE is 1.74 with a minimum of 0.80 and
maximum of 3.5. The mean value of volatility in case of NSE is 1.58 with a minimum
of 0.9 and maximum of 2.7. BSE is more volatile than NSE in the case of volatility
index. BSE volatility index is positively skewed but NSE volatility index is negatively
skewed. Both the volatility indexes are normally distributed during the time period
under study.
Figure 5.6.4 shows the trends in volatility of BSE and NSE during the time period
under study.
303
Figure 5.6.4: Volatility index
2.5
1.5
0.5
BSE NSE
As seen in the figure 5.6.4 the two magnitudes for BSE and NSE are very close to
each other and moving in the same direction for all the years.
Internationally, the index is at low levels. As is evident from the table 5.6.5, it is quite
low in comparison to countries like Unites States of America (USA), United Kingdom
(UK), France, Australia, South Africa, Hong Kong and Brazil.
Table 5.6.5 : Volatility of International Stock Indices, 2013 (percentages)

USA 1.3
UK 1.1
France 1.5
Australia 1.0
HongKong 1.4
Singapore 1.2
Brazil 1.6
Mexico 1.1
South Africa 1.3
Japan 1.5
India( BSE) 0.8
India (NSE) 0.9
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After the reforms, the Indian capital market has become modern in terms of market
infrastructure, trading and settlement practices and has also become a safer place than
it was before the reforms process began. The operational risk benchmark that takes
into consideration the settlement and safekeeping benchmarks and other operational
factors such as the level of compliance with recommendations, the complexity and
effectiveness of the regulatory and legal structure of the market and counter party risk,
improved. The secondary market has become deep and liquid; there have been
reductions in transaction cost and substantial improvements in efficiency and
transparency.
Despite significant improvements in trading and settlement infrastructure, risk

management system, liquidity and containment of volatility, the role of Indian capital
market has remained less significant in terms of resources raised by the corporate
sector. Its role in capital formation both directly and indirectly through mutual funds
has remained less significant. The public issue segment of the market has shrunk over
the past years. The size of primary market in India remains much small
internationally, both in comparison to the developed economies and emerging market
economies. On the whole, after financial sector reforms, the Indian stock market
has for sure become modern and transparent.
5.7 Relationship between Stock market development and economic growth
The linkage between stock market and economic growth has occupied a central
position in the development literature. Osaze (2000) sees the capital market as the
driver of any economy to growth and development because it is essential for the long-
term growth capital formation. According to Akingbohungbe, 1996. It is crucial in
the mobilization of savings and channelling of such savings to profitable self-
liquidating investment. Capital market is defined as the market where medium to
long-term finance can be raised In another exposition, Ekezie (2002) noted that
capital market is the market for dealings (i.e. lending and borrowing) in longer-term
loanable funds. Mbat (2001) described it as a forum through which long-term funds
are made available by the surplus to the deficit economic units. Nyong (1997) viewed
the stock market as a complex institution imbued with inherent mechanism through
which long-term funds of the major sectors of the economy comprising households,
305
firms, and government are mobilized, harnessed and made available to various sectors
of the economy.
It is often debated that if stock market can predict the economy growth or vice versa.
Economists (e.g., Adajaski and Biekpe, 2006; Mun et al., 2008) believe that larger
increase in stock prices is reflective of future economic growth, and large decrease in
stock prices is an indication of future economic recession. Levine and Zervos (1996)
examined whether there is a strong empirical connection between stock market
development and long run growth for forty-one countries by using data from 1976 to
1993 on real per capita average growth and stock index. Results of cross-country
growth regression suggest that a pre condition of stock market development is
positively and strongly associated with long-run economic growth. Pearce and Roley
(1983) study showed that stock prices could lead the direction of the economy. His
study was carried out for the time span of 1956 to 1983 for the U.S. and discovered
that stock market is as an indicator of economic growth.
Empirical studies of Atje and Jovanovich (1993); Levine and Zervos (1996 &
1998) showed that there exists a strong positive relationship between stock market
development and economic growth. Alam and Hasan (2003) find that the stock
market development has a sizeable positive impact on economic growth in the case of
US. Dailami and Aktin (1990) find that a well developed stock market can enhance
savings and provide investment capital at lower costs by offering financial
instruments to savers to diversify their portfolios. In doing so, these markets
efficiently allocate capital resources to productive investments, which would
eventually promote economic growth.
Similarly Brasoveanu et al. (2008) have studied the correlation between capital
market development and economic growth in Romania for the period 2000 to 2006.
Results indicate that capital market development is positively correlated with
economic growth by way of feed-back effect. However, the strongest link is from
economic growth to capital market, signifying that financial development follows
economic growth. Likewise, El-Wassal (2005) study also supports demand following
hypothesis in 40 emerging economies, where emerging stock markets development is
determined by economic growth, financial liberalization policies and foreign portfolio
investment.
306
On the Contrary, study of Shleifer and Summers (1988); showed that stock market
development would lead to harm the economic growth by easing counterproductive
corporate takeovers. In a similar fashion, Devereux and Smith (1991) study also
specified that greater risk sharing through internationally integrated stock markets can
minimize saving rates and that would decelerate the economic growth. Some other
empirical studies (Bencivenga and Smith, 1991; Naceur and Ghazouani, 2007)
who could not determine any significant relationship between stock market
development and economic growth, particularly in developing countries. Likewise,
Barro, (1989) study also found evidence that stock market development doesn‘t
support as a leading indicator of economy.
Studies of Relationship in Indian Context
Kamat and Kamat (2007) have investigated the nexus between developments in
financial intermediation and economic growth for India for the period of 1971 to
2004. Their results support ‗supply leading hypothesis‘ for India i.e., financial sector
development leads to stimulate economic growth in the short-run. Similarly,
Bhattacharya and Sivasubramanian (2003) study found that financial sector
development leads to promote GDP and not the other way. Acharya et al. (2009)
investigated the nexus between financial development and economic growth in Indian
states for the time span of 1981 to 2002. Results indicate that there is a long-run
relationship between financial development and growth across Indian states. This
study concludes that economic growth is followed by financial development.
In a similar study by Agrawalla and Tuteja (2007) found that stable long-run
equilibrium relationship exists between stock market development and economic
growth in case of India. Deb and Mukherjee (2008) tested the causal nexus between
stock market development and economic growth for Indian economy for the period of
1996 to 2007 by using quarterly data on real GDP, real market capitalization ratio and
stock market volatility. Their study found strong causal flow from the stock market
development to economic growth and also evidenced that there is a bi-directional
relationship between market capitalization and economic growth; finally their study
concludes that ‗supply leading‘ hypotheses exists in Indian context. However,
Chakraborthy (2007) study indicates that causality runs from the GDP growth to
stock market growth.
307
Based on the review of published literature it is found that nexus between economic
activity and financial development is conflicting. This study aims to test this
relationship using most recent data and advanced econometric techniques in the
context of India. Understanding of this relationship will provide important insight into
this relationship for policy makers who seek to develop economic policies to best
target for a sustainable economic development. This will be of importance for
investors who are interested in the future direction of economic development and
stock market movements.
5.7.1 Variables and methodology
long run relationship between stock market indicators and economic growth of India.
A Toda and Yamamoto causality test is applied for determining the causality among
the variables. The four variables included in the analysis are Economic Growth
(EGFC), Gross Domestic Capital Formation(GDCF) and two variables for the stock
market development, first is size of the stock market i.e., Market Capitalisation Ratio
(MCR) and second is for liquidity Value Traded Ratio. Other important attributes of
stock market is volatility. However, this indicator is not considered in the regression
analysis, since its contribution to long-term economic growth turned out to be
insignificant. All the variables are transformed into natural logarithm form to remove
the problem of heteroscedasticity. The annual time series data for the time span of
1991-92 to 2012-2013 is analysed because data for the various stock market variables
is not available for the pre-reform period.
5.7.2 Results of the analysis
study i.e., Economic Growth (EGFC), Gross Domestic Capital Formation (GDCF),
Value Traded Ratio (VTR) and Market Capitalisation Ratio (MCR) during the period
from 1991-92 to 2012-13.
308
presented in the table 5.7.1. It is found that all variables have positive mean value and
positive skewness except LNVTR. Jarque –bera test value and the probability show
that the data series are normal.

(1992-2013)
LNEGFC LNGDCF LNMCR LNVTR
Mean 14.79246 3.345802 3.853320 3.555684
Median 14.74076 3.261837 3.784332 3.861179
Maximum 15.51700 3.640572 4.635020 4.712229
Minimum 14.12825 3.081925 3.116178 1.808289
Std. Dev. 0.436984 0.195770 0.464288 0.842797
Skewness 0.162024 0.249583 0.110093 -0.949212
Kurtosis 1.827702 1.366356 1.914273 2.609883
Jarque-Bera 1.356015 2.674796 1.125012 3.443192
Probability 0.507627 0.262528 0.569779 0.178781
Sum 325.4341 73.60763 84.77305 78.22504
Sum Sq. Dev. 4.010064 0.804843 4.526830 14.91644
Observations 22 22 22 22
Notes: LNEGFC- Natural Lag of Economic Growth at Factor Cost, LNGDCF –
Natural Log of Gross Domestic Capital Formation, LNMCR- Natural Log of Market
Capitalisation Ratio, LNVTR- Natural Log of Value Traded Ratio.
Line Graph
line graph as presented by the figure 5.7.1. All the variables move in the same
direction with minor fluctuations but there are much fluctuations in the market
capitalisation ratio and value traded ratio.
309
LNEGFC LNGDCF
15.6 3.7
3.6
15.2
3.5
3.4
14.8
3.3
3.2
14.4
3.1
14.0 3.0
92 94 96 98 00 02 04 06 08 10 12 92 94 96 98 00 02 04 06 08 10 12
LNMCR LNVTR
4.8 4.8
4.4
4.4
4.0
4.0 3.6
3.2
3.6 2.8
2.4
3.2
2.0
2.8 1.6
92 94 96 98 00 02 04 06 08 10 12 92 94 96 98 00 02 04 06 08 10 12
In order to proceed for the cointegration analysis, one must establish that the variables
possess the same order of integration. A variable is called integrated order of ‗d‘, I(d),
if it has to be differenced ‗d‘ times to become stationary (Kennedy, 1996).Augmented
Dickey–Fuller (ADF) (1981) unit root tests is used to test the nonstationarity in the
data series. Considering the low power of the ADF test, the Phillips Perron (PP) test
(1988), which takes account of the serial correlation and heteroscedasticity, as an
alternative test is also used. Table no. 5.7.2 shows the Test Statistics (TS) and the
corresponding Critical Values (CV) at the 5% levels of significance. The null
hypothesis for the presence of a unit root is rejected if the TS value is bigger (in
absolute terms) than the corresponding CV statistic. Rejection of the null hypothesis
implies that the series is stationary. The ADF unit-root test and Philips Perron test
results are as shown below:
310
Table 5.7.2: Unit root test (1992-2013)
ADF critical
Level/first Calculated –
Variables value Stationarity
5%
First difference -3.832045** -3.658446 Stationary
LNMCR Level -2.988881 -3.644963 Not stationary
LNVTR Level -1.574636 -3.644963 Not stationary
PP critical
5%
LNMCR Level -3.065376 -3.644963 Not stationary
LNVTR Level -1.502381 -3.644963 Not stationary
** Denotes the rejection of the null hypothesis at 1%level of significance
The results in Table 5.7.2 show that the null hypothesis for unit root at the level of all
variables is accepted. The observed CV values are higher than TS in ADF and PP
difference for the LNEGFC, LNGDCF, LNMCR and LNVTR is rejected because the
TS values of ADF and PP tests are higher than the corresponding critical values (CV).
It means that all the variables are integrated of order I(1) and all the series are non-
stationary at level but become stationary at first difference.
The variables are integrated of the same order, so there may be long run cointegration
equation. The step of discovering the long run relationship among variable requires an
adequate lag length of them in order to remove any serial correlation. The optimum
lag length is usually selected based on AIC, SIC and HQ test statistic. The reason for
using information criterion is to determine the optimal lags that can balance the risk
resulting from the bias when a lower order is selected and the risk resulting from the
311
increase of variance when a higher order is selected (Hsiao, 1979). Table 5.7.3 shows
the results of these tests.
Table 5.7.3: VAR Lag order Selection Criteria (1992-2013)
Lag LR AIC SIC HQ

0 NA -0.145477 0.053670 -0.106601
1 138.6404* -7.788173 -6.792440* -7.593795
2 21.92071 -8.180965* -6.388647 -7.831086*
The LR test and SIC test indicate that lag order of 1year should be selected but, AIC
test and HQ test suggest that lag order of 2years should be selected for the data
analysis. It is common procedure to estimating the model with large number of lags
and then reducing down by re-estimating the model for one lag less until we reach
zero lag. In each of the models, values of the AIC and the SIC criteria, as well as the
diagnostics concerning autocorrelation, heteroscedasticity, possible ARCH effects and
normality of the residuals inspected. Finally the lag order of 2 years is selected as this
model minimizes AIC and SIC value. the diagnostic tests at lag 2 also show
appropriate results.
Given that the variables are non-stationary in levels and stationary at first difference,
it is necessary to determine whether they are cointegrated, in order to support the
argument of a long-run equilibrium and the application of Vector Error Correction
Model (VECM). According to Engel and Granger (1987), it is always of interest to
test whether a set of variables are cointegrated because of the economic
recommendations such as whether the system is in equilibrium in the long run. E-
Views, the statistical package is used in this analysis, implements a Vector
Autoregressive (VAR) based cointegration test using the methodology developed by
Johansen (1988). Johansen's method is to test the restrictions imposed by
cointegration on the unrestricted dynamic VAR model involving the series, and
312
compute both the Trace Statistic and Max-Eigened estimator in a multivariate
relationship.

None * 0.821133 58.42613 47.85613 0.0037
At most 1 0.636704 24.00383 29.79707 0.2003
At most 2 0.157862 3.753090 15.49471 0.9224
At most 3 0.015719 0.316874 3.841466 0.5735

None * 0.821133 34.42229 27.58434 0.0057
At most 1 0.636704 20.25074 21.13162 0.0660
At most 2 0.157862 3.436217 14.26460 0.9135
At most 3 0.015719 0.316874 3.841466 0.5735
of the hypothesis of no cointegrating vectors under both the trace and maximal
eigenvalue forms of the test. In the case of the trace test, the null hypothesis of no
the trace statistic 24.00 is smaller than 5% critical value of 29.79, so the null
cointegrating vectors, the Max statistic 20.25 is smaller than 5% critical value of
21.13, so the null hypothesis is accepted. Therefore, the null hypothesis of no
cointegrating vectors is rejected by the trace test and by the Max test at 5% level. On
the basis of the results it is concluded that there is 1 cointegrating equation among the
variables.
313
The acceptance of cointegration in the statistic regression means that the parameter
equilibrium relationship are presented below in table 5.7.6:
Table no. 5.7.6: Long Run Relationship (1992-2013)
Dependent variable is LNEGFC

Variable Coefficient T- ratio
LNGDCF 5.402624 11.2243*
LNMCR -1.071496 4.86432*
LNVTR -0.107121 2.66062**
* , ** indicates 1% and 5% level of significance
Notes same as in table 5.7.1
The above table shows that in the long run Gross domestic Capital Formation (GDCF)
has positive but, Market Capitalisation Ratio (MCR) and Value Traded Ratio (VTR)
has negative and statistically significant impact on economic growth. Gross domestic
Capital Formation and Market Capitalisation Ratio affecting economic growth
significantly at 1% whereas Value Traded Ratio affecting economic growth at 5 %
level of significance. An increase of 1 % in Gross domestic Capital Formation leads
to 5.40 % increase in the level of economic growth. An increase of 1 % in Market
Capitalisation Ratio (MCR) leads to 1.07 % decrease in the level of economic growth.
Likewise an increase of 1% in Value Traded Ratio leads to 0.11 % decrease in the
economic growth of India. Results are in line with the findings by Sanusi and Salleh
(2007) for Malaysia and Kargbo and Adamu (2009) for Sierra Leone.
Vector Error Correction Model (VECM) and the results are shown in the following
table 5.7.7:
314
Variable D(LNEGFC)
CointEq1 -0.143317 -5.40777*
D(LNEGFC(-1)) -0.731669 -3.05157**
D(LNEGFC(-2)) -0.705367 -3.10957**
D(LNGDCF(-1)) 0.479372 3.90644*
D(LNGDCF(-2)) -0.122415 -1.98528***
D(LNVTR(-1)) 0.017443 2.54561**
D(LNVTR(-2)) 0.004983 0.90568
D(LNMCR(-1)) 0.117050 4.17826*
D(LNMCR(-2)) 0.055322 3.32682*
Constant 0.168461 7.00480*
R-squared 87 % F-statistic 6.678312 Prob. (0.004)
optimal lag length is two, the short-run results are also presented for two lags of each
variable. The coefficient of the lagged error correction term (CointEq1), representing
the speed of adjustment between the short and the long-run periods, had a coefficient
of -0.14, being statistically highly significant at 1% level. This indicates that
deviations from the short run to the long run are corrected by 0.14 per cent per year.
The negative sign is an indicator of model consistency both in the short and long run,
and the model actually converges to long-run equilibrium (Harris and Sollis, 2003).
economic growth as shown by the 1 and 2 year lag periods at 5 % level of
significance. The past level of Gross Domestic Capital formation(GDCF) for the 1
year lag in the short run has positive impact on economic growth and statistically
significant at 1% level of significance. This implies that a 1 % increase in the Gross
Domestic Capital formation (GDCF) generates 0.47 % increase in economic growth.
Gross Domestic Capital formation (GDCF) for the second year lag period has
negative and significant affect on the economic growth but it is at 10 % level of
significance. This results supported the Harrod-Domar model which proved that the
economic growth will directly or positively be related to saving ratio and capital
formation (i.e. the more an economy is able to save-and invest, the greater will be the
315
growth of that GDP). In other words the Harrod-Domar model is applicable to India‘s
situations.
The past level of VTR for the 1 year lag in the short run has positive impact on
economic growth and statistically significant at 5% level of significance. This implies
that 1 % increase in the value traded ratio (VTR) generates 0.02 % increase in
economic growth. The past levels of market capitalisation ratio (MCR) for the 1 and 2
year lag periods in the short run had positive impact on economic growth and
statistically significant at 1% level of significance. This implies that a 1 % increase in
the market capitalisation ratio (MCR) for the 1 year lag period generates 0.12 %
increase in economic growth and for the 2 year lag period it generates 0.05% increase
in economic growth. These results are in line with several studies including that of
Levine and Zervos (1998), Rousseau and Wachtel (2000), Beck and Levine (2004)
and Seetanah, (2010).
The results, in lower part of the table 5.7.7, which relates to the whole model, are
explained below, in order to support the assumption that the estimated long-run
equation indeed represents a cointegrating relationship, and that CointEq1 (ECM) can
appropriately be used in the estimation of the model.
relevant and statistically significant at 1 % level of significance. The value of R-
squared is 87% indicates an appropriate measure of the model's success in predicating
the values of the dependent variable (EGFC) within the sample. The inference is that
the explanatory variables are jointly able to explain up to 87 % of the variation in
Economic growth. The study also applied the Durbin-Watson test for checking the
autocorrelation among the variables. The value is 2.15 which is near to the standard
value of 2, so it can be said that there is no autocorrelation among the variables.
specified the test for serial correlation, normality and heteroscedasticity are
316
conducted. The equation error statistics provided information on the structure of the
residuals which should be 'white noise' that do not change over time and hence have
no serial correlation. The underlying theory is that, all empirical macroeconomic
models are stochastic in nature and so allow for error components or 'shocks'
(Hendry, 1993). If serial correlation is indicated in the residuals, then the standard
errors would be considered invalid and should not be used for inference. the
diagnostic test results are shown in the table 5.7.8 below:
Table 5.7.8: Diagnostic Test Result (1992-2013)

Test Statistics

1.807593 0.405029
The LM (Lagrange Multiplier) test, adopted in the study, is a general test for error
The results, indicated in Table 5.7.8, show that the test did not reject the null
317
consistent. White (1980) describes a general test for model misspecification, since the
null hypothesis underlying the test assumes that the errors are both homoscedastic and
independent of the regressors and that the linear specification of the model is correct
(Asteriou and Hall, 2006). The ARCH test is used to test of the null hypothesis of no
heteroscedasticity. In this case, as can be seen from table 5.7.8, the Obs*R-squared
statistic value of 0.968235 had a probability of 61.62% such that it did not reject the
null hypothesis of no heteroscedasticity.
normally distributed. It can seen from the jarque- Bera value is 1.807593 and
Probability is 40.50%. The probability value is more than 5 %, so the null hypothesis
is accepted that the residuals are normally distributed. The results of the diagnostic
test reveal that the model is well specified, indicating that the estimated Error
Correction Model performs well.

(1975). Unlike chow test that requires break points to be specified, the CUSUM test
the null hypothesis of all co-efficients in the given regression are stable and cannot be
318
10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
-7.5
-10.0
2005 2006 2007 2008 2009 2010 2011 2012 2013
(1992-2013)
1.6
1.2
0.8
0.4
0.0
-0.4
2005 2006 2007 2008 2009 2010 2011 2012 2013
319
The importance of stock markets in both developed and developing economies of the
world has shifted the research focus to identify the cause and effect relationship
between stock market development and economic growth over the last few decades.
Mun et al. (2008) tested the causal relationship between stock market and economic
activity in Malaysia for the period of 1977 to 2006. Their study used annual data on
real GDP and Kuala Lumpur Composite index (KLCI), results from Granger causality
test indicated that causality runs from stock market to economic activity and not the
other way around. The causal nexus between stock market development and economic
growth was examined by Vazakidis and Adamopoulos (2009) for France for the
period of 1965 to 2007. This study employed co-integration, Granger causality test
and Vector error correction model; results indicate that there is a positive association
from economic growth to stock market development and at the same time interest rate
has a negative effect on stock market development.
Padhan (2007) examined the causal linkages between stock market and economic
activity in India for the post liberalization period by using monthly data on IIP and
stock prices of Sensex for the time period of 1991 to 2005. Empirical results from
TYDL model (Toda-Yamamota, Dolado and Lutkephol model) exposes that there is a
bidirectional relationship between stock prices and economic activity and it implies
that a well developed stock market will stimulate economic activity and vice versa.
To take policy decision it is important to know which way stock market development
and economic growth cause each other and therefore an attempt is made to find out
the causality between stock market development and economic growth in Indian
Context. To inspect the causality between the different variables of the model, the
short run and the long run causality is determined. The first test reveals the
significance of the sum of lagged terms of each explanatory variable by the mean of
Chi-square test and the second test indicates the significance of the error correction
term by the mean of the T-test. Table 5.8.1 below illustrate the results of all these
causality tests.
320
Table 5.8.1
ECTt-1
Coefficient
variable (p-value)
[t-ratio]
LNEGFC LNGDCF LNVTR LNMCR All
LNEGFC 9.868929 0.334941 3.340666 11.81146 -0.143317
(0.0017)* (0.5628) (0.0676)*** (0.0081)* [-5.40777]*
LNGDCF 1.444620 0.329609 2.072152 2.678874 -0.430164
(0.2294) (0.5659) (0.1500) (0.4438) [-2.19476]**
LNVTR 4.304587 3.878526 6.472757 8.581746 -0.027889
(0.0380)** (0.0489)** (0.0110)** (0.0354)** [-0.02249]
LNMCR 0.300078 6.826503 0.735380 8.125884 -2.618422
(0.5838) (0.0090)* (0.3911) (0.0435)** [-3.91641]*
GDCF does not cause EGFC is rejected at 1% level of significance and MCR not
cause EGFC is rejected at 10% level of significance. It means that there is
unidirectional causality runs from GDCF and MCR to Economic Growth in the short
run. When EGFC is dependent variable and all other independent variables were
taken together then the null hypothesis is also rejected at 1% level of significance
means all the variables taken together can cause EGFC. No variable was found that
can significantly cause GDCF in the short run period, even all the variables when
taken together cannot cause GDCF. In the short run EGFC, GDCF and MCR can
cause VTR at 5 % level of significance. It means that there is unidirectional causality
running from EGFC, GDCF and MCR to VTR. The causality is also running from
these three variables taken together as independent variable to the VTR at 5% level of
significance. The null hypothesis of GDCF does not cause MCR is rejected at 1%
level of significance. It means that there is unidirectional causality runs from GDCF
to MCR in the short run. The causality is running from these three variables (GDCF,
VTR and EGFC) taken together as independent variable to the MCR at 5% level of
significance. Overall results show that there is unidirectional causality among the
variables.
321
causality from the three independent variables such as GDCF, VTR and MCR to
EGFC meaning that GDCF, VTR and MCR have influence on dependent variable
EGFC in the long run at 1% level of significance.
Chakraborthy (2007) made a study in India by taking market turnover, market

capitalisation ratio, bank credit, stock market volatility for financial development
indicator during 1996-2005 and found out that causality is run from economic growth
to financial development in the post liberalisation period. It seems that the role of
financial development may not be crucial for economic growth in the post
liberalisation period. This study does not confirm the results but contradict and state
that causality runs from financial development to economic growth. It is understood
that policy makers need to concentrate on financial development to boost economic
growth.
5.9 Conclusion
Stock market is an important and growing ingredient of the financial market, more so
in developing countries. Well developed stock markets may be able to offer different
impetus to investment and growth. Various reforms undertaken since the early 1990s
by the SEBI and the government of India have brought about a significant structural
transformation in the Indian capital market. The reforms have been implemented in a
gradual and sequential manner, based on international best practices; modify to suit
the country‘s needs.
The most significant reform in respect of the primary capital market was the
introduction of free pricing. Greater disclosure now required has enhanced
transparency, thereby improving the level of investor protection. Trading
infrastructure in stock exchanges has been modernised and trading and settlement
cycles successively shortened. This greatly reduces the risk associated with unsettled
trades to market fluctuations. The Electronic Fund Transfer (EFT) facility combined
with dematerialisation of shares has created a conducive environment for reducing the
settlement cycle in stock markets. The improvement in clearing and settlement system
has brought about a substantial reduction in transaction costs. Several measures are
322
also undertaken to enhance the safety and integrity of the market. As a result of
various measures, the Indian equity market has become modern and transparent.
From the discussions on the various indicators of stock market development like size,
liquidity and volatility, it is clear that On the whole, after financial sector reforms,
the Indian stock market has for sure become modern and transparent.
Various indictors of economic and stock market development are analysed in the post
reform period i.e., 1992-2013. In the long run there is positive impact of GDCF in
EGFC and negative impact of MCR and VTR on EGFC in India. In the short run,
GDCF, VTR and MCR positively affect the EGFC. Various diagnostic and stability
tests are conducted and all the tests indicate that the estimated model performs well.
To take policy decisions, it is important to know which way stock market

development and economic growth cause each other and overall results show there is
short run and long run unidirectional causality running from GDCF and MCR to
EGFC.
323
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NBER,Working paper series no. 9082.Cambridge Mass: NBER.
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47(2). pp. 475-94.

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Poshakwale and Murinde (2001). Modelling the volatility in East European

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Rajan,R. and Zingales,L.(1996). Financial Development and Growth. University of

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Development.The Economic Journal.vol.107 (442), pp. 771-782.
325
CHAPTER 6
RELATIONSHIP BETWEEN FINANCIAL DEVELOPMENT AND

ECONOMIC GROWTH
In the previous chapters it has been shown that after the reforms, substantial
development has taken place in the financial sector in terms of number of selected
variables. Both institutions and markets have witnessed remarkable progress in the
post-reform period as compared to the pre-reform period. Savings and investment
during the post- reform period have also increased at much higher rates in comparison
to the pre-reform period. The basic objective of this study is to establish whether the
reforms undertaken in the financial sector of the economy have had any influences on
the country‘s economic growth. So the subject matter of this chapter is to analyse that
how far this development of the financial sector have led to the economic growth.
This will depend upon the extent to which financial development (banking sector
development and stock market development) in India is related to the country‘s
economic growth.
6.1 Financial Development
Financial development is usually defined as a process that marks improvement in

quantity, quality and efficiency of financial intermediary services. It refers to the
development of well functioning financial markets and intermediaries. Financial
Development Report published by World Economic Forum defined financial
development as the factors, Policies and institutions that lead to effective financial
intermediation and markets, as well as deep and broad access to capital and financial
services. Financial development occurs when financial instruments, markets and
intermediaries ameliorate though does not necessarily eliminate–the effects of
information, enforcement and transactions cost and therefore do a correspondingly
better job at providing the financial functions. Financial development involves
improvement in the production of ex-ante information about possible investments,
monitoring of investment and implementation of corporate governance, trading
diversification and management of risk, mobilization & pooling of savings and
exchange of goods and services. According to Dorrucci and Drutti (2007), financial
development means the capability of a country to channel its savings into investments
effectively and efficiently within its own borders owing to the quality of its
326
institutional and regulatory framework, the size of its financial markets, the diversity
of its financial instruments and private agent‘s ease of access to them and the financial
market‘s performance in terms of efficiency, liquidity. Hartmann and Heider (2007)
defined financial development as the process of financial innovation as well as
institutional and organisational improvements in a financial system, which reduce
asymmetric information, increase the completeness of markets, add possibilities for
agents to engage in financial transactions through contracts, reduce transaction costs
and increase competition. The scope of financial development therefore includes
improvements or innovations in products, institutions and organisations in the
banking sector, non banking financial structures and capital markets.
Financial development is usually defined as a process that marks improvement in

quantity, quality, and efficiency of financial intermediary services. This process
involves the interaction of many activities and institutions and possibly is associated
with economic growth. A financial system operates through financial institutions and
markets. The development of financial sector involves significant changes of
quantitative and qualitative nature in the financial institutions and markets. Financial
development help the financial sector to serve its basic function of increasing savings
and investments in the economy and allocating available funds in the best possible
manner.
Financial development is a very broad concept, as the financial sector develops

various kinds of financial institutions, markets and instruments increase substantially
in the economy (Bhole, 2004). The institutions become geographically widespread
and more of the population is able to access the services of the financial system. The
new strong, active, large banking and non-banking financial institutions, markets are
emerged and developed with the financial development. The surplus funds are more
greatly encouraged to move to the productive uses via the financial sector.
Financial development involves the emergence and development of many private

sector banks including foreign banks and other financial institutions. The competition
and efficiency improved with the private sector banks coming in the financial sector.
The new methods and improved ways of functioning e.g. computerisation becomes
important and with this time, energy and cost of transaction reduced. The institutions
and markets become more efficient in their functioning and rate of interest becomes
327
market determined. There is strong and effective system of supervision, inspection,
auditing and regulations of financial organisations maintaining international standards
with respect to non-performing assets, capital adequacy etc. With all these the
financial system is able to increase savings and investments in the economy and
allocate the available funds to the productive uses.
6.2 Economic Growth
India‘s economic journey from an impoverished country to an emerging global

economy is an inspiring example for many developing nations. After 200 years of
British rule India became an independent sovereign country in 1947. This newly born
nation faced a number of issues including shattered economy, a minimal rate of
literacy and horrific poverty. During the first 45 years after independence, India‘s
economy is divided into two distinct segments, private and public. The private sector
owned and operated small to medium size businesses and industries protected by the
government and the government took care of everything else. The government was in
charge of most of the consumer services including transportation such as airlines, rail,
roads and local transportation, communication services such as postal. Telephone and
telegraph, radio and television broadcasting, and social services such as education and
health care. The intention of the government was to provide these services at a
reasonable rate as well as employment. India adopts a five year development plan in
order to improve infrastructure, agricultural production, health care and education.
During the early 1990s, India‘s economy began to worsen and was faced with
growing inflation, unemployment and poverty and historically low foreign exchange
reserves. The collapse of Soviet Union significantly affected India‘s economy because
the soviet‘s were India‘s major trading partner and a key supplier of low cost oil. As a
result India had to buy oil from the free market. India was receiving a huge remittance
offering exchange from the Indians working in the Middle East, but the Gulf War sent
thousands of Indian workers back home resulting in huge dent in India‘s foreign
reserves. Consequently India‘s foreign exchange reserve fell to low of $240 million,
just enough to support only two weeks of imports. The international monetary fund
(IMF) and World Bank offered help to India in exchange for economic reforms.
In 1991, several economic reforms were introduced like lower tariff levels, reformed
exchange rate policy, liberalised industrial licensing policy and also relaxed India‘s
328
Foreign Direct Investment (FDI) policy. These reforms opened the doors for
multinational corporations to invest in India. India got positive response from
international investors. Before 1991 reforms, foreign equity ownership was restricted
to 40 percent and the transfer of technology was necessary to do business in India.
These barriers were removed for foreign companies. Many multinational corporations
(MNCs) took advantage of India‘s new economic policies and increased their stakes
to more than 51 percent in their subsidiaries resulting in a several fold increase in
foreign direct investment in just three years.
There were three major driving forces behind India‘s economic growth and prosperity
after the reforms of 1991; increased foreign direct investment, India‘s expertise in
information technology and increased domestic consumption because of growing
middle class population. The combination of foreign direct investment and expertise
in information technology helped produce thousands of new jobs and created a
growing middle class that in turn created increased domestic consumption and that
resulted again in more foreign direct investment to meet the demand of Indian
consumers. India‘s growing middle class is the backbone of its economy and it is
expected that about half of its population will fall into the category of middle class by
2040 with a substantial amount of disposable income.
India became a hub for information technology and knowledge based economy.
Because of the availability of the highly talented technical workforce and improved
protection of intellectual property many western firms shifted their research and
development department to India in order to reduce their Research & Development
cost. India is the major recipient of outsourced call centres, medical billing centres,
and other business administration and insurance related services. India‘s economy is
now supported by its own expertise in information technology, larger capital market,
improving infrastructure and growing middle class with increasing disposable income.
In the table 6.2.1, Gross domestic Product at Factor cost is shown from 1967-68 to
2012-13. in 1967-68 the GDP at FC was Rs.513860 Crores and increased constantly
during the years under study and reached to Rs. 5482111 crores in 2012-13.
329
Table 6.2.1: Gross Domestic product at factor cost
Rs.in Crores
Pre-reform period Post-reform period
Year GDPFC Year GDPFC
1967-68 513860 1991-92 1367171
1968-69 527270 1992-93 1440503
1969-70 561630 1993-94 1522343
1970-71 589786 1994-95 1619694
1971-72 595741 1995-96 1737740
1972-73 593843 1996-97 1876319
1973-74 620872 1997-98 1957031
1974-75 628079 1998-99 2087827
1975-76 684634 1999-2000 2254942
1976-77 693191 2000-01 2348481
1977-78 744972 2001-02 2474962
1978-79 785964 2002-03 2570935
1979-80 745083 2003-04 2775749
1980-81 798506 2004-05 2971464
1981-82 843426 2005-06 3253073
1982-83 868091 2006-07 3564364
1983-84 936269 2007-08 3896636
1984-85 973357 2008-09 4158676
1985-86 1013866 2009-10 4516071
1986-87 1057612 2010-11 4918533
1987-88 1094992 2011-12 5247530
1988-89 1206243 2012-13 5482111
1989-90 1280228
1990-91 1347889
Source: Handbook of statistics on Indian economy 2012-13.
330
The above table can be better understood with the help of the following figure 6.2.1,
which shows that the curve is constantly going in upward direction since 1967-68.
The growth is more in the post reform period as compared to pre-reform period as can
be seen from the figure.
Figure 6.2.1: Gross Domestic product at factor cost
6000000
5000000
4000000
3000000
2000000
1000000
2006-07
1967-68
1970-71
1973-74
1976-77
1979-80
1982-83
1985-86
1988-89
1991-92
1994-95
1997-98
2000-01
2003-04
2009-10
2012-13
6.3 Role of Financial Development in Economic Growth
Economists hold different perspectives on the theoretical link between financial

development and economic growth. Schumpeter (1911) mentioned that the services
provided by financial intermediaries are essential drivers for innovation and growth.
According to Aziz and Duenwald (2002) financial development can affect growth
through three main channels. Firstly, it can increase the marginal productivity of
capital by collecting information to evaluate alternative investment projects and risk
sharing; secondly, it can raise the proportion of savings channelled to investment via
financial development by reducing the resources absorbed by financial intermediaries
and thirdly it can raise the private saving rate. Ansari (2002) noted that financial
development contribute economic growth in the following six ways that is financial
markets enable small savers to pool funds, savers have a wider range of instruments
stimulating savings, efficient allocation of capital is achieved as the proportion of
financial saving in total wealth rises, more wealth is created as financial
intermediaries redirect savings from the individuals and the slow growing sectors to
the fast growing sectors, financial intermediaries partially overcome the problem of
331
adverse selection in the credit market and financial markets encourages specialisation
in production development of entrepreneurship and adoption of technologies.
Recent studies indicate that financial development is one of the main factors behind
growth. The literature on Economics and Finance has identified a number of channels
through which the financial sector supports economic growth. Creane et. al (2004)
argued that a modern financial system promotes investment by identifying and
funding good business opportunities; mobilising savings; monitoring the performance
of managers; enabling the trading , hedging and diversification of risk; and facilitating
the exchange of goods and services. These functions result in a more efficient
allocation of resources, a more rapid accumulation of physical and human capital, and
faster technological progress which in turn feed economic growth. Based on
theoretical literature the views on financial development in economic growth can be
classified into two major categories. The first view was put forwarded by
Schumpeter (1911), who was the earliest economist and who highlighted the
importance of finance in the process of economic development. He emphasised the
importance of financial services in promoting economic growth and highlighted the
circumstances in which financial institutions can actively encourage innovation and
promote future growth by determining and funding productive investments. He
argued that financial systems are important in promoting innovations, i.e. economies
with more efficient financial systems grow faster. The second view was contributed
by Robinson (1952) who considered finance as a relatively unimportant factor in
growth process. He argued that as output increases, the demand for financial service
increases as well, which in turn has a positive effect on financial development.
According to Robinson (1952) all other things being constant, financial development
follows economic growth and not the other way around.
6.4 Relationship between Financial Development and Economic growth
In India, financial sector reforms have made tremendous change in the financial
market and the banking sector. Since the beginning of the 1990s the Indian economy
has been undergoing economic reforms which include financial sector reforms among
others. The reforms were carried out mainly in the case of banking sector and the
capital market. With the reduction in interest rate, Indian banking system has become
more market oriented. Finally it has given output to the stock market also. The
332
number of stock exchanges has also increased. The principal objective of financial
sector reforms is to improve the allocative efficiency of resources, ensure financial
stability and maintain confidence in the financial system by enhancing its soundness
and efficiency.
In economics literature, ever since the pioneering works of Goldsmith (1969),

McKinnon (1973) and Shaw (1973), the relationship between financial development
and economic growth has remained an important topic of debate. Many studies have
dealt with different aspects of this relationship at both theoretical and empirical levels.
Systematic analysis of the relationship between financial development and economic
development was first popularised by Goldsmith (1955). He found sound positive
correlation between financial development and the level of real per capita GDP. Most
of the original contributions to this literature coincide in suggesting a strong positive
correlation between financial development and economic growth. Financial
development has dual effect on economic growth. On one hand the development of
financial markets may enhance the efficiency of capital accumulation. On the other
financial intermediation can contribute to raising savings and therefore investment
rates. On the whole mass of studies suggest that better functioning financial system
supports faster economic growth. Goldsmith (1969) provided the first cross country
empirical study showing the existence of positive link between the functioning of the
financial system and growth.
The McKinnon-Shaw school examines the impact of Government intervention on the

development of the financial system. Their main proposition is that Government
restrictions on the banking system such as interest rate ceilings and direct credit
programmes have negative effects on the development of the financial sector and,
consequently, reduce economic growth. Several other studies, on the other hand, have
documented a negative relationship between financial development and economic
growth like Robinson (1952), Friedman and Schwartz (1963). Gregorior and
Guidotti (1955) found that financial development has a negative impact on the
economic growth of the countries especially in Latin America and China. So in this
context, it is important to study the relationship between financial development and
333
6.5 Variables and methodology
This section pins down the variables relevant to the model and methodology adopted
in analysing the data. Economic growth is a measure of growth in aggregate output of
a nation during a specified time period. It can be measure by GDPfc at constant prices.
When the growth rates are to be used to judge the improvement in the economic well
being of people, or any other similar purpose, the rate expressed in per capita terms
would be more meaningful. In this analysis however, the objective is to see the impact
of financial development on economic growth, in terms of an overall output
expansion. So using the rates in per capita terms will not be meaningful. The rates of
growth of per capita will be affected by the growth rate of the population, which has
as such no bearing in context of role of finance. So as an indicator of economic
growth, the study has used the annual GDPfc at constant prices (EGFC).
In studies where credit has been used as an indicator of financial development, it is

only bank credit that is considered. However, significant financial development takes
place outside the banking system. Moreover as the financial system develop, the
portion of the bank credit to the total credit advanced usually falls. For this reason the
credit advanced by non baking financial institutions has also been included in the
study. Credit thus consist of non-food credit advanced by scheduled commercial
banks, credit advanced by non scheduled commercial banks, cooperative banks and
financial assistance disbursed by the non- banking financial institutions. It excludes
credit to the public sector in the form of food credit and therefore is able to represent
more accurately the role of financial intermediaries in channelizing funds to the
private market participants. This measure will therefore be more directly linked to
investment and growth than various other measures often used in other studies. So
institutional credit to the private sector (Credit) is used as an indicator of banking
sector development that can affect economic growth in India. Chakraborty (2007)
used bank credit as variable to measure the banking sector in his study.
The indicators used for stock markets in various studies relates to size and/or liquidity
of the secondary market. Although it would have been more appropriate to include an
indicator for size (Stock Market Capitalisation Ratio) and one for liquidity (turnover
ratio or the value traded ratio). For the liquidity indicators the data is available only
since the beginning of 1990‘s. Pre-financial sector reform data is available only for
334
stock market capitalisation. So SMC is the only possible capital market variable that
could be included in the analysis. Chakraborty (2007) used market capitalisation
ratio to represent the stock market in India.
Capital formation takes place in private sector and public sector. The trends and
composition of the public and private sector and their influence on economic growth
can often be different. In such a case they need to be separately accounted for. In case
of India however, during the time period under study, the two trend to move parallel
to each other. Both seen equally related to economic growth initially three time series
were examined: capital formation by private sector, capital formation by public sector
and total capital formation. All the three series follow a more or less similar pattern.
Moreover the correlation coefficients of each series with economic growth are nearly
the same. Therefore rather than taking the rates as separate variables and adding to the
number of variables , the study has used Gross Domestic Capital Formation (GDCF)
both public and private as single variable. Barro (1974) concluded in his study that
Economic growth is supposed to be an increasing function of capital formation.
long run relationship among banking sector indicators, stock market indicators and
economic growth of India. Toda and Yamamoto causality tests is applied for
determining the causality among the variables. The four variables are included in the
analysis related to indicators of economic growth and financial sector development.
annual GDPfc at constant prices (EGFC) is used for indicator of economic growth.
Two indicators of financial development are Institutional credit to the private
sector as a ratio of GDP (CR) and Stock market capitalisation ratio (SMC). One
variable i.e., CR is taken for the banking sector development and other variable i.e.,
SMC is taken for the stock market development. Gross domestic capital formation
as ratio of GDP (GDCF) is other important variable is used because Economic
growth is supposed to be an increasing function of capital formation. The annual time
series data is used for analysing the relationship between financial development and
economic growth. The time period is 1968 to 2013, so that a sufficient time period is
covered during pre- financial sector reforms and post- financial sector reforms. The
data is transformed in natural logarithm form and then the analysis is done.
335
6.6 Results for the entire period (1968-2013)
test) results ,lag selection criteria ,co-integration test ,long run and short run
study i.e., Economic Growth(EGFC), Gross Domestic Capital Formation(GDCF) ,
Institutional Credit to the Private Sector (CR) and Stock Market Capitalisation
(SMC) during the entire period ( 1968-2013).
presented in the table 6.6.1 . It is found that all variables have positive mean value and
positive skewness. Jarque –bera test value and the probability show that the data
series are normal.
Table no. 6.6.1: Descriptive Statistics of variables (1968-2013)

LNEGFC LNCR LNGDCF LNSMC
Mean 14.15878 3.075367 3.117980 2.859724
Median 14.08830 3.054921 3.114109 2.652405
Maximum 15.51700 4.007432 3.640572 4.634984
Minimum 13.14971 2.191841 2.570713 1.049085
Std. Dev. 0.712517 0.556482 0.285435 1.071932
Skewness 0.349782 0.172977 0.196913 0.032423
Kurtosis 1.918868 2.139521 2.252033 1.686924
Jarque-Bera 3.178284 1.648540 1.369561 3.312715
Probability 0.204101 0.438555 0.504201 0.190833
Sum 651.3039 141.4669 143.4271 131.5473
Sum Sq. Dev. 22.84561 13.93524 3.666279 51.70669
Notes: LNEGFC- Natural lag of Economic Growth at factor cost,
LNCR- Natural Log of Credit, LNGDCF- Natural Log of Gross Domestic
Capital Formation, LNSMC- Natural Log of Stock Market Capitalisation.
336
Line Graph
line graph presented below in figure 6.6.1. LNEGFC and LNCR both move in the
same direction with some fluctuation while LNGDCF and LNSMC variables show
more fluctuations in the upward trend.
LNEGFC LNCR
16.0 4.5
15.5
4.0
15.0
3.5
14.5
3.0
14.0
2.5
13.5
13.0 2.0
70 75 80 85 90 95 00 05 10 70 75 80 85 90 95 00 05 10
LNGDCF LNSMC
3.8 5
3.6
4
3.4
3.2
3
3.0
2.8
2
2.6
2.4 1
70 75 80 85 90 95 00 05 10 70 75 80 85 90 95 00 05 10
Figure 6.6.1: Line graph of the variables (1968-2013)
Since many macroeconomic series appear to be non stationary, as Nelson and Plosser
(1982) affirm, so first need to check for the stationarity of the series. Several unit root
tests exist to check for stationarity of the series. In order to proceed for the
cointegration analysis, one must establish that the variables possess the same order of
integration. A variable is called integrated order of ‗d,‘ I(d), if it has to be differenced
d times to become stationary (Kennedy, 1996). Augmented Dickey-Fuller (ADF)
(1981) test and Philips Perron test were used to examine the stationarity
337
characteristics of the series. Table 6.6.2 reports the ADF unit-root test and Philips
Perron test results as below:
Table no. 6.6.2: Results of Unit Root Test for the entire period (1968-2013)
ADF
Level/first Calculated–
Variables critical Stationarity
difference Test statistics
value 5 %
Economic
Growth(LNEGFC)
Gross domestic
Capital Formation Level -3.410730 -3.513075 Not stationary
(LNGDCF)
Stock Market
Capitalisation Level -2.713835 -3.513075 Not stationary
(LNSMC)
PP critical
5%
Economic
Growth(LNEGFC)
Gross domestic
Capital Formation Level -3.365038 -3.513075 Not stationary
(LNGDCF)
Stock Market
Capitalisation Level -2.713835 -3.513075 Not stationary
(LNSMC)
Table 6.6.2 shows the test statistics (TS) and the corresponding critical values (CV) at
the 5% levels of significance. The null hypothesis for the presence of a unit root is
rejected if the TS value is bigger (in absolute terms) than the corresponding CV
statistic. Rejection of the null hypothesis implies that the series is stationary. The test
results seem to support the argument that the series became stationary after the first
difference.
338
The results in Table 6.6.2 show that the unit root null of the level of all variables is
accepted. The observed CV values are higher than TS in ADF and PP tests with
constant and trend. However, the null hypothesis of the unit root for the first
difference for the LNEGFC, LNCR, LNGDCF and LNSMC is rejected because the
TS values of ADF and PP tests are higher than the corresponding critical values (CV).
It means that all the variables are integrated of order I(1) and all the series are non-
stationary at level but become stationary at first difference.
lag length is usually selected based on AIC, SIC and HQ test statistic. All the test
indicates that 1 lag order should be selected for the data analysis.
Table no. 6.6.3: VAR Lag order Selection Criteria for the entire period
(1968-2013)
Lag LR AIC SIC HQ

0 NA -1.105076 -0.939584 -1.044416
1 331.0038* -9.289219* -8.461758* -8.985922*
2 24.57586 -9.272038 -7.782607 -8.726102
3 11.21552 -8.896875 -6.745475 -8.108302
4 9.684955 -8.522369 -5.708999 -7.491157
LR: sequential modified LR test statistic (each test at 5% level),
Given that the variables were non-stationary in levels, it was necessary to determine
whether they were cointegrated, in order to support the argument of a long-run
equilibrium and the application of an Error Correction Model (ECM). According to
Engel and Granger (1987), it is always of interest to test whether a set of variables
are cointegrated because of the economic recommendations such as whether the
system is in equilibrium in the long run. E-Views, the statistical package used in this
analysis, implements a Vector Autoregressive (VAR) based cointegration test using
339
the methodology developed by Johansen (1988). Johansen's method is to test the
restrictions imposed by cointegration on the unrestricted dynamic VAR model
involving the series, and compute both the Trace Statistic and Max-Eigened estimator
in a multivariate relationship. Table presents the results of the cointegration test and
show rejection of the hypothesis of no cointegrating vectors under both the trace and
of no cointegrating vectors is rejected since the test statistic of 60.40 is greater than
5% critical value of 47.85. Moving on to test the null of at most 1 cointegrating
vectors, the trace statistic 26.49 is smaller than 5% critical value of 29.79., so the null
cointegrating equation , the Max test statistics is 16.09 ,which is smaller than 5 %
critical value of 21.13. So the null hypothesis is accepted. Therefore, the null
hypothesis of no cointegrating vectors is rejected by the trace test and by the Max test
at 5% level.
Table no. 6.6.4: Trace Cointegration Rank Test (1968-2013)

None * 0.537368 60.40946 47.85613 0.0022
At most 1 0.306257 26.49323 29.79707 0.1146
At most 2 0.143828 10.40445 15.49471 0.2509
At most 3 0.077973 3.571933 3.841466 0.0588
Trace test indicates 1 cointegrating eqn(s) at the 0.05 level
Table no. 6.6.5: Maximum Eigenvalue Cointegration Rank Test (1968-2013)

None * 0.537368 33.91623 27.58434 0.0067
At most 1 0.306257 16.08878 21.13162 0.2197
At most 2 0.143828 6.832517 14.26460 0.5091
At most 3 0.077973 3.571933 3.841466 0.0588
Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level
340
Hence both the tests conclude that there is one cointegrating vector and there is long
run relationship among the variables.
equilibrium function are summarised as below:
Table 6.6.6: Long Run Relationship (1968-2013)
Dependent variable is LNEGFC

LNCR 1.094546 4.67475*
LNGDCF 0.379992 0.81777
LNSMC 0.150458 3.65278*
* indicates 1% level of significance
Table 6.6.6 shows that Credit has positive and Stock Market Capitalisation has
negative and significant impact on the economic growth in the long run. An increase
of 1 % in credit leads to 1.09% increase in the level of economic growth. Likewise an
increase of 1% in Stock Market Capitalisation leads to 0.15 % increase in the
economic growth. Gross domestic Capital Formation has also positive impact but it is
not statistically significant.
error correction model.
341
Variable D(LNEGFC)
CointEq1 -0.083209 [-3.21229]*
D(LNEGFC(-1)) -0.068273 [-0.43515]
D(LNCR(-1)) -0.012250 [-0.14120]
D(LNGDCF(-1)) -0.063127 [-1.08824]
D(LNSMC(-1)) -0.010319 [-0.80896]
Constant 0.059041 [ 5.74588]*
R-squared 75% F-stat 2.61 prob. (0.03)
DW-statistic 1.92
*denotes 1% level of significance
The error correction term , representing the speed of adjustment between the short and
the long-run periods, had a coefficient of - 0.08, being statistically highly significant
at 1%. The negative sign is an indicator of model consistency both in the short and
long run, and the model actually converges to long-run equilibrium (Harris and
Sollis, 2003). Past levels of all the variables in the short run have negative impact on
economic growth but not statistically significant at 5% level of significance.
squared is 75 % indicates an appropriate measure of the model's success in
342
variables.
specified the test for serial correlation, normality and hetroscadasticity are conducted.
The LM (Lagrange Multiplier) test, adopted in this study, is a general test for error
The results, indicated in Table 6.6.8, show that the test does not reject the null
hypothesis of no serial correlation in the residuals.
Table 6.6.8 : Test Results for Serial Correlation (1968-2013)
Breusch-Godfrey Serial Correlation LM Test:

F-statistic 0.257712 Probability F. 0.6147
Obs*R-squared 0.304349 Probability Chi-Square 0.5812
The null hypothesis of the test is that there is no serial correlation in the residuals up
to the specified order. The Probability of Chi-Square is 58.12 %, which is greater than
5 %. So the null hypothesis is accepted that there is no serial correlation in the
residuals. The implication is that the model has valid standard errors and could be
used for making inferences and valid economic policy suggestions.
343
consistent. White (1980) describes a general test for model mis-specification, since
and independent of the regressors, and that the linear specification of the model is
correct. The ARCH test is used to test of the null hypothesis of no heteroscedasticity.
In this case, as can be seen from table 6.6.9 the probability Chi-Square 67.92%, which
is greater than 5 %. So the null hypothesis is accepted of no heteroscedasticity.
Table 6.6.9: Test Results for Heteroscedasticity: ARCH Test (1968-2013)

F-statistic 0.163758 Probability F 0.6878
The Histogram Normality Test is used to test the null hypothesis that residuals are
normally distributed. It can be seen from the following histogram that jarque- Bera
value is 9.731636 and Probability is 0.7 % which is less than 5%. Therefore we
cannot accept the null hypothesis that the residuals are normally distributed. Even
then, the model can be accepted as other diagnostic results are valid. The results of the
diagnostic test reveal that the model is well specified, indicating that the estimated
Error Correction Model performs well.
12
Series: Residuals
Sample 1970 2013
10 Observations 44
8 Mean 1.29e-17
Median -0.004349
Maximum 0.048092
6 Minimum -0.087270
Std. Dev. 0.025088
Skewness -0.736337
4
Kurtosis 4.771834
2 Jarque-Bera 9.731636
Probability 0.007706
0
-0.08 -0.06 -0.04 -0.02 0.00 0.02 0.04
Figure 6.6.2 : Histogram normality test of Jarque-Bera (1968-2013)
344
(1975). Unlike chow test that requires break points to be specified, the CUSUM test
the null hypothesis of all co-efficient in the given regression are stable and cannot be
30
20
10
-10
-20
1975 1980 1985 1990 1995 2000 2005 2010
345
(1968-2013)
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
1975 1980 1985 1990 1995 2000 2005 2010
Figures 6.6.3 and 6.6.4 evidently shows that CUSUM and CUMSUMSQ plots lie
outside the bound. Thus it is providing evidence that parameter of the model suffer
from structural instability over the period. It shows that there is a structural break in
the data series used for the study.
6.7 Existence of Structural Break
Table 6.7.1: Chow Test Result (1968-2013)

Null hypothesis F statistics Probability Conclusion
No breaks at specified breakpoints 10.25541 0.0000 Rejected
Note: year 1991 is taken as a break period
The chow test result shown in table 6.7.1 confirms the structural break in the data
during the year 1991. The null hypothesis of no break at specified break point (1991)
is rejected at 1% level. By considering the structural break, for studying the
relationship between financial development and economic growth in India, it is
necessary to check the pre -reform and post- reform period performance. Therefore
346
the study period is divided in to two sub-periods that are pre-reform period (1968-
1991) and post-reform period (1992-2013).
6.8 Results for Pre- reform period (1968-1991)
study i.e., economic growth, gross domestic capital formation ,credit and stock market
capitalisation during the pre financial sector reform period ( 1968-1991).
presented in the table . It is found that all variables have positive mean value and
negative skewness except economic growth. Jarque-bera test value and the probability
show that the data series are normal.
Table no. 6.8.1 Descriptive Statistics of variables (1968-1991)

LNEGFC LNCR LNGDCF LNSMC
Mean 13.57791 2.658511 2.909144 1.948934
Median 13.54796 2.772388 2.922321 2.041678
Maximum 14.11405 3.131669 3.259335 2.740544
Minimum 13.14971 2.191841 2.570713 1.049085
Std. Dev. 0.287697 0.321119 0.171043 0.491311
Skewness 0.287467 -0.131150 -0.041485 -0.082213
Kurtosis 1.959823 1.481621 2.506433 1.682210
Jarque-Bera 1.412518 2.374275 0.250493 1.763606
Probability 0.493487 0.305093 0.882280 0.414036
Sum 325.8699 63.80427 69.81946 46.77441
Sum Sq. Dev. 1.903694 2.371705 0.672879 5.551887
347
Line Graph
line graph presented below figure 6.8.1. The entire variables move in the same
upward direction with minor fluctuation but there is much fluctuation in the stock
market capitalisation.
LNEGFC LNCR
14.2 3.2
14.0 3.0
13.8 2.8
13.6 2.6
13.4 2.4
13.2 2.2
13.0 2.0
68 70 72 74 76 78 80 82 84 86 88 90 68 70 72 74 76 78 80 82 84 86 88 90
LNGDCF LNSMC
3.4 2.8
3.2 2.4
3.0 2.0
2.8 1.6
2.6 1.2
2.4 0.8
68 70 72 74 76 78 80 82 84 86 88 90 68 70 72 74 76 78 80 82 84 86 88 90
examine the stationarity characteristics of the series. Table 6.8.2 reports the ADF unit-
root test and Philips Perron test results as below:
348
Table 6.8.2: Results of unit root test for pre reform period (1968-1991)
ADF
Calculated
Level/first critical
difference value
statistics
5%
First difference -3.447723 -3.632896* Stationary
LNSMC Level -0.561446 -3.644963 Not stationary
Calculated PP critical
Level/first
difference
statistics 5%
* At 1 % otherwise at 5% level of significance
Table 6.8.2 shows the test statistics (TS) and the corresponding critical values (CV)
at the 5% levels of significance. The null hypothesis for the presence of a unit root is
rejected if the TS value is bigger (in absolute terms) than the corresponding CV
statistic. Rejection of the null hypothesis implies that the series is stationary. The test
results seem to support the argument that the series became stationary after the first
difference.
The results in show that the unit root null of the level of all variables is accepted. The
observed CV values are higher than TS in ADF and PP tests with constant and trend.
However, the null hypothesis of the unit root for the first difference for the LNEGFC,
LNCR, LNGDCF and LNSMC is rejected because the TS values of ADF and PP tests
are higher than the corresponding critical values (CV). It means that all the variables
are integrated of order I(1) and all the series are non- stationary at level but become
stationary at first difference.
349
The step of discovering the long run relationship among variables requires an
adequate lag length of them in order to remove any serial correlation. The optimum
lag length is usually selected based on AIC, SIC and HQ test statistic. The entire test
indicates that 1 lag order should be selected for the data analysis.
Table 6.8.3: VAR Lag order Selection Criteria (1968-1991)
Lag LR AIC SIC HQ

0 NA -3.404845 -3.206474 -3.358115
1 137.3336* -10.02874* -9.036888* -9.795093*
2 15.46340 -9.763692 -7.978349 -9.343119
cointegrating vectors is accepted since the test statistic of 43.70 is smaller than 5%
critical value of 47.85. In the case of the Max test, the null hypothesis of no
cointegrating vectors is accepted at 5% critical value since the Max statistic of 22.92
is smaller than 5% critical value of 27.58. Therefore, the null hypothesis of no
cointegrating vectors is accepted by the trace test and by the Max test at 5% level of
significance.

None 0.647287 43.70043 47.85613 0.1164
At most 1 0.362245 20.77422 29.79707 0.3719
At most 2 0.329492 10.87859 15.49471 0.2191
At most 3 0.090410 2.084744 3.841466 0.1488
Trace test indicates no cointegration at the 0.05 level
350
Table 6.8.5: Maximum Eigen value Cointegration Rank Test (1968-1991)

No. of CE(s) Eigen value Statistic Critical Value Prob.**
None 0.647287 22.92620 27.58434 0.1767
At most 1 0.362245 9.895633 21.13162 0.7544
At most 2 0.329492 8.793845 14.26460 0.3037
At most 3 0.090410 2.084744 3.841466 0.1488
Max-eigenvalue test indicates no cointegration at the 0.05 level
It is clear from the cointegration test that no cointegrating vectors are there as shown
by the trace test and by the Max test at 5% level. If there is no cointegration then there
is no long term relationship among the variables. So the VAR with the difference data
is analysed for the short term relationship among the variables. The empirical
investigation regarding the short run dynamics is important for policy makers because
the signs and magnitudes of the short run dynamics provide the direction and
movements of variables. Thus short run dynamics are estimated through error
correction model.
Table 6.8.6: Short run relationship during pre reform period (1968-1991)
Variable D(LNEGFC)
D(LNEGFC(-1)) -0.296188 [-1.38601]
D(LNCR(-1)) -0.322265 [-1.86079]***
D(LNGDCF(-1)) -0.130895 [-1.32955]
D(LNSMC(-1)) 0.021237 [ 0.67337]
Constant 0.071669 [ 5.03470]*
R-squared 68 % F-stat 2.13 prob. (0.09)
DW-statistic 1.89
*,**,*** indicates1 %,5% and 10% level of significance
It is clear from the analysis that only credit is negatively and significantly affecting
negatively economic growth at 10 % level of significance. The stock market
capitalisation is affecting positively and GDCF affecting negatively but these are not
statistically significant at 5 % level of significance.
351
variables.
It can be seen from the following histogram that jarque- Bera value is 0.911 and
Probability is 63.40 % which is more than 5%. Therefore we can accept the null
hypothesis that the residuals are normally distributed.
Figure 6.8.2: Histogram normality test (1968-1991)

6
Series: Residuals
Sample 1970 1991
5 Observations 22
4 Mean 3.47e-18
Median -0.004091
Maximum 0.049399
3 Minimum -0.050086
Std. Dev. 0.027070
Skewness 0.107731
2
Kurtosis 2.026457
1 Jarque-Bera 0.911359
Probability 0.634017
0
-0.06 -0.04 -0.02 0.00 0.02 0.04
352
The null hypothesis of the LM test is that there is no serial correlation up to lag order
‗p‘, where ‗p‘ is a pre-specified integer. The results, indicated in Table 6.8.7 , show
that the test does not reject the null hypothesis of no serial correlation in the residuals.
Table 6.8.7: Test Results for Serial Correlation (1968-1991)

The null hypothesis of the test is that there is no serial correlation in the residuals up
to the specified order. The Probability of Chi-Square is 71.95 %, which is greater than
5 % level of significance. So the null hypothesis is accepted that there is no serial
correlation in the residuals. The implication is that the model has valid standard errors
and could be used for making inferences and valid economic policy suggestions
case, as can be seen from table 6.8.8 the probability of Chi-Square is 33.68 %, which
is greater than 5% level of significance. So it does not reject the null hypothesis of no
heteroscedasticity.
Table no. 6.8.8:Test Results for Heteroscedasticity ARCH Test

(1968-1991)
The results of the diagnostic test reveal that the model is well specified, indicating
that the estimated Error Correction Model performs well.

test was computed to provide an examination stability of the model. The CUSUM test
(Brown, Durbin, and Evans, 1975) is based on the cumulative sum of the recursive
residuals. This test plots the cumulative sum together with the 5% critical lines. The
353
test finds parameter instability if the cumulative sum goes outside the area between
the two critical lines.
Figure 6.8.3 Plot of Cumulative Sum of Recursive Residuals (1968-1991)

15
10
-5
-10
-15
1976 1978 1980 1982 1984 1986 1988 1990
Figure 6.8.4 : Plot of Cumulative Sum of Squares of Recursive Residuals
(1968-1991)
1.6
1.2
0.8
0.4
0.0
-0.4
76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91
Figures 6.8.3 and figure 6.8.4 evidently shows that CUSUM and CUMSUMSQ plots
lie inside the bound. Thus it is providing evidence that parameter of the model is free
from structural instability over the period.
354
6.9 Results for Post- reform period (1992-2013)
study i.e., Economic Growth, Gross Domestic Capital Formation ,Credit and Stock
Market Capitalisation during the post- financial sector reform period ( 1992-2013).
presented in the table 6.9.1. It is found that all variables have positive mean value and
skewness. Jarque –bera test value and the probability show that the data series are
normal during the period under study.

(1992-2013)
LNEG LNCR LNGDCF LNSMC
Mean 14.79246 3.530120 3.345802 3.853314
Median 14.74076 3.444859 3.261837 3.784302
Maximum 15.51700 4.007432 3.640572 4.634984
Minimum 14.12825 3.038350 3.081925 3.116183
Std. Dev. 0.436984 0.367973 0.195770 0.464298
Skewness 0.162024 0.176852 0.249583 0.110071
Kurtosis 1.827702 1.432336 1.366356 1.914166
Jarque-Bera 1.356015 2.367455 2.674796 1.125207
Probability 0.507627 0.306136 0.262528 0.569724
Sum 325.4341 77.66264 73.60763 84.77290
Sum Sq. Dev. 4.010064 2.843481 0.804843 4.527017
Line Graph
line graph as presented below by figure 6.9.1. The entire variables move in the same
355
direction with minor fluctuation but there is much fluctuation in the Stock Market
Capitalisation and Gross Domestic Capital Formation.

LNEGFC LNCR
15.6 4.2
4.0
15.2
3.8
14.8 3.6
3.4
14.4
3.2
14.0 3.0
92 94 96 98 00 02 04 06 08 10 12 92 94 96 98 00 02 04 06 08 10 12
LNGDCF LNSMC
3.7 4.8
3.6
4.4
3.5
3.4 4.0
3.3 3.6
3.2
3.2
3.1
3.0 2.8
92 94 96 98 00 02 04 06 08 10 12 92 94 96 98 00 02 04 06 08 10 12
examine the stationarity characteristics of the series. Table 6.9.2 reports the ADF unit-
root test and Philips Perron test results below:
356
Table 6.9.2: Unit root test (1992-2013)
Level/first Calculated – ADF critical

difference test statistics value at 5 %
Level/first Calculated – PP critical
difference test statistics value at 5 %
*indicates 10 % level of significance
Lag order selection
lag length is usually selected based on AIC, SIC and HQ test statistic.These test
results are shown in the table 6.9.3 as below:
357
Table no. 6.9.3: VAR Lag order Selection Criteria (1992-2013)
Lag LR AIC SIC HQ

0 NA -4.970572 -4.771426 -4.931697
1 140.4223* -12.73206* -11.73632* -12.53768*
2 16.61658 -12.64265 -10.85034 -12.29278
All the test indicates that 1 lag order should be selected for the data analysis. Here lag
order 2 is selected as the values are not so different from the lag suggested by the
criterion and the diagnostic and stability test results are more authentic at lag order 2.
Testing for cointegration
the trace statistic 21.09 is smaller than 5% critical value of 29.79. So the null
hypothesis of atmost 1 cointegrating vector is accepted. In the case of the Max test,
the null hypothesis of no cointegrating vectors is rejected at 5% critical value since
the Max statistic of 34.00 is greater than 5% critical value of 27.58. Moving on to test
the null at most 1 cointegrating vectors, the max test statistics is 13.43 is smaller than
5% critical value of 21.13. So the null hypothesis of at most 1 cointegrating vector is
accepted. Therefore, the null hypothesis of no cointegrating vectors is rejected by the
trace test and by the Max test at 5% level of significance, but accepted for at most 1
cointegrating vector.
Table no. 6.9.4: Trace Cointegration Rank Test (1992-2013)

None * 0.833023 55.10416 47.85613 0.0090
At most 1 0.506940 21.09607 29.79707 0.3517
At most 2 0.320397 7.660701 15.49471 0.5024
At most 3 0.016805 0.322006 3.841466 0.5704
358
Table no. 6.9.5: Maximum Eigenvalue Cointegration Rank Test (1992-2013)
None * 0.833023 34.00809 27.58434 0.0065
At most 1 0.506940 13.43537 21.13162 0.4130
At most 2 0.320397 7.338695 14.26460 0.4499
At most 3 0.016805 0.322006 3.841466 0.5704
equilibrium function are summarised below.
Table no. 6.9.6: Long Run Relationship, Dependent variable is LNEGFC
(1992-2013)
Variable Coefficient T- ratio

LNCR 0.443248 1.84295***
LNGDCF 2.253146 2.94138**
LNSMC -0.188737 0.96436
*,**,*** indicates1 %,5% and 10% level of significance
Table 6.9.6 shows that Credit and Gross domestic Capital Formation have positive
and significant impact on the economic growth in the long run at 10 % and 5% level
of significance respectively. An increase of 1 % in credit leads to 0.44 % increase in
Formation leads to 2.25 % increase in the economic growth. Stock Market
Capitalisation has negative impact but it is not statistically significant even at 10 %
level of significance.
359
error correction model. The results are shown in the following table 6.9.7.
Table no. 6.9.7: Short run relationship (1992-2013)

Variable D(LNEGFC)
CointEq1 -0.159548 [4.20070]*
D(LNEGFC(-1)) -0.749066 [2.36545]**
D(LNEGFC(-2)) -0.803565 [2.79482]**
D(LNCR(-1)) -0.029333 [0.39316]
D(LNCR(-2)) 0.026417 [ 0.39718]
D(LNGDCF(-1)) -0.169323 [1.55577]***
D(LNGDCF(-2)) -0.025151 [0.37500]
D(LNSMC(-1)) 0.031692 [ 1.27951]
D(LNSMC(-2)) 0.028063 [ 1.54875]***
Constant 0.174496 [ 5.39810]*
R-squared 81 %, F-statistic 4.163478 Prob. (0.022)

*,*and** denotes 1%, 5% and 10% level of significance

The error correction term, representing the speed of adjustment between the short and
the long-run periods, has a coefficient of - 0.15, being statistically highly significant at
1%. The negative sign is an indicator of model consistency both in the short and long
run, and the model actually converges to long-run equilibrium (Harris and Sollis,
2003). Past levels of credit period in the short run has no statistically significant
impact on economic growth. Past levels of economic growth period with lag 1 and lag
2 in the short run has statistically significant positive impact on economic growth at
5% level of significance. Gross domestic Capital Formation with lag period of 1 year
is also statistically significant and has negative impact on the economic growth of
India at 10% level of significance. Stock market Capitalisation at lag period 2 years
have positive statistically significant impact at 10 % level on the economic growth.
360
variables.
The results , indicated in Table 6.9.8, show that the Probability of Chi-Square is 50.79
%, which is greater than 5 %. So we accept the null hypothesis that there is no serial
correlation in the residuals. The implication is that the model had valid standard errors
and could be used for making inferences and valid economic policy suggestions.
Table 6.9.8: Test Results for Serial Correlation (1992-2013)

case, as can be seen from table 6.9.9, the probability of Chi-Square is 57.18 %,which
is greater than 5 % level of significance. So it does not reject the null hypothesis of no
heteroscedasticity.
361
Table no 6.9.9: Test Results for Heteroscedasticity ARCH Test(1992-2013)
normally distributed. It can be seen from the following histogram that jarque- Bera
value is 0.43 and Probability is 80.52 % which is more than 5%. Therefore we can
accept the null hypothesis that the residuals are normally distributed.
Figure 6.9.2: Histogram Normality test (1992-2013)

9
Series: Residuals
8 Sample 1995 2013
Observations 19
7
6 Mean -2.17e-17
Median 0.001571
5 Maximum 0.015416
Minimum -0.016575
4 Std. Dev. 0.007661
Skewness -0.367599
3
Kurtosis 3.082197
2
Jarque-Bera 0.433258
1 Probability 0.805229
0
-0.02 -0.01 0.00 0.01 0.02
The results of the diagnostic test reveal that the model is well specified, indicating
that the estimated Error Correction Model performs well.

test was computed to provide an examination stability of the model. The CUSUM test
(Brown, Durbin, and Evans, 1975) is based on the cumulative sum of the recursive
residuals. This test plots the cumulative sum together with the 5% critical lines. The
test finds parameter instability if the cumulative sum goes outside the area between
the two critical lines.
362
15
10
-5
-10
-15
1996 1998 2000 2002 2004 2006 2008 2010 2012
(1992-2013)
1.6
1.2
0.8
0.4
0.0
-0.4
1996 1998 2000 2002 2004 2006 2008 2010 2012
lie inside the bound. Thus it is providing evidence that parameter of the model are free
from structural instability over the period under study.
6.10 Discussion of the results
In the post-reform period, the credit to the private sector has grown at a much rapid
pace in comparison to the pre-reform years. This has been the result of positive real
363
interest rates tuned to the market and a wide range of financial assets to meet the
diversified needs of individual savers. Thus financial savings have substantially
increased. Then with increased competition and autonomy of operations, efficiency of
financial institutions has also greatly improved. Moreover with substantial reductions
in CRR, SLR and credit to the priority sector, much greater proportion of available
funds can be lent out to the private sector for speedy growth process. The economic
growth can also negatively affect the increase in institutional finance to the private
sector in the long run. The possible reason could be tight monetary policy often
pursued during inflationary conditions that often accompany high rates of growth.
Moreover when growth is good, households earning increase. These increases are also
often diverted to real estate, precious metals, consumer durables and other items of
conspicuous consumption. Huge amounts are spent partying, on ceremonies,
luxurious accessories, clothing consumer durables and the like. Maximum savings in
India come from the household sector. They save for their future needs. When growth
is good people are optimistic about their future incomes also and less inclined to
savings. Moreover once a certain high level of savings for future is reached, they may
often indulge into conspicuous consumption rather than more savings, as the marginal
utility from savings at that point may drop too low. This explains the negative impact
of economic growth on increase in institutional finance in the long run.
In case of stock market, the results are substantially different in context of markets
explaining capital accumulation and the growth process. Stock market capitalisation
does not affect economic growth at 5 % level of significance. However as seen from
the p- values of all lagged values it is permissible to say that at 10 % level of
significance stock market capitalisation does effect economic growth. The effect is
much small in magnitude and negative in direction. Thus stock markets do influence
economic growth but the impact is small and negative. The possible reason for the
negative impact is that the benefits of stock market are more from the point of view of
maximising speculative returns for the individual investors and market operators. The
stock market induced liquidity may encourage investor myopia and weaken investor
commitment. It may reduce investor incentive to exert corporate control and monitor
company‘s performance, which can hurt economic growth. In today‘s liberalised and
globalised world, stock markets can easily act as conduit for spreading speculative
pressure all over the world. An undesirable implication of these types of pressures is
364
that economies may be forced to bear a greater degree of risk with financial
liberalisation than without it. They may actually reduce the total volume of real sector
investment while exerting upward pressures on the interest rates in view of higher
risks. Moreover, in the wake of unfavourable economic shocks, the interactions
between stock market and currency markets may exacerbate macro economic
instability and reduce long term economic growth.
Growth of stock market often leads to speculative pressures. These pressures may
emanate from transactions induced by the euphoria created by financial liberalisation
that rewards speculators with short term horizons and punishes those with a long term
view (Keynes, 1936). In the light of above it can be said that the possible reason for
the negative impact of market capitalisation on economic growth could be found in
the nature of Indian stock market that is predominantly speculative in nature. This
makes it highly volatile. Often stock prices experience substantial speculative
increases when such a momentum is built up, lot of money goes into the stock market
and gets diverted away from the institutions and from other productive investments.
Moreover when stock prices start to fall, speculative shares drop in prices and people
often suffer losses. If such a situation continues for a long time may create a seriously
liquidity crunch in the economy as illustrated by the current scenario in the stock
market. Stock market by its nature is a secondary market and does not provide fresh
funds to the productive units. It increases the liquidity of primary securities so that
they become more attractive to surplus units.
When the stock market is going good it is often noted that IPO‘s (Initial Public
Offerings of bonds) are oversubscribed and the corporate firms are easily able to raise
fresh capital. In case of India, such a role is limited and overshadowed by speculative
trading so that funds are diverted away from productive to unproductive channels,
Thereby having a negative influence on growth. Thus it can be noted that in context of
long run equilibrium the institutional finance to the private sector significantly affect
the economic growth, the effect is strong and positive.
During the short run there is negative association between the credit and economic
growth in the post liberalisation period. This negative association can greatly be
attributed to counter cyclic policies of the government. For instance if economic
365
growth moves up above the long term equilibrium, it leads to inflationary conditions
in the economy. Government may then undertake different combinations of restrictive
monetary and credit policies such as increase in bank rate and/or repo rate. Such
policies will make credit taking unattractive for production units or else the CRR or
SLR may be revise upward, thus making lesser funds available for lending to the
private sector. On the whole less institutional credit will flow to the private sector in
short run. This reduced flow of credit will affect the production activity adversely and
via the positive long run equilibrium impact of institutional credit on economic
growth rate, the rate of growth of the economy will dampen, thus taking the economy
backwards the long run equilibrium. Conversely of the economic growth rate was to
fall below the equilibrium level, the expansionary monetary policies of the
government will increase the flow of credit to the private sector in the short run. This
will stimulate the economic activity and put the economy back on the long run
equilibrium path.
On the whole it is found that higher levels of financial development are significantly
and robustly correlated with faster current and future rates of economic growth and
physical capital accumulation. From the results it can be concluded that a strong
positive relationship exists between financial sector development and economic
growth.

Based on the Robinson (1952) and Schumpeterian‟s (1911) view, Patrick (1966)
contributed to financial development and economic growth literature by identifying
two patterns in the causal relationship between financial development and economic
growth. The first one is called ―Demand Following‖ which is the creation of modern
financial institutions and the supply of their financial assets, liabilities and related
financial services in response to the demand for these services by investors and savers
in the real economy .The second one is called ―Supply Leading‖ which is the creation
of financial institutions and the supply of their financial assets, liabilities and related
financial services in advance of demand for them, especially the demand of
entrepreneurs in the modern growth inducing sectors. Supply leading has two
functions: to transfer resources from traditional (non-growth) sectors to modern
sectors and to promote and stimulate an entrepreneurial response in the modern
366
sectors. Patrick (1966) also argued that the causal relationship between financial
development and economic growth varies according to the stages of the development
process. He suggests that the supply-leading pattern dominates during the early stages
of economic development. As financial and economic development proceeds, the
supply-leading characteristics of financial development diminish gradually and are
eventually dominated by demand following characteristics of financial development.
The financial and real sectors may expand simultaneously contributing to the
development of each other, which points to bidirectional causality between the two.
Two way relationships between financial development and economic growth has been
shown by, for example, Berthelemy and Varoudakis (1997), Greenwood and
Bruce(1997) and Luintel and Khan(1999). Most of the earlier research pertaining to
the causal relationship between financial development and economic growth were
concentrated on developed countries particularly on capitalist countries. Their
relevance to the developing countries like India is limited due to the existence of vast
differences in socio economic and political characteristics between developed and
developing countries.
There are so many studies which have analysed the causal relationship between
financial development and economic growth, for example Adamopoulos (2008) made
study in Ireland, Muhammad and Umer (2010) in Pakistan etc. The direction of
causality between financial development and economic growth is crucial because it
has different implications for development policies. Economic growth leads financial
development, (demand following hypothesis) means when real growth has been
taking place so that the expansion of financial institutions is only a result of the need
of the expansion of the real economic activities. Support of this view can be found; in
Arestis and et al (2002), Ang and Mckibbin(2007) has found out that unidirectional
causality that runs from Economic Growth to financial development.
On the other hand financial development leads economic growth (supply leading
hypothesis) means that the expansion of financial system may help to improve and
lead economic growth by increasing savings and improving borrowing options and
the reallocation of capital. Bhattacharya and Sivasubramanian (2003),
Amenounve and et al. (2005) investigated the unidirectional causality runs from
financial development to economic growth. At the same time, financial and the real
367
sectors may expand together contributing to the developments of each other, which
shows bidirectional causality between financial development and economic growth.
Two way relationship between financial development and economic growth has been
shown by Demetriades and Luintel(1996),Ghirmay(2004). From the above studies
it is understood that causality will differ from country to country. Patrick (1966)
mentions that, there are economies with supply leading and demand following
hypothesis, he also mentions that in the early stages of development the economy will
follow the supply leading hypothesis, where, as when the economy grows, it will
follow the demand following hypothesis.
To take policy decision it is important to know which way financial development and
economic growth cause each other and therefore an attempt is made to find out the
causality between financial development and economic growth in Indian Context. To
inspect the causality between the different variables of the model, the short run and
the long run causality is determined. The first test reveals the significance of the sum
of lagged terms of each explanatory variable by the mean of Chi-square test and the
second test indicates the significance of the error correction term by the mean of the
T-test. Table 6.11.1 below illustrates the results of all these causality tests during the
total period i.e., 1968-2013.
Table 6.11.1
Chi-sq -statistics ECTt-1
Dependent (p-value)
Coefficient
variable
[t-ratio]
LNEGFC LNCR LNGDCF LNSMC All
LNEGFC 1.088695 1.078811 0.200870 1.554471 -0.083209
(0.2968) (0.2990) (0.6540) (0.6698) [-3.21229]*
LNCR 6.058288 0.316882 1.819225 9.918025 0.138469
( 0.0138)** (0.5735) (0.1774) (0.0193)** [ 3.15282]
LNGDCF 4.207921 4.127424 1.790272 8.558647 0.167969
(0.0402)** (0.0422)** (0.1809) (0.0358)** [ 2.48316]

LNSMC 0.014442 0.001180 0.307059 0.363824 -0.360925
(0.9043) (0.9726) (0.5795) (0.9476) [-1.10074]

368
GDCF does not cause EGFC is not rejected at 1% level of significance and CR not
cause EGFC is not rejected at 1% level of significance. SMC also cannot cause EGFC
at 1% level of significance. It means that there is no causality runs from GDCF,SMC
and CR to Economic Growth in the short run. When EGFC is dependent variable and
all other independent variables were taken together then the null hypothesis is also not
rejected at 1% level of significance means all the variables taken together cannot
cause EGFC. EGFC is found that can significantly cause CR in the short run period at
5% level of significance, even all the variables when taken together can cause CR at
5% level of significance. In the short run EGFC and CR can cause GDCF at 5 % level
of significance, even all the independent GDCF variables when taken together can
cause at 5 % level of significance. No variable was found that can significantly cause
SMC in the short run period, even all the variables when taken together cannot cause
SMC at 1% level of significance. It means that there is unidirectional causality
running from EGFC and CR to GDCF.
causality from the independent variables such as GDCF, SMC and CR to EGFC
meaning that GDCF, SMC and CR have influence on dependent variable EGFC in the
long run at 1% level of significance.
To inspect the causality between the different variables of the model during the pre-
reform period i.e., 1968-1991, the short run causality is determined as there is no long
run causality among the variables. The short run test reveals the significance of the
sum of lagged terms of each explanatory variable by the mean of Chi-square test.
Table no.6.11.2 below illustrates the results of all the causality tests.
Bhattacharya and Sivasubramanian (2003) made a study in India by taking

M3/GDP as proxy for financial development and reached to similar conclusion that
financial development leads the economy to grow not the other way. It helps the
policy makers to decide which way they can develop the financial sector and
ultimately the development of economy.
369
Table 6.11.2
(p-value)
variable
LNEGFC 3.045431 0.548368 0.125948 5.784172
(0.0810)*** (0.4590) (0.7227) (0.1226)
LNCR 2.677299 0.357101 0.023480 3.765813
(0.1018) (0.5501) (0.8782) ( 0.2879)
LNGDCF 2.428913 0.010589 0.013378 2.544809
(0.1191) (0.9180) (0.9079) ( 0.4672)

LNSMC 0.313272 0.017971 0.531939 0.982970
(0.5757) (0.8934) (0.4658) (0.8054)

GDCF does not cause EGFC is not rejected at 1% level of significance means that
there is no causality runs from GDCF to Economic Growth in the short run. The null
hypothesis of CR not cause EGFC is rejected at 10% level of significance. It means
that there is unidirectional causality runs from CR to Economic Growth in the short
run. When EGFC is dependent variable and all other independent variables are taken
together then the null hypothesis is not rejected at 1% level of significance means all
the variables taken together can not cause EGFC. The null hypothesis of SMC not
cause EGFC is not rejected at 1% level of significance. It means that there is no
causality runs from SMC to Economic Growth in the short run. No variable was
found that can significantly cause CR, GDCF and SMC in the short run period, even
all the variables when taken together cannot cause CR, GDCF and SMC at 1% level
of significance respectively.
To inspect the causality between the different variables of the model during the post-
reform period, the short run and the long run causality is determined. The first test
reveals the significance of the sum of lagged terms of each explanatory variable by
the mean of Chi-square test and the second test indicates the significance of the error
370
correction term by the mean of the T-test. Table no.6.11.3 below illustrates the results
of all these causality tests during the post- reform period i.e., 1992-2013.
Table 6.11.3
ECTt-1
Coefficient
variable (p-value)
[t-ratio]
LNEGFC 7.306100 0.945126 4.444822 22.41278 -0.159548
(0.0259)** (0.6234) (0.1083) (0.0010)* [-4.20070]*
LNCR 0.726710 0.369903 4.556172 4.905748 0.138825
(0.6953) (0.8311) ( 0.1025) (0.5560) [ 0.82125]
LNGDCF 0.122875 8.910529 4.371619 15.38950 -0.143529
(0.9404) ( 0.0116)** ( 0.1124) (0.0174)** [-0.60104]

LNSMC 1.292429 4.219899 0.522227 15.51788 -1.547328
(0.5240) (0.1212) (0.7702) (0.0166)** [-1.32360]

GDCF does not cause EGFC is accepted at 1% level of significance and CR not cause
EGFC is rejected at 5% level of significance. It means that there is unidirectional
causality runs from CR to Economic Growth in the short run. When EGFC is
dependent variable and all other independent variables were taken together then the
null hypothesis is also rejected at 1% level of significance means all the variables
taken together can cause EGFC. CR is found that can significantly cause GDCF at 5
% level of significance in the short run period, even all the variables when taken
together can cause GDCF at 5 % level of significance. Overall results show that in the
short run period, there is unidirectional causality running from CR to EGFC and
GDCF. No variable is found that can influence SMC in the short run period, but when
all the independent variables are taken together then they can influence SMC at 5 %
level of significance.
causality from the independent variables such as GDCF, SMC and CR to EGFC
371
meaning that GDCF, SMC and CR have influence on dependent variable EGFC in the
long run at 1% level of significance.
Chakraborthy (2007) made a study in India by taking market turnover, market

capitalisation ratio, bank credit, stock market volatility for financial development
indicator during 1996-2005 and found out that causality is running from economic
growth to financial development in the post liberalisation period. It seems that the role
of financial development may not be crucial for economic growth in the post
liberalisation period. This study does not confirm the results but contradict and state
that causality runs from financial development to economic growth.
Amenounve et.al (2005). It is understood that policy makers need to concentrate on
financial development to boost economic growth.
6.12 Conclusion
Indian economy follows the Patrik (1966) view of causality. In his study he mentions
that the direction of causality will differ from country to country and according to the
economic conditions. This study also agrees with his views, i.e. in the pre-reform
period, financial development leads economic growth and during post-reform, there is
no change in the direction of causality. On the whole it is found that higher levels of
financial development are significantly and robustly correlated with faster current and
future rates of economic growth and physical capital accumulation. From the results it
can be concluded that a strong positive relationship exists between financial sector
development and economic growth. This relationship is not just a contemporaneous
relationship. The existence of such a relationship has important policy implications.
372
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375
CHAPTER 7
CONCLUSION AND SUGGESTIONS
7.1 An overview
This study has analysed the impact of the reforms undertaken in the financial sector
on economic growth in India. Starting with an introduction of the financial system and
its development, it then gives a brief overview of the Indian financial system since
independence. This is followed by an outline of the major reforms recommended in
the financial sector as part of Narsimham Committee Reports I and II. Next a
comprehensive survey of literature has been presented. These gives theoretical and
empirical overview of the relationship between financial development and economic
growth for developed as well as developing economies. Financial growth nexus has
been examined by the cross section and time series studies. Different methodologies
varying from ordinary least square to vector error correction models have been used
in cross country as well as country specific studies. There exist only a few studies that
examined the financial growth relationship in India. Some studies have examined the
productivity growth and performance of the banking sector in India and also growth
of credit in the Indian economy.
The survey of the theoretical and empirical literature is followed by research

methodology and the results of empirical analysis. Available data shows that
substantial financial development has taken place during the post-reform period based
on various quantitative indicators. The performance of the commercial banking sector
has shown noticeable improvement during the post-reform years. The Indian capital
market has also done major changes and improvements. Finally it has been found that
the financial sector has strong positive effect on the economic growth in India.
7.2 Banking sector development
The commercial banks play an important role in mobilising savings of economically

surplus units which are widely scattered. The banks perform the process of financial
intermediation through the institutionalisation of savings and investment that foster
economic growth. Stultz (2001) states that even though a country has enough
resources to generate adequate capital accumulation, its growth potential can be
376
hindered if the domestic financial intermediation mechanism fails to allocate these
savings to available investment opportunities efficiently.
The impact of financial sector reforms on the Indian banking sector has been
examined in terms of the changes in growth rates of savings, gross domestic capital
formation, deposits and credit/institutional finance, density etc. To start with time
series of all stated indicators have been plotted against time. This gives a fairly good
indication of the presence or absence and direction of the trend. Where substantial and
consistent data is available for both pre and post- reform periods, in respect to those
indicators regression analysis has been used to find whether there exists a significant
difference in the growth rates in the pre and post- reform periods. In cases where
substantial pre -reform data is not available or the magnitudes in entirety have been
sharply fluctuating, simple data analysis has been done.
It has been found that the average annual rate of growth is increased to 0.41 % during
post- reform period as compared to 0.31 % during pre- reform period in case of
household savings. The average annual rate of growth is increased to 0.68% during
post- reform period as compared to 0.33 % during pre- reform period in case of total
gross domestic savings. The growth rate in case of total gross domestic savings is
more than double in the post- reform period.
Total Gross Domestic Capital Formation (GDCF) rate of average annual growth is
increased 0.79 % in the post- reform period as compared to the 0.41 % in the pre-
reform period. It is clear that the rate of growth has nearly doubled in the post- reform
period for total Gross Domestic Capital Formation (GDCF). The GDCF in the case of
private sector has also increased during the post-reform period from 0.18 % to 0.73%.
The rate of growth has nearly four times in the post- reform period for the private
sector capital formation.
The average annual growth rate for deposits of the banking system is increased in the
post- reform period to 1.96 % as compared to 1.12 % in the pre- reform period.
Aggregate deposits of Non Banking Companies (NBCs) increased from 569 crores in
1970-71 to 348243 crores in 1996-97.
In the pre-reform period, the percentage of rural deposit has increased from 5.9
percent to 15.46 percent, but it declined to 9.60 percent by 2013.The percentage of
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semi urban deposit steadily declined during pre and post- reform periods. The urban
deposit also declined constantly in the post- reform years. But the metropolitan
deposit has steadily increased during pre and post- reform periods. So in the post-
reform period, rural, semi urban and urban deposits have declined and metropolitan
deposits have increased.
The average annual rate of growth is decreased during post- reform period to -0.37 as
compared to pre- reform period of -0.08 in case of semi urban deposits. The average
annual rate of growth is decreased during post- reform period to -0.13 as compared to
pre reform period of 0.09 in case of urban deposits. The average annual rate of growth
has increased during post-reform period to 0.85 as compared to pre- reform period of
-0.45 in case of metropolitan deposits. The growth rate for the metropolitan deposits
is nearly doubled in the post-reform period.
The sharp change in the growth of institutional finance after the reforms is also
brought out by the regression analysis. The average annual rate of growth has
increased during post- reform period to 1.99 as compared to pre-reform period of 0.64
in case of institutional finance to the private sector. The growth rate is more than three
times in the post-reform period.
The average annual rate of growth is decreased during post -reform period to -0.39 as
compared to pre- reform period of 0.88 in case of rural credit. The average annual rate
of growth is decreased during post -reform period to -0.26 as compared to pre reform
period of 0.22 in case of semi urban credit. The average annual rate of growth is
decreased during post- reform period to -0.09 as compared to pre reform period of
0.01 in case of urban credits. The average annual rate of growth is increased during
post- reform period to 0.73 as compared to pre- reform period of -1.12 in case of
metropolitan credit. In the post-reform period growth rate of the institutional finance
to the private sector is decreased in the case of rural, semi-urban and urban areas but
increased in the case of metropolitan area in comparison to the pre-reform period.
From the above discussion of deposits and credit area wise , it is clear that after the
reforms, the growth rates for the deposit and credit in case of metropolitan areas
increased. It shows that more emphasis is on the metropolitan areas and other areas
are neglected especially rural areas.
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Population/ bank offices rate of average annual growth is increased to -0.10 % in the
post- reform period as compared to the -1.44 % in the pre- reform period, but the sign
is negative which shows that in the pre- reform period population per bank offices
decreased at higher rate than in the post- reform period. In the case of number of
scheduled commercial banks per million populations is increased at the rate of 2.83 in
the pre- reform period and 0.41 percent in the post- reform period.
The average annual rate of growth is decreased during post- reform period to -1.04 as
compared to pre- reform period of 1.43 in case of rural branches. The average annual
rate of growth is increased during post reform period to 0.29 as compared to pre
reform period of -0.80 in case of semi urban branches. The average annual rate of
growth is increased during post- reform period to 0.30 as compared to pre- reform
period of -0.31 in case of urban branches and to 0.45 from -0.31 in case of
metropolitan branches of scheduled commercial banks. This clearly shows that during
the post reform period, only the branches in the rural area decreased. This means that
semi urban, urban and metropolitan areas given preference in opening branches and
rural areas neglected.
The performance of the financial sector is also examined in terms of level of

profitability, non- performing assets, capital adequacy ratio and various indicators of
efficiency and productivity.
In the pre- reform period growth rate of deposits for Regional Rural Banks registered
highest growth rate of 36.25 percent followed by Foreign Banks 25.90 percent and
Nationalised Banks 18.38 percent. The overall growth rate for all Scheduled
Scheduled Commercial Banks including RRBs. In the post reform period growth rate
of deposits for Private Sector Banks registered highest growth rate of 25.55 percent
followed by the Regional Rural Banks 18.15 percent and Nationalised Banks 16.90
percent.
In the post-reform period, growth rate of deposits for Private Sector Banks increased
and for all other bank groups decreased in comparison to pre-reform period. The
reason for shrinking of deposits growth rate of public sector banks was on account of
coming up of new competitors in the market and boom in the stock exchange market
in the early nineties. The foreign banks were much successful in pre-reform period
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mainly because of their selected branch expansion and selected deposits mobilisation,
which by and large confined to metropolitan areas only. The quality of services
provided by them was also accountable to higher growth rates in deposits. The reason
for steep fall in the deposits growth rate of foreign banks could be assigned to new
competition and high transaction costs in comparison to public sector banks.
In the pre-reform period growth rate of advances for the Regional Rural Banks
registered highest growth rate of 30.33 percent followed by Foreign Banks 22.97
percent and Nationalised Banks 18.17 percent. The overall growth rate for all
Scheduled Commercial Banks excluding RRBs was 17.60 percent and 17.81 percent
for all Scheduled Commercial Banks including RRBs. In the post-reform period
growth rate of advances is maximum for Private Sector Banks and minimum for
Foreign Banks. The Private Sector Banks registered highest growth rate of 28.92
percent followed by the Nationalised Banks 19.92 percent and Regional Rural Banks
18.75 percent. The overall growth rate of all Scheduled Commercial Banks excluding
RRBs increased to 20.21 percent from 17.60 percent in the pre reform period and rate
of all Scheduled Commercial Banks including RRBs increased to 20.18 percent from
17.81 percent as compared to the pre-reform period.
In the post-reform period, growth rate of advances for foreign banks declined and for
other bank groups rose in comparison to pre-reform period. The reason for rise in
advances growth rate of public sector banks was on account of lending policy of the
public sector banks which became more business oriented than welfare based in the
post reform period. IBA Bulletin (1997-98) states that the outflow of money, in the
form of credit in the post reform period became more restrictive, selective and based
on credit worthiness of the borrowers. Further efficient management and personalised
customer services have had helped to register higher growth rate. The foreign banks
suffered lower growth rate in the post reform period on account of their selected
branch expansion and too specific favoured locations coupled with tapping up of only
big clients. The growth rate of advances for the foreign banks lowered in the post
reform period because of entry of new competitors and high cost of credit to the
borrowers in comparison to public sector banks.
The breakup of the post- reform period revealed that growth rate of total business for
State Bank and its associates declined from 18.10 percent to 16.74 percent, Foreign
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Banks from 24.69 percent to 15.73 percent, Regional Rural Banks from 33.33 percent
to 18.33 percent, all Scheduled Commercial Banks excluding RRBs from 18.34
percent to 17.50 percent. All Scheduled Commercial Banks including RRBs increased
from 18.05 to 18.54 percent and for Private Sector Banks increased to 26.86 percent
from 13.71 percent, Nationalised Banks from 17.96 percent to 18.02 percent in
comparison to the pre-reform period. The reasons for rise in total business growth rate
of Private sector banks was on account of professional customer oriented approach,
better branch network and removal of various financial controls which led to higher
growth in total business. The Foreign Banks registered a marked fall in the rate of
growth in post reform period in comparison to the State Bank group because of their
restricted branch expansion and their deposit policy discourages the smaller
depositors. In addition to this, the rate of growth was affected due to increased
completion from both public and private sector banks, and various other financial
intermediaries.
The breakup of the post-reform period revealed that growth rate of total assets for
percent, in comparison to the pre-reform period. The main reason behind this was the
introduction of new policy reforms of 1991, which exposed banks to more volume of
business, thereby showing decline in the growth rate of total assets in the post-reform
periods.
The breakup of the post- reform period revealed that growth rate of total income for
percent, in comparison to the pre reform period. The reason for lowering of total
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income growth could be assigned to frequent cuts in interest rates and competition
being posed by private sector banks and foreign banks. Further the growing level of
non-performing assets and market recession had added fuel to the fire by adversely
affecting the income of public sector banks.
After he financial sector reforms, the profit position of all the categories of banks has
substantially improved. All public sector banks as a group (SBI & associates and
Nationalised banks) show a distinct jump in the post-reform period. The operating
profits which were nearly 0.1% of total assets during 1980s were more than 1% in
post reform years and in recent years more than 2% i.e. increase by 10-20 times. For
nationalised banks and State banks it was less than 1% in 1992-93 and 1993-94
possibly due to the adoption of prudential norms.
For all other categories substantial pre- reform data is not available. The data that is
available for the other groups (as given in table 4.2.16) shows distinct improvement in
mid to late 1990‘s. For the private sector banks, the profit rose from 0.03 percent of
total assets in 1989-90 to 2.64 percent in the year 2012-13 and throughout sustained
itself close to 2% with some fluctuations during the 2005-6 to 2012-13. These profits
were higher in most years in relation to bank groups in the public sector. The foreign
bank shows profits much higher than both the public and the private sector banks for
all years. This is because of their presence predominantly in metropolitan areas
serving high end customers, providing a host of services and charging for them. As is
evident from the data in the post-reforms period profits for foreign banks also in
multiples to pre-reform profits but the multiple is substantial low in comparison to the
other banks groups i.e., public sector and other than foreign banks in the private
sector. This is due to high level of profits for the foreign banks right from inception.
From a little above 1.46 percent of total assets in the years preceding liberalisation, it
rose to more than 3% in most years after the reforms and in few years more than 4%
i.e., increase by four times in 20 years.
As for the Regional Rural banks the profit in the first half of 1990‘s was throughout
negative. The poor profitability position can be attributed to the operations in the
areas where risk is substantially high, defaults are high, and a large proportion of
advances go towards concessional lending. The profits that were negative even before
the introduction of prudential accounting norms took time to recover from the jolt of
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prudential accounting. The losses steadily fell after the reforms and by the closing of
decade the profits had risen to more than 1% of total assets. During the second half of
2000‘s the profit position further improved.
The data shows substantial improvement in profitability of all bank groups after the
reforms. All groups (except RRBs) could stand the prudential income recognition
norms without their operating profits becoming negative even for one year. After
announcement of the reforms in 1991, giving much autonomy to the banks in their
operations and freedom on fixing the interest rates, the profits for all groups show an
immediate jump as is evident in figure 4.2.1 next year i.e., 1992-93 when new
accounting norms were adopted, the profits for all the groups substantially came
down, but remained substantially higher than compared to the profits in years
preceding the reforms. One more jolt to profitability came when in 1998 NCR II made
the prudential norms more stringent. However, within 2 years the profit percentages
higher than those in 1998 were achieved.
Since all bank groups (except RRBs with a small share in total) shows similar trends
in profits, the average for all scheduled commercial banks as a group is bound to
move on the same pattern. Even when RRBs are included in the total, it does not
make any noticeable difference as can be seen from the two almost overlapping
curves in figure 4.2.1 and last two columns of table 4.2.16. The operating profits for
all SCBs in the aggregate including the RRBs increased from 0.20% of total assets
prior to liberalisation to more than 2% after the reforms in 1991.
In 1994-95, the ratio of Non-Performing assets of scheduled commercial banks as %

of net advances was at reasonably high levels for public sector banks and old private
sector banks- higher in case of public sector banks i.e., 10.7 % of net advances. Even
since mid 1990s, it has shown a sharp decline as is evident from the data in table
4.2.17 by 2006-07, it reached a level of just a little above 1% and this continues till
2010-11. For the old private banks, the ratio initially increased in the late 1990s but
2000 onwards it registered a sharp decline to reach 1.0 % of net advances in 2006-07
and 0.8 % in 2012-13.
The trend for the foreign banks and banks established in the private sector after
liberalisation i.e., new private sector banks is somewhat different. In 1996-97, the
ratio for both groups was appreciably low at 2% for new private sector banks and 1.9
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% for foreign banks. Right from inception these banks followed the prudential norms
and their recovery process were relatively more effective. The new private sector
banks recorded an increase for a couple of years but never went above 5%. After
2001-02, the ratio showed a steep decline and reached to 1% in 2006-07 and 0.4 % in
2012-13. The trend for foreign banks was on similar lines. Some increase in the
closing years of 1990s followed by a steep decline after 2001-02 to reach 1.0 % in
2012-13. The ratio itself was never 3 % or more in any of these years for which data
is available.
All the bank groups however quickly recovered and showed a sharp decline in the
opening years of 2000. By 2012-13, all the bank groups could attain net NPAs to net
advances ratio close to 1%. The foreign banks and the banks in the private sector
could touch levels below1.0 %. Thus, in aggregate all scheduled commercial banks
showed a similar pattern. Starting from 8.1 % of net advances in 1996-97 the net
NPAs reached 1.7 % of net advance by 2012-13. Thus, it can be seen that with
regard to NPAs, a significant improvement has been made after the reforms.
In 1995-96, less than half of the total scheduled commercial banks had CRAR above
10%. In the year to follow, the percentage of such banks in the total sharply increased.
After 2002-03 more than 90% banks had CRAR above 10% for all years. Only in
2004-05 the percentage was 88.6 % but, of the remaining 10 banks that had CRAR
less than 10%, 8 banks had CRAR above 9%. So 86 out of 88 i.e., close to 98% banks
have CRAR above 9%. By 2006-07 the percentage of banks with CRAR above 10%
had reached more than 95% and 100% in 2012-13.
Ratio of intermediation cost to total assets of scheduled commercial banks, for

Foreign banks these costs declined from around 3.74 % in opening 1990 to 2.36 in
2012-13, a decrease of nearly 36 % in 2 and half decades. The decline is more marked
in the case of RRBs; from 2.3 to 1.96% during the same period i.e., nearly 15 %
decline. The high costs in case of regional rural banks can be expected due to the
nature of operating environment and clients in the rural areas, a high proportion of
priority sector lending and associated high default rate, greater efforts and therefore
high costs involved in recovery. These banks greatly benefitted from the changes
brought by the reforms. For all groups other than RRBs and private sector banks the
ratios increased somewhat before it started to decline after the mid 1990s. In case of
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foreign banks, the decline came much later towards the end of 1990s, only for 4-5
years and was marginal. All through mid 1990s to 2008-09, the foreign banks had
highest intermediation cost ratio among all bank groups. It fluctuated between 2.5 to
4% during the period. This high level rather than inefficiency in operations is related
to high quantum and quality of services provided by foreign banks. These banks are
located largely in metropolitan areas provide a host of additional services and
facilities in relation to other scheduled commercial banks. For better services, they do
appropriately charge the customers and consequently, together with intermediation
costs their incomes are also high in relation to other bank groups. This is documented
in highest level of profits earned by foreign banks among all bank groups.
Inefficiency and higher profits do not go together in an environment of free price
competition. So, better quality of intermediation makes for high costs that do not go
down with the reforms measures.
For all other groups and for all scheduled commercial banks as a whole, the overall
trend after the reforms is for the intermediation cost ratio to go downwards. The
maximum and consistent decline is seen in case of nationalised banks. All through
1980s the ICR was almost stagnant; thereafter till mid 1990s it increases and reaches
above 3%. This was largely because of large expenses under voluntary pre-mature
retirement of more than 10 % of their total staff strength and other expenses on up
gradation of technology etc. Nevertheless, after mid 1990s it decline and by 2012-13
reached nearly 1.41%. Thus, despite initially increased expenses necessitated in
various ways in the process of implementation of the reforms measures, the
intermediation costs had overall falling trend. For scheduled commercial banks as a
whole it fell down from 2.42% in 1989-90 to 1.84% in 2012-13, a fall of nearly 24%
in over 2 decades. Even after the decline, the intermediation cost continues to be high
in relation to the developed countries.
The trend of operating profit per employee for RRBs and private sector banks is
almost steady in upward direction with somewhat constancy in recent years. For the
private sector banks, partly the new banks set up after liberalisation is causing the
uptrend. As in case of foreign banks, they have high profits per employee and when
old and new private banks are taken together as a single group, the overall ratio is
increasing (with new banks increasing in importance in relation to old banks). The
ratio for foreign banks is distinctly higher than all other bank groups for all years.
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Over the years, the differential falls with the ratio slightly falling for foreign banks
and increasing for other groups. The average for all scheduled commercial banks
(both including and excluding RRBs) is almost steadily increasing. On the whole, the
overall picture on operating profits per employee is that of an uptrend in the
post-reform years (except foreign banks where relative values were substantially
high in early 1990s).
It is only in case of foreign banks that one does not find any improvement in
productivity indicators and lesser gains in profitability as compared to other bank
groups. Major reasons lie in the fact that these banks had high levels of profitability
and productivity right from the inception. In the environment that has become
competent consequent upon deregulations of interest rates and free entry of new units,
it is not possible to maintain the high differential in profit rates that existed in 1990s.
Nevertheless, profits did increase in relation to total assets, but only at rates lower
than other groups so that there was convergence among profit rates of different bank
groups. Reasons for high intermediation costs also were in the better quality of service
provided. As for productivity, they had much better technology and efficient working
methods, so that their productivity levels were very high in relation to other bank
groups. The salaries paid by these banks were also high. Despite this, productivity
indicators are at higher levels to other groups. One other reason for falling values of
productivity indicators can be higher increases in salaries given by foreign banks.
The all bank averages increased significantly during the post-reform years for
profitability indicators and moderately for the productivity indicators. The poor
performance of RRBs, on both aspects in initial years did not pull down the average
performance because they were in very small proportion in relation to the entire
banking industry. In term of profitability the Indian scheduled commercial banks
stand at a competitive international position. Internationally, a return of 1% on assets
is considered as outstanding. India‘s banking system in 2002 was the second most
profitable n world after US. (Mohan, 2005)
In case of business per employee table 4.2.22 and figure 4.2.5 shows the overall
picture is similar in that in uptrend is noted over the entire period of around one and
half decade after liberalisation. The important difference lies in the years after 2000
where operating profit (relative to wage bill) is almost stagnant or slightly falling for
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all bank groups, but business per employee registered a jump for all groups except
foreign banks. The trend for RRBs and private sector banks is almost continuously
upward, the uptrend being very sharp in case of private banks mainly due to entry of
new private banks and greater relative increase in their business. Foreign banks that
had highest business per employee in the initial years registered a downtrend and by
2008-09, they had gone below the other groups (except RRBs). The overall trend for
public sector banks groups (SBI & associates and nationalised banks) all through
1980s is that of almost constancy and till mid 1990s somewhat decline. The trend
thereafter is upward, being moderate in second half of 1990s and a sharp uptrend
thereafter till 2008-09. The average for all scheduled commercial banks as a group
(whether including or excluding the RRBs) fall gradually till the first half of 1990s
,recovers gradually in the second half and thereafter increases sharply.
In the case of spread, the rate of RRBs, private sector banks and foreign banks is lot
better, near to 3%. The spread is highest in case of foreign banks in the years
preceding liberalisation. After liberalisation it increased maximum, all through
remaining above all other bank groups. The other bank groups with noticeable
increase are SBI & associate where the spread increased from 0.83 to 2.98 %. In case
of private sector banks the spread fluctuates above and below 3% and ended little
above 3 %., for the RRBs, the spread fluctuated and ended at 2.83% in 2012-13. The
average for all SCBs moved to above 3% by mid 1990s but then declined to around
3%.
Thus in case of spread there is no marked upward or downward trend. There were
both up and down movements for most bank groups. Overall trend is
predominantly upward, though not marked. One thing worth noting is that by
2008-09 the spread for all bank groups had reached around 3.1%, this convergence
indicates competition. The only exception was the foreign banks where it was
substantially higher. The high interest rate differential that these banks could maintain
was because of quality and quantity of services provided by them. It was not lack of
competition but other facilities provided by these banks that they could get deposits at
relatively lower rates and lend at relatively higher rates. Moreover, they are not
concerned with maximising business as is evident in their falling business per
employee ratio.
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The analysis shows that the Indian financial sector has developed substantially in
terms of the quantum of deposits and credit, contribution to increased savings and
investment in the economy and with regard to numerous changes in the structure of
the financial sector. In terms of the most of the indicators discussed the developments
subsequent to the reforms have been of much higher magnitude in relation to the
period prior to the reforms.
The banking sector shows that the commercial banks in India had experienced strong
balance sheet growth and have substantially improved their profit position in the post
reforms period. The profitability is at distinctly higher levels for all post-reform years
in comparison to years prior to reforms. Improvement in the financial health of the
banks, as reflected in significant improvement in capital adequacy and improved asset
quality is distinctly visible. All indicators of productivity that have been examined
stand at a much higher level today in comparison to the years prior to the reforms. It is
noteworthy that this progress has been achieved along with adoption of international
best practices in prudential norms. Technology deepening and flexible Human
Resource Management (HRM) has largely enabled competitiveness and productivity
gains.
7.3 Stock Markets Development
The impact of financial sector reforms on the Indian stock markets has been analysed
in term of the changes in size, liquidity and volatility of the stock markets. The
changes in regulatory and governance framework have brought about an improvement
in investor confidence. Together with these developments on the positive front it also
needs to be noted that with opening up to the foreign sector the stock market has
become much more volatile and vulnerable to foreign disturbances.
In most cases the pre-reform data is not available. Therefore rather than comparing
the pre and post- reform trends, the study has examined the trends after reforms. In
view of the sharp up turns and down turns noted in the data any attempt to obtain any
average rates of growth over the time period using the regression analysis would give
grossly misleading results so simple descriptive analysis has been used.
On BSE, in the first half of 1990‘s the number of listed companies more than doubled
and then remained constant for nearly a decade. In 2004-05 the number took a sharp
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downturn and has increased only slightly after that. The NSE started its functioning in
the financial year 1994-95 with 135 companies on its list. In little more than a decade
the number of listed companies has increased by more than a multiple of 10.
In the years before reforms, the market Capitalisation Ratio (MCR) though low, was
steadily increasing. Post-reform values show ups and downs, at times sharply. Of
course the magnitudes are much above the pre-reform levels. Amidst lots of
fluctuations, the ratio has significantly increased in the recent years. Apart from the
new listings the ratio in early years of 21st century has gone up due to substantial
increases in stock prices.
Two commonly used measures of liquidity are the turnover ratio and the value traded
ratio. Both ratios fluctuated with small variations in the first half of 1990‘s. In the
second half, however, they registered a sharp increase. This increase was similarly
driven by sharp rise in stock prices due to IT boom. It must however be remembered
here that an increase in stock prices may lead to an increase in liquidity ratio even
without an increase in actual number of transactions or a fall in transaction costs.
Further liquidity may be concentrated among large stocks.
In 1991-92, turnover ratio falls around by 40% to 20.3 % and fluctuates around the
same level till 1995-96.during the same time period SMC also fluctuates in a narrow
range after increasing more than two folds in 1991-92. This indicates that after
announcement of the reforms, SMC greatly increased in hope of higher rates of
economic growth and improved institutional and infrastructure facilities. A large
number of companies got listed on stock exchanges. So value of listed shares i.e.,
SMC showed a substantial increase. Trading in new stock and earlier listed stocks
however, lagged behind. This makes for a lower turnover ratio. As for the TVR, it
fluctuated sharply during these years. A sudden jump of over 70 % in 1991-92 can at
least in part be explained by the very low rate of growth of GDP during the years. For
the years that followed, GDP growth rated steadily increased. This indicates
fluctuations in trading volumes. During rest of the decade both liquidity ratios steeply
increased. Opening of the next century saw fall in both liquidity measures although at
varying rates. On the whole liquidity measures show higher magnitude and higher
rates of growth after reforms as compared to the pre-liberalisation period. The basic
trend is same as in case of SMC. India is among the least transaction cost countries.
389
Automation is trading of stock exchanges has increased the number of trades and
number of shares traded per day. This has greatly helped in reducing transaction costs.
Volatility of stock exchange is measured by the standard deviation of daily returns.

Two magnitudes for BSE and NSE are very close to each other for all the years. No
pre-reform data is available on volatility. BSE index was very high in the year 1992 at
3.5 %. The possible reason for this can be found in the drastically changing and
therefore uncertain economic environment in the immediate post- reform period.
Internationally, the volatility index is at low levels. It is quite low in comparison to

countries like Unites States of America (USA), United Kingdom (UK), France,
Australia, South Africa, Hong Kong and Brazil.
After the reforms of the Indian capital market has become modern in terms of market
infrastructure, trading and settlement practices and has also become a safer place than
it was before the reforms process began. The operational risk benchmark that takes
into consideration the settlement and safekeeping benchmarks and other operational
factors such as the level of compliance with recommendations, the complexity and
effectiveness of the regulatory and legal structure of the market and counter party risk,
improved. The secondary market has become deep and liquid; there have been
reductions in transaction cost and substantial improvements in efficiency and
transparency.
Despite significant improvements in trading and settlement infrastructure, risk

management system, liquidity and containment of volatility, the role of Indian capital
market has remained less significant in terms of resources raised by the corporate
sector. Its role in capital formation both directly and indirectly through mutual funds
has remained less significant. The public issue segment of the market has shrunk over
the past years. The size of primary market in India remains much small
internationally, both in comparison to the developed economies and emerging market
economies. On the whole, after liberalisation, the Indian stock market has for sure
become modern and transparent.
7.4 Relationship between Financial Sector development and economic growth
It is important to examine the relationship between banking sector development and

the economic growth with a view to determining the direction of causality that exists
390
amongst them. This study helps us to critically assess whether banks through their
role of intermediation can be relied on to stimulate the growth of the Indian economy.
With some research work reporting reverse causality in their study, it will be
necessary to also examine the direction of causality for this study relative to India.
The chow test result confirmed the structural break in the data during the year 1991.
The null hypothesis of no break at specified break point (1991) is rejected at 1% level.
By considering the structural break, for studying the relationship between financial
development and economic growth in India, it is necessary to check the pre-reform
and post-reform period performance. Therefore the study period is divided in to two
periods that is pre-reform period (1968-1991) and post-reform period (1992-2013).
In the pre reform period the variables are not cointegrated means there is no long term
relationship among the variables. So the VAR with the difference data is analysed for
the short term relationship among the variables. The past levels of credit (CR) for the
1 year lag in the short run had negative impact on economic growth and statistically
significant at 5% level of significance. This implies that a 1 % increase in the credit
(CR) generates nearly 0.27 % decrease in economic growth. The past level of Gross
Domestic Capital formation(GDCF) for the 1 year lag in the short run had negative
impact on economic growth but not statistically significant at 5 % level of
significance.
In the post- reform period, there was one cointegrating equation among the variables,
so VECM was applied for the long run and short run relationship. In the long run,
Credit (CR) has positive and significant impact on the economic growth at 5% level
of significance in the long run. An increase of 1 % in credit leads to 0.70% increase in
Formation leads to 1.44 % increase in the economic growth but it is not statistically
significant at 5 % level. During short run, the coefficient of the lagged error correction
term, representing the speed of adjustment between the short and the long-run periods,
had a coefficient of - 0.13, being statistically highly significant at 1% level. This
indicates that deviations from the short run to the long run are corrected by 0.13 per
cent per year. The negative sign is an indicator of model consistency both in the short
and long run, and the model actually converges to long-run equilibrium (Harris and
Sollis, 2003). The past levels of economic growth had a negative impact on current
391
levels of economic growth as shown by the 1 and 2 year lag periods at 5 % and 1%
level of significance respectively. The past level of Gross Domestic Capital formation
(GDCF) and credit (CR) for the 1 year lag and 2 year lag in the short run had no
statistically significant impact on economic growth at 1% level of significance.
The linkage between stock market and economic growth has occupied a central
position in the development literature. Osaze (2000) sees the capital market as the
driver of any economy to growth and development because it is essential for the long-
term growth capital formation.
In the post-reform period, there is one cointegrating equation among the variables, so
VECM is applied for the long run and short run relationship. In the long run Gross
domestic Capital Formation (GDCF) has positive but, Market Capitalisation Ratio
(MCR) and Value Traded Ratio (VTR) have negative and statistically significant
impact on economic growth. Gross domestic Capital Formation and Stock Market
Capitalisation affecting economic growth significantly at 1% whereas Value Traded
Ratio affecting economic growth significantly at 5 % level of significance. An
increase of 1 % in Gross domestic Capital Formation leads to 5.40 % increase in the
level of economic growth. An increase of 1 % in Market Capitalisation Ratio (MCR)
leads to 1.07 % decrease in the level of economic growth. Likewise an increase of 1%
in Value Traded Ratio leads to 0.11 % decrease in the economic growth of India.
Results are in line with the findings by Sanusi and Salleh (2007) for Malaysia and
Kargbo and Adamu (2009) for Sierra Leone.
The coefficient of the lagged error correction term, representing the speed of
adjustment between the short and the long-run periods, had a coefficient of - 0.14,
being statistically highly significant at 1% level. This indicates that deviations from
actually converges to long-run equilibrium (Harris and Sollis, 2003).
economic growth as shown by the 1 and 2 year lag periods at 5 % level of
significance. The past level of Gross Domestic Capital formation(GDCF) for the 1
year lag in the short run had positive impact on economic growth and statistically
392
significant at 1% level of significance. This implies that a 1 % increase in the Gross
Domestic Capital formation (GDCF) generates 0.47 % increase in economic growth.
Gross Domestic Capital formation (GDCF) for the second year lag period had also
negative and significant affect on the economic growth but it is at 10 % level of
significance. This results supported the Harrod-Domar model which proved that the
economic growth will directly or positively be related to saving ratio and capital
formation (i.e. the more an economy is able to save-and invest, the greater will be the
growth of that GDP). In other words the Harrod-Domar model is applicable to India‘s
situations.
The past level of VTR for the 1 year lag in the short run had positive impact on
economic growth and statistically significant at 5% level of significance. This implies
that a 1 % increase in the value traded ratio (VTR) generates 0.02 % increase in
economic growth. The past levels of market capitalisation ratio (MCR) for the 1 and 2
year lag periods in the short run had positive impact on economic growth and
statistically significant at 1% level of significance. This implies that a 1 % increase in
the market capitalisation ratio (MCR) for the 1 year lag period generates 0.12 %
increase in economic growth and for the 2 year lag period it generates 0.05% increase
in economic growth. These results are in line with several studies including that of
Levine and Zervos (1998), Rousseau and Wacthel (2000), Beck and Levine
(2004), Seetanah, (2010) and Wong and Zhou (2011).
Both institutions and markets have witnessed remarkable progress in the post-reform
period as compared to the pre-reform period. The basic objective of this study is to
establish whether the reforms undertaken in the financial sector of the economy have
had any influences on the country‘s economic growth. So for analysing the
relationship between financial development and economic growth variables related to
banking sector and stock exchange are taken together also for the time period of 1968
to 2013.
The chow test result confirmed the structural break in the data during the year 1991.
The null hypothesis of no break at specified break point (1991) is rejected at 1% level.
By considering the structural break, for studying the relationship between financial
development and economic growth in India, it is necessary to check the pre-reform
393
and post-reform period performance. Therefore the study period is divided in to two
periods that is pre-reform period (1968-1991) and post-reform period (1992-2013).
In the pre reform period the variables are not cointegrated means there is no long term
relationship among the variables. So the VAR with the difference data is analysed for
the short term relationship among the variables. It is clear from the analysis that only
credit is statistically significantly and affecting negatively economic growth, when
variables related to banking sector and stock exchange are taken together. The stock
market capitalisation is affecting positively but this is not statistically significant.
In the post- reform period, there is one cointegrating equation among the variables, so
VECM was applied for the long run and short run relationship. In the long run credit
and Gross domestic Capital Formation have positive and significant impact on the
economic growth in the long run at 10% and 5% level of significance respectively. An
increase of 1 % in credit leads to 0.44 % increase in the level of economic growth.
Likewise an increase of 1% in Gross domestic Capital Formation leads to 2.25 %
increase in the economic growth. Stock Market Capitalisation has negative impact but
it is not statistically significant even at 10 % level of significance. In the short run, the
error correction term, representing the speed of adjustment between the short and the
long-run periods, had a coefficient of - 0.15, being statistically highly significant at
1%. The negative sign is an indicator of model consistency both in the short and long
run, and the model actually converges to long-run equilibrium (Harris and Sollis,
2003). Past levels of credit period in the short run had no statistically significant
impact on economic growth. Gross domestic Capital Formation with lag period of 1
year is also statistically significant and has negative impact on the economic growth
of India at 10% level of significance. Stock market Capitalisation at lag period of 2
years have positive statistically significance impact at 10 % level of significance on
the economic growth.
In the case of banking sector development variables during pre- reform period, there
is short run unidirectional causality running from CR to EGFC and from EGFC to
GDCF at 5% and 10 % level of significance respectively. During post- reform period,
there is unidirectional causality running from CR to EGFC and GDCF at 10% and 5%
394
level of significance respectively. In the long run, the error correction term
coefficients show that there is long run causality from the two independent variables
such as GDCF and CR to EGFC meaning that GDCF and CR have influence on
dependent variable EGFC in the long run at 1% level of significance
In the case of stock market development variables during post reform period, there is
unidirectional causality runs from GDCF and MCR to Economic Growth, from
EGFC, GDCF and MCR to VTR, from GDCF to MCR in the short run. In the long
run, the error correction term coefficients show that there is long run causality from
the three independent variables such as GDCF, VTR and MCR to EGFC meaning that
GDCF, VTR and MCR have influence on dependent variable EGFC in the long run at
1% level of significance.
When variables related to banking sector and stock exchange are taken together, in the
pre- reform period there was unidirectional causality runs from CR to Economic
Growth in the short run at 10% level of significance. During the post-reform period,
there is unidirectional causality running from CR to EGFC and GDCF at 5% level of
significance. In the long run, the error correction term coefficients show that there is
long run causality from the independent variables such as GDCF, SMC and CR to
EGFC meaning that GDCF, SMC and CR have influence on dependent variable
EGFC in the long run at 1% level of significance.
The hypotheses formulated in the beginning have been confirmed substantially

showing that there is significant impact on banking sector development; financial
performance of financial institutions; Size, liquidity and volatility of the stock market
after the financial sector reforms. There is positive relationship among the credit,
stock market capitalisation, gross domestic capital formation and economic growth of
395
India in the long run during post reform period. The direction of causality does not
change in the pre-reform period and post-reform period. Supply leading hypothesis is
followed in Indian context means that the development of financial sector may help to
improve and lead economic growth
7.6 Suggestions
Based on the findings of the study and in the light of the observations several
suggestions are being made for improving commercial banking performance in terms
of efficiency, productivity, profitability and overall performance. Indian banking
needs to focus on the following aspects and to build required capabilities to cope with
the challenges of the dynamic banking environment.
In the changed scenario, besides pursuing economic objectives, banks should explore
the possibilities of social banking for their survival and growth in the long run.
Banks should continue to pay adequate attention to deposits and credit as they
constitute the core of banking activities. Efforts should be made to manage the bank‘s
maximum lending. This policy thrust will most likely result into increased investment
activities which will enhance capital formation in India.
To expand their business, the banks should intensify their role in the provision of Para
banking facilities. There should be shift in operations from traditional banking to fee
based services. Collection and payment of outstation instruments, fund remittances
etc. Provide huge flow of funds to banks. Further they should explore the possibilities
in insurance, since the deregulation of insurance business has given a scope for banks
to enter into this area.
The banks also need to reduce their dependence on interest income and should earn
more from other sources. The other income should be enough to cover major portion
of salary and allowances of staff and overheads of banks. Banks should develop new
areas like custodial services, D-Mat accounts and retailing of government securities.
The alternative avenues to boost non-interest income should be increasing tie-ups
arrangements in the various forms like ATM sharing which acquire additional non-
interest income. Further new initiatives like tie-ups for payment of fees, utility bills,
issue of passenger ticketing, charging of mobile phones using ATMs etc., should be
materialised in a better way.
396
A cautious approach to branch expansion, reducing staff costs and improving
productivity through technology in the inflationary environment should be the main
step towards control of costs, expand clientele base and retain the existing customer
base as well.
The technology which has emerged as a strategic tool in the operation of banks has
pivotal role for profit enhancement and operational efficiency. Computerisation,
implementation of single window concept, on-line banking ,anytime anywhere
banking ,electronic fund transfer ,automated teller machines tele-banking should be
on the priority list of the banks. The cost effective strategy at the branch level can
pave the way for higher profitability, effective manpower utilisation, increased
productivity and achieving economies of scale. The technology is further expected to
pass on the benefits of low cost to consumers, which in turn bringing higher volume
of business and increase in profitability.
Another area of attention is to reduce transaction costs. This can be achieved by

popularizing the IT based delivery channels like tele-banking, remote customer
enquiry terminals, internet banking etc., so that the customers are facilitated to carry
out most of the transactions without having to visit the branch premises.
The new private sector banks and foreign banks have been the early adopters of
technology as compared to public sector banks. Chopra(2006) states that the public
sector banks which command over three quarters of the market share have been very
slow in imbibing technology in their operations despite they had very large branch
network spread over the length and breadth of the country.
Banks should ensure the best interest of all the stakeholders in a transparent and
ethical way as a means of corporate governance. It should be a part and parcel of the
culture and mindset of management, as regulations alone may not be adequate to
ensure compliance in letter and spirit.
Banks should have more investment in human resource development with focus on
the quality, timeliness and delivery of financial services. It would become impossible
to survive and prosper unless organisation skills are effectively channelized towards
innovative new ideas, new products and new strategies for wining over and retaining
the customer.
397
Another area which requires urgent attention is improving the staff productivity in
public sector banks. They should downsize staff to cut high cost of staff expenses. It
is also necessary to redistribute staff to strengthen the neglected areas. Further in
order to bring radial changes in the staff structure, the public sector banks should
improve the existing practices of recruitment, training, development and
redeployment. The focus must shift from generalist orientation of the staff to
specialist orientations.
There is a dire need to educate the customers on the various aspects of banking. The
banks should make efforts to encourage the large number of households to avail
banking services. In order to identify the demands for banking services, emerging
customer‘s expectations should be surveyed.
The profitability of banks largely depends upon their ability to manage the non-
performing assets. There is a general belief that priority sector lending are mostly
responsible for growing level of non-performing assets in Indian banking sector.
There is a growing demand to downsize the priority sector lending from 40 percent 10
percent. But, in country like India where poverty, illiteracy and unemployment exists
on large scale, commercial banks cannot neglect the aspects of social banking. Hence
the necessity of continuing credit to the priority sector cannot be disputed.
It is not possible to totally eliminate non-performing assets in the banking business

but, there incidence can be minimised. Sound credit appraisal, credit risk evaluation
and credit monitoring through periodic interaction with borrowers to find out the end
use of credit are some of the measures to prevent the growth of non-performing
assets. Chronic non-performing assets can now be managed through the enactment of
‗the Securitisation and Reconstruction of Financial Assets and Enforcement of
security Interest Act (SRFAESI Act). The more important way of helping banks to
reduce non-performing assets could be though the Asset Reconstruction Corporations
(ARC). Overhauling the regulation system and strengthening the Debt Recovery
Tribunals (DRTs) could be conducive steps for speedy recovery of bank dues.
In a competitive environment banks cannot perform unless there are means of

mitigating various risks. Derivative instruments like, swaps, options, futures etc.,
could enable such risk mitigation. Therefore it is required to introduce comprehensive
legislation to facilitate securitisation. Further, such instruments are inevitably required
398
considering the globalisation of corporate sector and integration of Indian economy
with the world economy. The public sector banks are lagging behind the private and
foreign banks in acquiring skills to offer such products.
There is also need to bring in greater professionalism in the quality of top

management in public sector banks. Their bureaucratic style of functioning also need
to be changed by modifications to management structure by cutting down the tiers
involved in decision making, as they will have to handle sophisticated business and
give a differential treatment to the existing and new borrowers.
The new banking licenses to the corporate houses should be issued to increase the
competitive strength of public sector banks.
Banking in the new millennium should be marked by high expectations of customers

who are well informed. The commercial banks need to reorient their strategies,
practices, products and clientele and in tune with changing environment. Banks have
to concentrate on the profitability, off balance sheet activities exposure, quality of
staff and operational risk. The banks are further required to avail the maximum
returns from the productive opportunities of globalisations.
Despite the heightened attention received by stock market, investor base of Indian
stock market is miserably low. Theoretically, stock market investment aims at risk
diversification and direct participation in project financing in a widespread manner. It,
therefore, requires the existence of a relatively large number of investors with the
sophistication, means and ability to shoulder such risks. However, irrespective of the
long array of reform programmes implemented, fraudulent practices and excessive
speculation are still a nightmare to genuine investors in the country. People do not
consider stock market as formal financial institutions like banks. Instead it is treated
as a gambling place for speculators. Serious policy initiatives are required in this
regard so as to make stock market a more relevant institution. Indian stock markets
needs to focus on the following aspects and to build required capabilities to cope with
the challenges of the dynamic financial environment.
Domestic capabilities in the stock market should be enlarged by allowing institutions

like provident funds to invest into the stock market. The current level of participation
399
of pension funds also should be enhanced by allowing them to invest in various
derivative instruments.
Suitable investor educational programmes are essential to attract potential investors to

stock investing. Necessary steps should be taken to enhance participation of rural
investors in the stock market. For this, investment management should be included in
the curriculum during the years of schooling itself. Similarly for undergraduate course
in Economics, a comprehensive study of stock market should be included.
Training programmes for existing investors should be conducted on a regular basis to

make them aware of the behaviour of stock market and management of risk through
scientific analysis.
Further reforms in stock market should aim at enhancing the efficiency of the market,
since it is found to be more robustly related to long run economic growth of the
country. To control the concentration of turnover and price volatility, benchmark
indices like BSE Sensex and CNX Nifty should be made broader based. More fiscal
incentives should be given to stock market investment to attract investors with high
income.
For better enforcement of reforms and to avoid institutional overlap, regulatory

framework of the stock market should be unified. Integration of stock exchanges
should be encouraged by giving incentives for establishing central trading system
through interconnectivity.
Primary market should be made more dynamic by making pricing of shares more
credible, IPO rules less cumbersome, and disclosure norms more alert. Investors
should be attracted towards mutual fund investments by giving more incentives.
Stock markets should be made more formal financial institutions by curbing excessive
speculation and other fraudulent practices. For this better disclosure norm, quality
intermediation services, legal and accounting practices should be introduced. Listing
of government securities in stock exchanges can help in this regard.
Government need further reforms to speed up privatisation of government owned

businesses, improve financial and legal system to protect investment and modernise
its infrastructure. It is also important to introduce business friendly tax reforms,
400
upgrade labour laws to international levels and eliminate bureaucracy to attract more
international corporations with more investment. More than 40 percent live on little
more than $ 1.00 per day and more than 25 percent live below the national poverty
line. The government should pay special attention and take the necessary steps to
reduce inequalities so everyone can enjoy economic growth evenly especially people
living in rural area. The government should promote the manufacturing sector for
future economic growth, in order to reduce dependency on technology industry and
service industry. Divert future investments to rural areas of India to decrease
urbanisation and increase employment in small towns and villages.
The empirical findings of the study provide important policy insights in the Indian
context. As the Indian financial sector is largely bank-centric, the performance of the
banking sector is crucial in the development process of the economy. Given the
potential of further credit disbursement by Indian banks, there is still scope for them
to channelize credit to the productive sectors of the economy. Therefore, Indian banks
need to develop strong linkages with the real sector to develop the ability to maintain
high growth levels over a sustained period of time which was one of the critical
lessons emerged from the global financial crisis.
There is a need to stabilize the frequent ups and downs in the domestic stock market.
This market has undergone peaks and troughs since the starting of economic reforms,
many a time because of non-fundamental factors such as speculation, sentiments, and
manipulation of the institutions and so on. Without stabilization, there might be an
adverse impact of these non-fundamental factors on FII behavior through volatile
returns in the stock market.
401
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IMPACT OF FINANCIAL SECTOR REFORMS ON

SUBMITTED TO THE HIMACHAL PRADESH UNIVERSITY, SHIMLA

Supervised by: Submitted by:

Dr. Vijay Kumar Sharma Neeraj Kumar

Dr. Vijay Kumar Sharma

Certified that the thesis entitled “IMPACT OF FINANCIAL

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