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4. Pattern of Growth and Determinants of Banking Services

4.2 Banking Service in India: A Brief Background

Indian banking sector, prior to its nationalisation was criticised for its neglect to agricul- ture and other small sectors like small scale industries in providing bank credit despite some progress in terms of geographical coverage (Kumbhakar and Sarkar, 2003). Na- tionalisation of bank in 1969 and subsequently in 1980 brought some major structural changes into Indian banking system. These structural transformations are in terms of reg- ulatory measures adopted by the Reserve Bank of India. These measures include changes in the sectoral composition of credit, stipulated lending targets to priority sectors, opening up of bank branches in rural and semi-urban areas etc.9 According to Kumbhakar and Sarkar (2003), public sector banks became unprofitable during the period due to their ex- cessive focus on quantitative achievements. Similarly, some banks were considered under- capitalised according to international standards while some other had low capital adequacy ratio and high non-performing assets.10 Following these, the Government of India initi- ated banking sector reforms in 1991 aiming to create an efficient, profitable and sound banking system in the country. Banking sector reforms in 1991 include deregulation of control of interest rates, introduction of international norms like capital adequacy require- ments and other prudential norms to strengthen Indian banking system. The reform also aimed at improving competitiveness in the banking services, diversification of ownership to private investors to certain limit and reduction in cash requirements and statutory re- quirement of the banks. These financial reforms were expected to increase efficiency in mobilisation of resources and its allocation in the real economy which in turn are regarded crucial for macro economic stability and are expected to generate higher economic growth (Ahluwalia, 2000). According to Mohan (2005b), the main objective of economic reforms in 1991 was to accelerate growth of the entire economy. The author mentioned about three channels which can affect economic growth of an economy. These are- improving pro- ductivity of capital, investment in human capital and raising total factor productivity. He further argued that the quality of financial sector has the capacity to affect the function- ing of all other sectors in the economy. The quality of financial intermediation improves the efficiency of resource allocation and thus promotes productivity in other sectors as well. Zhao et al. (2010) divided the banking sector reforms in India into two stages. The first stage is related to deregulation aiming at promoting competition. This stage was

characterised by deregulation of interest rate on deposit and lending. Private sector was also allowed to operate. These deregulations have led the banking service in India to a greater operational flexibility. The second stage focused on financial stability in terms of prudential norms of classification of assets, loans and capital requirement of the banking system. Mohan (2005a) argues that deregulation is supposed to boost competitive forces in the banking system in India. These competitive forces are expected to enable the banks to alter their input-output mix. Changing structures of input combinations endowed with technological developments improve output of banks that raises overall bank productivity and efficiency. Again, new private and foreign banks equipped with superior management and technology are supposed to have better efficiency. Panagariya (2008) pointed out that the entry of foreign and new private banks as a result of the reforms in 1991, has positive influence on productivity of Indian banks. Pointing out the better performance of bank- ing system in India, he mentions the significant improvement in profit per employee from

| 10 thousand in 1995-96 to | 130 thousand at 2004-05 constant prices. Similarly, the increase in business per employee from| 6 million to 17.3 million and rise in deposit per branch during the same period is another indication of significant increase in productivity of banks in India. However, these ratios only give an idea of partial productivity since output (in terms of value) has been compared with number of employee or branch. Hence, these parameters fail to capture the overall performance of the banking services. In the absence of representative measure or index to capture overall performance of banking ser- vices, many studies relied upon the productivity growth of banking services to examine the overall performance of banking sector in India. Some of these studies are briefly discussed below.

In a study of banks in India, Bhattacharyya et al. (1997a) pointed out that national- isation has brought not only changes in ownership but also changes in the development and planning. They pointed out that these changes initially thwarted productivity of all banks in India. According to the authors, during 1970 to1992, the productivity growth of banks in India was around 2 percent. However, they noted substantial rise in productivity growth during the last few years of their sample period which was the phase of economic liberalization and banking deregulation. Bhattacharyya et al. (1997b) examined productive efficiency of 70 Indian commercial banks using data envelopment analysis for the period of 1986 to 1991. They found public sector owned banks more efficient than private sector

banks with marginal improvement in the performance of overall banking services in India during the sample period of their study. Their findings also suggest that foreign banks were least efficient at the beginning of their sample period, however, they have noticed a rise in the efficiency of those bank over the period of their study. Keshari and Paul (1994) also found that foreign banks were less efficient as compared to the domestic banks in the context of Indian economy. However, they concluded that the differences in efficiency between foreign and domestic banks were not significant in terms of their efficiency. Mo- han and Ray (2004) compared productivity growth of public, private and foreign banks in India for the period 1992 to 2000. Their results reveal that the difference in productivity growth of private and public sector banks are insignificant which led them to reject the gen- eral belief that deregulation resulted in huge gap in productivity of privately and publicly owned banks. Shanmugam and Das (2004) in their study of technical efficiency of In- dian banks during the period 1992 to 1999 found that Indian banks performed inefficiently which according to the authors is due to technical inefficiencies of the banks. Ataullah et al. (2004) suggested that overall technical efficiency of banks in India improved after 1995-96 following the reform in Indian banking. They argued that the rise in efficiency is due to improvement in both technical efficiency and scale efficiency.11 De (2004) carried out a study on efficiency of Indian banking comprising a panel data of public, private and foreign banks for the period of 1985 to 1995-96. Their study reveals that there is no im- provement in the banking industry in India after the liberalisation in 1991-92. They argued that banking industry is technically inefficient and due to this inefficiency, banking indus- try was losing output during the period. In contrast to most of the studies, De (2004) found foreign owned banks to be the most efficient as compared to other banks. In an article, Mohan (2005b) argued that productive efficiency of Indian banks has improved in the post reform period as operating cost per unit of earning assets declined since 1992. Das and Ghosh (2006) in a study of banking service in India for the period 1992-2002, reported high degree of inefficiency of some banks during the period of liberalisation. They have also reported variation in the efficiency level in different categories of bank, according to ownership. Their study found public sector banks relatively more efficient compared to private banks. In a more recent study, Kumar and Gulati (2014) has estimated productivity growth of Indian commercial banks for the period of 1993-94 to 2007-08. Their study re- veals that public sector banks are more productive than privately owned and foreign banks.

Moreover their study found that Indian commercial banks registered higher productivity growth during 2000-01 to 2000-08 compared to 1993-94 to 1998-99.

The review of available literature presented in this section shows that banking services in India have recorded overall productivity growth during the liberalisation period. Most of the studies have reported that publicly owned banks are comparatively more productive then foreign and private sector banks.

4.3 Conceptual and Measurement issues in the Estimation of