Commentary

50 Years of Bank Nationalization: A Peek into Social and Development Banking

Fifty years ago, on July 19, 1969, Indira Gandhi, who was both Prime Minister and Finance Minister at that time, decided to nationalize 14 major privately-owned commercial banks of India. Banks with a deposit base of over Rs500 million were selected for nationalization while foreign banks were excluded. Six more private banks were later nationalized in 1980.

Analysts have described the nationalization of banks as the most significant economic event after India’s independence in 1947. But if we look globally, state ownership of banks and financial institutions was the norm during the 1960s and 70s. In the post-World War II period, state-ownership of banking witnessed a rapid expansion in many European countries which established such institutions for a variety of reasons, ranging from delivering essential banking services to financing infrastructure. The state ownership of the banking system was as high as 75 percent in Italy in the early 1970s.

During the 1960s and 70s, many countries from Asia, Africa, and Latin America nationalized their existing private banks and started new banks under full or substantial state ownership to achieve broader social and economic objectives. In diverse countries such as South Korea, Algeria, Egypt, and Tanzania, bank nationalization became the primary policy instrument to overcome the limitations of private banking and to pursue national developmental goals in the 1960s.

Most analysts believe that the bank nationalization move in India was mainly driven by politics – a by-product of a power struggle within the Congress party. They tend to overlook underlying economic reasons that led to the nationalization of banks. The bank nationalization took place against the backdrop of several economic and political shocks, including two wars (China in 1962 and Pakistan in 1965), severe droughts, food shortages, high inflation, lack of public investments in agriculture, and overall neglect of social and development banking. Before the bank nationalization in 1969, the limited outreach of banks coupled with weak regulatory framework represented a classic case of market failure in the Indian banking sector.

Based on my previous writings, India’s experience with the bank nationalization is summarized below to assess its far-reaching impacts on social and development banking.

Sheer Neglect of Social and Development Banking

Before nationalization, the entire banking system was in the hands of the private sector. Most of the privately-owned banks were in the form of joint-stock companies controlled by big industrial houses. More importantly, there were several bank failures due to imprudent bank lending in the absence of regulatory safeguards. During 1947-58, for instance, as many as 361 banks of varying sizes failed in India. The failed banks were either amalgamated or ceased to exist.

Before nationalization, privately-owned banks were predominantly in metropolitan, urban and semi-urban areas (Table 1). The population covered per branch was 136,000 in 1951. Much of bank lending was concentrated in a few organized sectors of the economy and limited to big business houses and large industries. Whereas farmers, small entrepreneurs, laborers, artisans and self-employed were dependent on informal sources (mainly traditional moneylenders and relatives) to meet their credit requirements. The share of agriculture in total bank lending was a meager 2.1 percent during 1951-67 (Table 2).

Table 1: Number of Bank Branches in India

Source: Reserve Bank of India.

Table 2: Sector-Wise Credit by Banks

Source: Reserve Bank of India.

In 1967, the Indian government introduced the policy of social control over banks. The objective of this policy framework was to bring structural changes in the management of banks by delinking the nexus between big business houses and big commercial banks. Under this policy, new guidelines on the management of banks were issued to ensure that persons with specialized knowledge and experience could join the board of directors of a bank. The Reserve Bank of India also got new powers to appoint or sack senior management in a bank. Another policy objective of social control was to improve the distribution of credit towards agricultural and developmental sectors.

Despite such laudable policy measures envisaged under the social control framework, a large segment of the population (particularly in rural areas) had no access to the institutionalized credit. Based on this largely failed experiment, the government realized that the nationalization was the only option to channelize banking resources to the neglected sectors of the economy and rural areas.

There were several policy objectives behind the bank nationalization strategy including expanding the geographical and functional spread of institutionalized credit, mobilizing savings from rural and remote areas and reaching out to neglected sectors such as agriculture and small-scale industries. Another policy objective was to ensure that no viable, productive business should suffer for lack of credit support, irrespective of its size. In sum, the bank nationalization drive was inspired by a larger social objective to sub-serve national development priorities.

The Positive Outcomes

Before nationalization, banks were reluctant to open small accounts as these were not considered profitable. Between December 1972 and June 1983, as many as 212 million new bank loan accounts were opened, out of which nearly 93 percent were small loan accounts (Rs10,000 or less).

At the time of nationalization, scheduled commercial banks had 8,187 branches throughout the country. However, the branch network increased to 59,752 in 1990. With such a rapid increase in bank branches across regions, the population covered per branch, which was 65,000 in 1969, also decreased to 13,756 in 1990.

In 1990, out of 59,752 bank branches in the country, 34,791 (58.2 percent) were located in rural areas. In contrast, the share of rural branches was 17.6 percent in 1969. Such a massive expansion of bank branches in the rural and unbanked areas was the result of 1:4 licensing policy of 1977 under the nationalization regime. Prior to nationalization, branch licenses were issued on the financial strength of the banks. The 1:4 licensing policy changed the focus to providing banking services throughout the country, particularly in remote and unbanked areas. Under the 1:4 licensing policy, banks were given the incentive to open one branch in metropolitan and one branch in urban areas, provided they open four branches in the rural areas.

This policy led to the rapid growth of bank branches in the rural and remote regions of the country and thereby helped in correcting the urban bias of the banking industry. Between 1977 and 1990, more than three-fourths of bank branches were opened in the unbanked areas.

The rapid expansion of the branch network led to massive deposit mobilization by banks, which in turn, contributed to a higher saving rate. The household financial savings increased manifold as nationalized banks enhanced public confidence in the banking system. For instance, household sector financial savings increased from Rs7950 million in 1969 to Rs60810 million in 1980. Similar trends were witnessed in bank credit too. The bank credit-GDP ratio witnessed a sharp rise, from 10 percent in 1990 to 24 percent in 1991.

Apart from licensing policy, the establishment of regional rural banks (RRBs) in 1976 also widened the reach of banking services in India. The mandate of RRBs was to serve small and marginal farmers, agricultural laborers, artisans and small entrepreneurs in the rural and remote areas. In rural areas, there was a significant rise in bank deposits and credit. According to official data, the share of rural deposits in total deposits increased more than five times, from 3 percent in 1969 to 16 percent in 1990. The share of credit to rural India in total credit jumped from 3.3 percent to 14.2 percent during the same period.

In addition, banks were directed to maintain a credit-deposit ratio of 60 percent in the rural and semi-urban branches to ensure that rural deposits are not used to increase urban credit. The credit-deposit ratio in rural areas increased from 37.6 percent in 1969 to over 60 percent in the 1980s and 1990s. In the early 1970s, the concept of priority sector lending (also known as directed lending) was evolved to ensure that adequate credit flows to the vital sectors of the economy and according to social and developmental priorities.

The nationalization regime witnessed the substantial flow of credit to all sectors, including the neglected sectors of the economy such as agriculture and small and medium enterprises (SMEs). The share of agriculture credit in the total bank credit increased from 2.2 percent in 1968 to 13 percent in 1980 and further to 15.8 percent in 1989. The share of small-scale industry in the total bank credit which was negligible before nationalization reached 15.3 percent in 1989, a significant achievement by international standards.

There is no denying that the banking system under the nationalization regime was not perfect as it could not reach out to every household but at least a serious effort was made to spread banking services: geographically, socially and functionally.

After 1980, no further nationalization of banks took place. As the Indian economy underwent significant policy shifts in the beginning of the 1990s, a series of policy measures were introduced to reduce the government stake in state-owned banks and to consolidate these banks. In other words, a step towards privatization. One of the negative consequences of banking sector reforms is the decline in bank branches in rural areas (even though the total number of bank branches in India has increased in the post-liberalization period) with adverse consequences on credit to agriculture, micro and small enterprises.

Public Banks and Financial Inclusion in the 21st Century

Since the early 2000s, financial inclusion has become a key policy priority with intending to achieve inclusive growth and development in India. In 2005, the RBI launched a scheme of “no-frills” account under which all public and private sector banks were advised to provide a basic banking “no-frills” savings account either with nil or very low minimum balance to provide access to basic banking services to the financially excluded sections of the society. According to the RBI statistics, close to 139 million “no-frills” bank accounts were opened between 2005 and 2012 by the banking system. The bank group-wise analysis indicates that state-owned banks opened nearly 90 percent of “no-frills” accounts.

In August 2014, the Indian government launched an ambitious Pradhan Mantri Jan Dhan Yojana (Prime Minister’s People Money Scheme) to ensure access to affordable essential financial services throughout the country. The government claims that on an inaugural day, a record 15 million bank accounts were opened across the country under this initiative. Nowhere else in the world, such a large number of bank accounts have been opened in a single day. According to the RBI, 307 million bank accounts were opened, and about 231 million Rupay debit cards were issued until December 2017 under this nation-wide initiative.

What is important to note is that state-owned banks played the pivotal role in achieving ambitious targets of opening bank accounts set under this national mission as more than 96 percent of accounts were opened by the state-owned commercial and regional rural banks while private banks opened the remaining 4 percent. Importantly, there was no participation of foreign banks operating in India under this scheme. In the absence of state-owned banks and regional rural banks, the government could not have executed such a massive bank account opening drive in India. Nevertheless, an important challenge is to make these accounts operational otherwise very little meaningful financial inclusion will be accomplished on the ground.