BANK NATIONALIZATION

Post-independence, India focused on holistic development, which required robust financial infrastructure to meet the diverse needs of the population. The Government of India (GOI) adopted planned economic development with a socialist framework, which led to the nationalization of banks.

Historical Background

• Start of Banking System: India’s banking system began with the Bank of Hindustan in 1770, which ceased operations by 1832.
• First Nationalization: In 1955, the Imperial Bank of India was nationalized, and State Bank of India (SBI) was formed to provide large-scale banking facilities, especially in rural and semi-urban areas.
• SBI Becomes Principal Bank: SBI became the principal agent of the Reserve Bank of India (RBI), handling banking transactions for the Union and State governments across India.
• First Wave of Nationalization: On July 19, 1969, the first major wave of nationalization took place, where 14 major commercial banks were nationalized.
• Second Wave of Nationalization: A second phase of nationalization occurred in 1980, with six more banks being nationalized as part of Indian banking reforms.
• GOI Becomes Major Owner: Through this process, the GOI came to own 80% of the banking sector, bringing the majority of the financial system under government control.

Factors Behind Bank’s Nationalization

1. Economic Factors:

• Fall in GDP: India experienced droughts in the 1960s, leading to negative growth rates in GDP and double-digit inflation.
• Increasing Population: The 1960s and 1970s saw rapid population growth, with economic growth barely outpacing this rise, leading to stagnation in average incomes.
• Green Revolution Need for Capital: With the initiation of the Green Revolution, the agriculture sector required a capital infusion to make India self-sufficient in food security.
• Collapse of Banks: There were frequent bank collapses, causing financial distress to citizens who lost their savings due to the lack of government regulation and protection.
• Failure of Social Control: Private banks were not adhering to government regulations under social control, making nationalization necessary to bring banking operations under strong government oversight.

1. Banking Factors:

• Lack of Credit to Agriculture: Agriculture received only a small percentage of the total credit, while the industry saw its share of credit disbursed by commercial banks double between 1951 and 1968 (from 34% to 68%), while agriculture’s share was less than 2%.
• Flow of Credit: Issues regarding the reach and flow of credit to priority sectors (like agriculture) led the government to undertake reforms.
  • For example: The number of banks was reduced from 566 banks in 1951 to 91 banks in 1967 to streamline the system.

• Political Factors Leading to Nationalization
• Two Wars: India fought two significant wars in the 1960s: one with China in 1962 and another with Pakistan in 1965. These wars exerted immense pressure on public finances and heightened the need for stronger economic control, including the banking sector.
• Death of Two Prime Ministers: The deaths of Jawaharlal Nehru in 1964 and Lal Bahadur Shastri in 1966 led to political instability. This political chaos necessitated a more robust financial system, making nationalization crucial.
• Two Successive Years of Drought: Consecutive droughts not only led to food shortages but also compromised India’s national security, as it became dependent on American food shipments. This created an urgent need for stable financial mechanisms to handle such crises.
• Lack of Trust in Private Banks: By the time Indira Gandhi became prime minister in 1967, private banks were failing, largely due to speculative activities. Nationalization was viewed as necessary to restore trust in the financial system.

Arguments in Favor of Nationalization of Banks

• Priority Sector Lending: Agriculture and its allied activities were crucial contributors to the national economy but remained credit hungry. Nationalization ensured that banks would provide priority sector lending to sectors like agriculture.
• Mobilization of Savings: Nationalization aimed to mobilize the savings of the masses and utilize them for productive purposes to spur economic growth.
• Stable and Safer Banking System: Nationalization was expected to create a more stable and safer banking system, enhancing public confidence and increasing deposits, while also preventing bank failures.
• Revenue for Government: Nationalized banks would serve as an instrument to increase profit and revenue for the government.
• Prevent Concentration of Wealth: One of the primary goals of nationalization was to reduce the concentration of wealth in the hands of a few corporate houses and redistribute economic power.
• Diversification of Resources: Nationalization enabled banks to diversify their resources for the benefit of priority sectors like agriculture, small industries, and exports.
• Remove Wasteful Competition: By nationalizing banks, the government sought to eliminate wasteful competition and improve the efficiency of the banking system.
• Socialistic Goals: Nationalization aligned with the socialistic goals of India’s Constitution. The focus was on the community interest rather than profit, ensuring that the banking system operated with a service-oriented model.
• Check Tax Evasion: Nationalization helped tackle tax evasion and the accumulation of black money in the country by increasing government oversight.
• To Serve Common People: Public sector banks would function similarly to any other public utility, serving the financial needs of ordinary citizens.

Arguments Against Nationalization of Banks

• Politicization: Critics argued that bank nationalization led to the use of financial resources for political purposes rather than productive purposes, which could distort economic objectives.
• Lack of Autonomy: Nationalization was seen as concentrating too much power in the hands of the RBI, reducing banks’ autonomy and effectively replacing corporate capitalism with state capitalism.
• Inefficiency and Corruption: Public sector banks faced accusations of increasing inefficiency and corruption post-nationalization. The rise in non-performing assets (NPAs) in public sector banks is often cited as an example of this.
• Make Banking Less Attractive: Public sector banks were criticized for providing less attractive customer services and increasing red tape, which discouraged efficient banking.
• Branch Expansion Can Be Done Privately: Critics claimed that the expansion of bank branches in rural areas could also be achieved by private banks, given that it would only be necessary where it is economically viable.
• Payment of Compensation: The government had to compensate shareholders during the nationalization process, which imposed financial costs on the state without immediate returns.

Achievements of Nationalized Banks

1. Expansion of Bank Branches: After nationalization, the number of public sector bank branches expanded by over 800%, from 7,219 to 57,000. This growth included rural and backward areas that were previously unbanked.
2. Expansion of Bank Deposits: Deposits in banks increased 200-fold after nationalization, a result of increased public trust and the wider reach of public sector banks.
3. Expansion of Credit Facilities: Nationalized banks greatly increased the availability of credit facilities to different sectors of the economy, now catering to the needs of industry, trade, agriculture, and more.
4. Advances Provided to Priority Sectors: The priority sectors like agriculture, small-scale industries, and retail trade benefited from nationalization.
   • For example: RBI mandates that scheduled commercial banks must lend 40% of their loans to the priority sector.
5. Social Banking and Poverty Alleviation Schemes: Nationalized banks were key participants in various poverty alleviation schemes launched by the government, thereby contributing to social welfare.
6. Interest Subvention Schemes: The government introduced a differential interest scheme to provide concessional loans to weaker sections. This allowed nationalized banks to provide loans at 4% interest rates to Economically Weaker Sections (EWS).

Negative Implications of Nationalization of Banks

1. NPA Crisis: The Non-Performing Assets (NPA) crisis, particularly since 2012, has been partly attributed to the nationalization of banks. The support for loans, including politically influenced ones, led to the credit bubble and subsequent issues of loan defaults.
2. Long-Term Risks: While liberal credit policies were intended to support rural development, they caused instability in the banking sector. Nationalized banks have faced difficulties managing overdue loans and economically unviable branches.
3. Complicated Interest Rates: Nationalization led to complex interest rate structures within the banking system, with different rates for different types of loans. This complexity created barriers for those in need of credit, and often loans were not adequately disbursed to the deserving.
4. Reduced Competition in the Banking Sector: Nationalization reduced competition by limiting the role of private banks, and thus, the public sector banks didn’t face the pressure to innovate or improve their services.
5. Inefficiency: A bureaucratic attitude became prevalent after nationalization, as public banks lacked accountability and incentive to improve. This resulted in delays, inefficiencies, and an overall lack of responsiveness to market needs.
6. High-Risk Lending: Nationalized banks were encouraged to lend to high-risk sectors, like agriculture and small-scale industries, but with fewer returns. This made banks vulnerable to non-performing loans.
7. Lack of Performance Audit: Public institutions suffered from a lack of performance audits, meaning there were no checks to ensure that funds were being utilized productively, leading to wastage of public resources.

Conclusion

Nationalization has significantly contributed to the growth of India’s economy, promoting financial inclusion and supporting underserved sectors. It has largely achieved its purpose, but the time has come to gradually move towards privatization to handle the growing NPA crisis and improve efficiency.

After 52 years, it may be time to re-evaluate whether the Indian economy needs so many public sector banks. While nationalization has contributed to financial inclusion and development, it has also resulted in inefficiencies, bloated public sector banks, and a burden of non-performing loans.

Nationalization brought both positive and negative impacts on the banking sector. It achieved some of its intended goals, but also led to several long-term consequences, especially related to the NPA crisis and inefficiencies. Moving forward, it is crucial to review the Narasimham Committee’s recommendations for reforms in the banking sector.