India’s banking sector is on the verge of a second wave of liberalization. Coming amid a global financial crisis, how will domestic and international banks – and their legal advisers – respond to the challenge? Barney Reynolds and Aatif Ahmad report

Despite opening up vast areas of the economy to foreign investment, the Indian government has continued to exercise tight control over the banking and financial services market.

Prior to the reforms of 1991, the banking sector was subject to detailed micro-management. Having nationalized the industry in 1969, the government imposed financial control through bureaucratic price-fixing and planned resource allocation, resulting in a substantial amount of resources being directed towards financing fiscal deficits rather than more productive uses.

The main tools of financial control included administered interest rates, statutory pre-emptions and directed credit policies. Deposit and lending rates were determined by India’s central bank and banking regulator, the Reserve Bank of India (RBI). Legislation imposed demanding statutory liquidity ratios (SLRs), which required banks to hold a certain minimum percentage of assets in the form of government securities, and equally tough cash reserve ratios (CRRs).

In addition, directed credit policies required banks to channel at least 40% of their credit into priority sectors such as agriculture and small scale industries.

Administered interest rates have since been replaced by more market-determined ones, although some price distortion still persists. The SLR, although reduced to 24% of the net demand and time liabilities, remains high by international standards and has been criticized for creating a captive market for government securities and crowding out productive private investment. Furthermore, banks are still expected to meet targets for credit to priority sectors even though more than half of all bad loans tend to arise from such lending.

The most important feature of recent reforms has been the reduction of entry barriers to foreign and private sector players. As a result, seven new private banks entered the market between 1994 and 2000 and over 20 foreign banks followed after 1994. The market, however, continues to be dominated by public sector banks (PSBs) which are majority owned by the Indian government (although many are listed on stock exchanges with substantial equity in the hands of foreign investors).

In March 2008 PSBs accounted for 69.9% of the aggregate assets and 72.7% of the aggregate advances of the scheduled commercial banking system. Nevertheless, the importance of foreign and private banks cannot be ignored. These institutions have developed solid businesses in niche areas such as foreign exchange and investment banking services. Non-banking financial companies (NBFCs) are also playing an increasing role in meeting the financing demands of the Indian economy.

Throwing open the doors

On 28 February 2005, the RBI announced a new two-phase roadmap to further facilitate the entry of foreign banks into India. The first phase, from March 2005 to March 2009, enables foreign banks to enter the market via the foreign direct investment (FDI) route, either by opening a branch or by setting up a wholly owned subsidiary in India. Once a foreign bank has obtained its banking licence, in theory it enjoys the same status as an Indian bank and is permitted to conduct the same activities. In fact, foreign banks enjoy a lower priority credit requirement than their domestic peers (32% as against 40% required for Indian banks).

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Barney Reynolds is a partner and Aatif Ahmad is an associate in the London office of Shearman & Sterling. They both specialize in financial institutions advisory and asset management work.