UNIT 2

Narismham Committee Report, 1991-92.

In 1991, a high level committee was appointed under the chairmanship of M. Narsimham,
which examined the aspects relating to the structure, organization, functions and procedures
of the financial system and submitted its report in November, 1991.
The Committee drew attention to the progress made and the achievements of the
Indian Financial System, as well as defects of the financial system. It expressed that the
financial system has to be more competitive and effective to meet the requirements of the real
sector during the period of New Industrial Policy (NIP), 1991.
In recommending the financial sector reforms, the focus of the committee was on
ensuring that the financial services operate on the basis of operational flexibility and
functional autonomy to enhance efficiency, productivity and profitability. Recommendations
are as follows :
(1) Operational Flexibility and Functional Autonomy : According to Narsimham
Committee, financial service industry should operate on the basis of operational flexibility
and functional autonomy. The internal organization of banks should be left to the judgement
of managements of the individual banks. Similarly, for functional autonomy, instead of
having common recruitment system for officers, individual banks should be free to make
their own recruitments.
(2) Depressed Income of banks (Low profitability) : Factors responsible for low
profitability were
(i) Low rate of interest.
(ii) System of directed investment in terms of SLR requirement. So the committee
recommended that –
(i) SLR to be brought down to 25% over the period of five years.
(ii) CRR may be progressively reduced.
(iii) Interest rates paid to the banks on their SLR investment and on CRR
should be raised and fixed at the level of bank’s 1 year deposit rate.
(3) Reduction of High level of CRR: Since 1989, CRR was 15% of the net demand
deposits and time deposit of banks. The committee has recommended that interest rate under
CRR should be above the basic minimum of 3%. It is also recommended progressive
reduction in CRR.
(4) Reduction in Priority sector credit: The priority sector’s credit limit has to be
brought down from 40% to 10%. Similarly, priority sector should be redefined and include
small and marginal farmers, small business, village and cottage industries. Committee also
recommended to phase out directed credit programme.
(5) Deregulation of interest rates : The committee found that interest rate structure is
complex and rigid. So, the interest rates should be deregulated. The concessional rates should
be phased out.
 (6) Removal of capital inadequacy: Banks in India suffer from capital inadequacy.
The committee recommended that it is to be removed within the next three years.
(7) Recommendation on Banks: The committee proposed that there should not be
further nationalisation of banks and new banks in the private sector to be welcomed.
(8) Structure of Rural Credit : To improve the viability of Regional Rural Banks
(RRBs) the committee recommended that each public sector bank should take over rural
bank. Interest rate structure of RRBs should be in line with those of commercial banks.
(9) RBI : Regulating agency : The committee opposed the duality of the control over
the banking system by the RBI and Banking Division of Ministry of Finance. The committee
recommended that the RBI should be made primary regulating agency. Further, separate
authority is to be set up under the RBI for supervision of banks and DFIs.
(10) Foreign Banks : The committee recommended that foreign banks should be
allowed in India. There should be joint venture between foreign banks and Indian Banks.
Further there is a need to lay down Prudential norms and guidelines for the functioning of
new institutions like merchant banks, Mutual Funds, Leasing Companies.

The Second Narsimham Committee report on financial sector reforms was submitted
on 23rdApril, 1998. The following are the recommendations of the second Narisimhan
Committee:
(1) Three-tier system of banking system: The committee recommended an active
movement towards a system of two or three large Indian banks with international character.
On the second tier, there should be eight to ten national banks. At the third tier, there should
be the remaining banks of regional or local character. This is for full convertibility and
greater integration with global financial system.
(2) Separate treatment for the weak banks: Problems of weak banks should be
tackled separately. If necessary, these banks may be closed down.
(3) Solving the Problem of NPAs: Non-performing Assets of nationalized banks are
considered as bad debts and some measures will be taken to solve the huge backlog of BPAs,
because it has severely affected the performance and profitability of banks.
(4) Merger of DFIs: The committee also suggested regarding the functioning of
Development Financial Institutions (DFIs) vis-a-vis commercial bank’s functioning. So the
committee suggested mergers of DFIs in India.
(5) Operational Flexibility for Public Sector Banks : The committee recommended
operational flexibility for public sector banks. It suggests functional autonomy to the bank
management and to fix accountability for their non-performance.
(6) New Principles by BIS : The committee recommended that new core principles
set out by Bank for International Settlement (BIS) would need to be exercised. Similarly,
appropriate legal framework is necessary to protect the interest of the secured creditors,
especially in the bankruptcy cases.
 (7) Review of sick industrial units : As per the banking amendments, it is necessary
to review the sick industrial units. The committee, therefore, recommends to review their
performance.
(8) Depoliticisation of Banking Boards: The committee has suggested that
appointment of chairman and banking boards should be totally depoliticized. The committee
reviewed that politicization affected the appointment of top officials of the banks. There was
no such thing happened with the appointment of non-official people.

Monetary policy:
Objectives of Monetary policy :
Monetary policy is a part of a broader macroeconomic policy which includes the
fiscal policy and trade policy of the government. As such the macroeconomic objectives of
the country constitute the objectives of monetary policy too.
The basic objectives of monetary policy are as follows.
(1) Neutrality of money
(2) Price stability or Economic stability
(3) Economic Growth
(4) Social justice, and
(5) Full employment.
Let us discuss the above said objectives of monetary policy in detail.

(1) Neutrality of Money : Money should be passive factor or neutral in the monetary
system. It should not be allowed to interfere with the real economic factors. This
objective has been stated by Prof. Hayek.According to him money should not be
allowed to produce any effect on volume of income, output and employment. It
should be allowed to function only as a ‘Medium of Exchange’. Money should not
be allowed to influence the price level. Money supply should be allowed to
change with changing demand for money. But quantity of money is to be so
adjusted that effective supply of money is kept constant. If velocity of circulation
increases, then quantity of money should be reduced. So money should be a
neutral factor in the monetary system. It should not be allowed to interfere with
real economic factors.

(2) Price stability or Economic stability : Price stability implies that the monetary
policy should aim at avoiding price fluctuations or changes. Price fluctuations can
lead to either inflation or deflation in the economy. Developing economies face
mainly inflationary situation whereas developed countries face the problem of
deflation. The process of development itself generates the inflationary tendencies
in the economy. Unless timely or prompt measures are undertaken to control
 inflation or deflation in the economy there may be hyper-inflation or depression in
the economy. Therefore, the monetary policy has the objective of controlling
inflation and maintaining price stability in the economy. In the context of a
developed country, the objective of stability has a wider meaning. It implies
avoiding business fluctuations and business cycle. The depression and recession
are two main phases of the business cycle which are avoided to ensure full
employment. The monetary policy is therefore expected to take suitable measures
that will stabilize the business.

(3) Economic Growth : This is the most important objective for the monetary policy
in a developing economies. But monetary policy is not much suitable to fulfill this
objective because unlike fiscal policy, it directly cannot influence the investment
expenditure in the economy. It operates indirectly by providing incentives through
variations in the rate of interest, easy availability of credit etc.

(4) Social Justice : Recently, social justice as an objective of monetary policy has
been mentioned by many economists. This is one of the desirable macroeconomic
goals of the country. Monetary policy can fulfill this objective by its selective
credit control instruments. For instance, the use of selective credit control to direct
easy credit to small and marginal farmers. Similarly unsecured small loans can be
provided to the needy people to start productive activity under the monetary
policy. This will lead to self employment, more jobs can be created. Thus, the gap
between the rich and the poor can be minimized and ‘an economy can fulfill the
objective of social justice.

(5) Full Employment : The objective of full employment is very popular in advanced
countries. Full employment implies full utilization of all resources in an economy.
Thus, it can create more employment opportunities and reduce unemployment.
Monetary policy can fulfill this objective by encouraging the investment in an
economy. The monetary measures like Bank Rate Policy and Selective Credit
Control measures can achieve this objective. This objective is important because :
(i) It promotes social welfare, and (ii) It encourages economic stability and control
cyclical fluctuations. The above-mentioned discussion enumerated the general
objectives of the monetary policy, let us now discuss the objectives of the
monetary policy of the RBI in India.

MONETARY POLICY TRANSMISSION

The transmission mechanism of monetary policy is a process through which monetary actions
affect the twin objective of growth with stable inflation. There are various monetary policy
tools which are used for achieving the same, but in the recent past interest rate has been
predominantly and frequently used. Changes in monetary policy affect the economic activity
in general and price level in particular through the following five channels of monetary
transmission:
1. The interest rate channel: The change in the policy rate affects directly money-
market interest rates and, indirectly, lending and deposit rates, which are set by
banks to their customers. A reduction in interest rates (an ‘easing’ of monetary
policy)reduces the cost of capital thus triggering aggregate demand by motivating
business investment and consumption decisions. A tightening in monetary policy
has the opposite effect on demand and inflation.

2)The exchange rate channel: Lower domestic interest rates could lead to a
depreciation of the domestic currency. On the one hand making exports more
competitive in the global market and adding to domestic demand and economic
activity. On the other hand, could also have a direct upward impact on the rupee
prices of imported inputs, making imports (for example, crude oil) costlier.

3)The credit channel: Through this channel an expansionary monetary policy

leads to higher deposits. Consequently, the banks disburse higher credit, which in
turn increases the investment and output in the economy. Further, debt obligations
of businesses may also change due to a change in the interest rate. For instance, if
the policy rate falls, debt obligations of firms may decrease, strengthening their
balance sheets. As a result, financial institutions may be more willing to lend to
businesses, thus increasing investment spending.
4) The asset price channel: Asset prices and people's wealth influence how much
they can borrow and how much they spend in the economy. The asset prices and
wealth channel typically affects consumption and investment. Lower interest rates
support asset prices (such as housing and equities) by encouraging demand for
assets. Higher asset prices also increase the equity (collateral) of an asset that is
available for banks to lend against. This can make it easier for households and
businesses to borrow. An increase in asset prices increases people's wealth. This
can lead to higher consumption and housing investment as households generally
spend some share of any increase in their wealth.