Nationalisation Of Banks In India The Economic Effect Economics Essay

After Independence India adopted a socialist pattern of economy as its goal. The aim was to achieve a society with wealth distributed as equitably as possibly but ensuring that the government does not acquire a totalitarian role.

The Government of India wished to play an active role in the economic life of the nation and with this the government adopted a mixed economy. The two sectors, private and public were allowed to function independently of each other. The private sector was regulated through a system of checks and balances such as regulations, licenses controls and legislations. The public sector was allowed to grow through setting up of institutions and industries and nationalization of some belonging to private sector who failed to achieve the desired result of growth of the economy. [1] 

Nationalization of Banks

Considering this basic objective in mind the government decided to nationalize the banks in an attempt to monitor and exercise some control over the banking sector. The motives for nationalization are both political and economic. It is the process whereby the means of production, distribution and exchange are owned by the state on behalf of the people or working class to allow rational allocation of output, consolidation of resources, rational planning or control of the economy. This enables the government to exercise full democratic control over the means thereby ensuring effective means of distribution of output to benefit the public at large. [2] 

The nationalization of banks in India was primarily done for two reasons. First, the partition of India in 1947 adversely affected the banking activities especially in Punjab and West Bengal. [3] The laissez faire regime was brought to an end and the government started to play an active role in the reconstruction of the economy especially banking and finance. Secondly, the government believed that the ownership of the Bank by the sovereign will give new confidence to the customers and that it would dispel the suspicions existing in the minds of the people with regards to the capabilities of the bankers in the private sector. [4] 

In the year 1948, the Reserve Bank of India, Indias central banking authority was nationalized and it became an institution owned by the government of India. In a further attempt to control the banking activities the government enacted the Banking Regulation Act, which authorized the RBI to regulate, control and inspect the banks in India. The act provided that no bank could be opened without the sanction of RBI and that no two banks can have the same directors. [5] 

Then in the year 1955, the government took another major step and nationalized the Imperial bank of India and its undertaking was taken over by State Bank of India.

However, the scheduled banks were accused of directing their advances to the large and medium scale industries and big business houses and the sectors such as agriculture, small scale industries and exports were not receiving their due share. Keeping this mind in February 1966, a scheme of Social Control was setup whose main function was to regularly assess the demand for credit from various sectors of the economy, to determine the needs of the economy and prioritize grant of loans and advances to ensure optimal allocation of resources. The main feature of this scheme was the establishment of a National credit council headed by the Finance Minister and representatives of agricultural sector, trade, industry, banks and professional groups as the members. [6] 

This scheme was challenged by the banking industry representatives who argued that social control was not necessary since the RBI had already been vested with effective and extensive powers over almost every aspect of banking. [7] 

However, this scheme failed to provide any remedy and therefore even though the number of banks were opened in the rural areas the private banks were still not oriented towards meeting the credit requirements of the weaker sections. [8] 

Since the social control had failed to meet its objective, on 19th July 1969, fourteen Major banks each having deposits of more than 50 crores and having between themselves aggregate deposits of Rs. 2,632 crores with 4130 branches were nationalized. This process of bringing the banks under the government control was considered nothing short of a revolutionary step and marked the beginning of a co-ordinated endeavour to use an important part of the financial mechanism for the country’s economic development. [9] 

Nationalisation was initially met with skepticism and faced strong opposition.

Arguments for Nationalisation

As stated earlier, the primary reason behind the nationalization of the banks was to achieve the socialistic pattern of society.

It was proposed that nationalization will enable to direct the credits to priority fields of agriculture, small scale and exports, that banking units would not expand in rural areas and there will be enhancement of public confidence. It was felt that Indian commercial banks were catering only to the large and medium scale industries who was ready to pay the money back to these banks at a higher interest rate in comparison to the rural areas. This can be evidenced by the fact that whereas industry’s share in credit disbursed by commercial banks almost doubled between 1951 and 1968, from 34 per cent to 68 per cent, agriculture received less than 2 per cent of total credit. [10] 

It was strongly believed that nationalization would enable the banks to charge lower rate of interest from the weak and the backward areas and the exporting sector thereby subsidizing these sectors. The long title of ‘The Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, 1969 for the nationalization of the 14 banks stated that the nationalization was being done ‘in order to serve the better needs of development of the economy in conformity with the national policy and objectives.’ [11] 

Moreover, in response to the argument that the social control scheme was not implemented for a longer period to achieve the desired results, the Prime Minister claimed that that the officials in the banks were not performing their duties efficiently but were doing so because they had been instructed to do the same. It was also argued that restrictions imposed by the social control measures were capable of being flouted in spirit although observed in form. The government then strongly believed that this temporary measure of imposing social control will not achieve the desired result. What is required is a plan which is imposed permanently and one which enables direct control. The need of the time were pressing and that the country could not afford a trial and error method. [12] 

The government also believed that these banks did not have enough paid up capital and were operating with other peoples money. This aspect of banking had led even the predominantly capitalist countries like france to nationalize their banks or atleast keep a control on them. [13] 

Arguments against Nationalisation

Several imminent persons including Morarji Desai, the then Deputy Prime Minister and the Finance Minister, opposed the measure. They argued that 168 days of imposition of social control was too short a period to achieve any results and it was wrong to conclude that it had failed.

On the other hand, they argued that social control in this short period of 168 days had achieved substantial rewards. The banks and the officials concerned were not acting under compulsion as alleged but were acting in the spirit of cooperation and willingness. [14] 

They also argued that there was no such pressing need as it was claimed to be and this measure of taking control over the bank was indicative of political tussles and result of inter party struggle for power. [15] 

They argued that by converting these banks and bringing them under state control will not remedy the evils but will only substitute one group of evils with another. Public sector institutions are known for the lack of their dynamism, non realization of its potential as a business and abysmal customer service. [16] Public control shall leave the door open for corruption and favoritism. Performances of these banks will go down and losses will pile up. Therefore instead of reforming the banking sector it shall stall the progress.

Legal procedure adopted for nationalisation

Disregarding the stiff opposition faced by the government, nationalization was carried out. On 19th July 1969, the Vice President of India, promulgated ‘The Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, 1969’. The ordinance provided that the banks each with a deposit of Rs. 50 crores or more shall be transferred to 14 new body corporates called ‘corresponding new banks’. The ordinance also provided for the machinery of management of these 14 new banks and payment of compensation to the shareholders of the banks being taken over. [17] The ordinance provided for the concept of priority sectors which included agriculture, small scale industry, retail trade, small business and small transport sectors. The ordinance made it mandatory for the bank to provide a minimum of 40 per cent of their net credit to these priority sectors. [18] 

Petitions were filed against this ordinance in the Supreme court. However, before the petition could be decided the ordinance was passed and enacted as the Banking Companies (acquisition and Transfer of Undertakings Act, 1969. This act was then challenged in the Supreme court in RC Cooper v. Union of India [19] where the court granted an interim injunction against the operation of the act.

On 15th April 1980, six more private sector banks having demand and time liabilities of not less than Rs. 200 crores each were nationalized thereby extending further public control over the banking sector. The acquisition by the state was done under the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980. This was done in conformity with the principles laid down in clause (b) and (c) of Article 39 of the Constitution. [20] 

RC Cooper v. Union of India

Facts: The petitioner held shares in 4 banks namely, the Central Bank of India Ltd, the Bank of Baroda ltd, the Union Bank of India Ltd and Bank of India ltd. He also held accounts with these banks and was the director of the Central Bank of India, Ltd. The petitioner challenged the Banking Companies (Acquisition and Transfer of Undertakings) Ordinance which was later enacted as Banking Companies (Acquisition and Transfer of Undertakings) Act 22 of 1969, as violative of Article 14, 19 and 31 of the Constitution. This ordinance provided that the assets, rights and obligations of every named commercial bank was to be taken over by the corresponding new bank. The petition was filed at the time of the promulgation of the ordinance. However, at the time when the petition was before the Supreme court the act was passed by the Parliament on August 9, 1969. The petitioner challenged both the ordinance and the act.

Arguments: The petitioner challenging the validity of the ordinance and the act contended that first The Ordinance promulgated in exercise of the power under Article 123 of the Constitution was invalid, because the condition precedent to the exercise of the power did not exist. Second, that in enacting the Act the Parliament encroached upon the State List in the Seventh Schedule of the Constitution, and to that extent the Act is outside the legislative competence of the Parliament. Third, that by enactment of the Act, fundamental rights of the petitioner guaranteed by the Constitution under Articles 14, 19(1)(f) & (g) and 31(2) are impaired, Fourth, that by the Act the guarantee of freedom of trade under Art. 301 is violated and fifth, that in any event retrospective operation given to Act 22 of 1969 is ineffective, since there was no valid Ordinance in existence. The provision in the Act retrospectively validating infringement of the fundamental rights of citizens was not within the competence of the Parliament. That Sub-sections (1) & (2) of Section 11 and Section 26 are invalid.

The respondents contended that the petitions are not maintenable since the petition is not the owner of the property of the undertaking taken over by the corresponding new banks and is thereby incompetent to present the petition.

The Supreme Court bench of 11 judges, decided the petition on 10th February 1970 holding by a majority of 10 to 1 that although the act was within the legislative competence of competence, it was void in its entirety for three reasons.

The act by prohibiting the 14 banking companies from carrying on banking business and allowing the other Indian banks or foreign banks committed hostile discrimination.

Even though these 14 banks were allowed to carry out other business, they were stripped of their assets, staff, premises and even names. This was an unreasonable restriction.

The method adopted for determining the compensation to the 14 banking companie were illusory and irrelevant.

After the judgment was delivered, the President promulgated another ordinance which was later enacted as The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970. The act made an attempt to plug the loopholes in the 1969 act.

Impact of nationalisation on the indian economy

The impact of nationalization was seen instantly. There were no longer any barriers, social, economic or political between the bankers and customers. This enabled in a massive quantitative expansion in customer base and also helped improve the services. [21] 

Nationalization also enabled the bank to widen its growth. There was no more concern for profitability and there was expansion in the rural areas. With this the economy also expanded and employment opportunities were created. [22] 

Moreover, with nationalization there was substantial increase in the no. of branches opened in rural/semi-urban centres [23] . According to bank economists, during the last 28 years of nationalisation, the branches of the public sector banks rose 800 per cent from 7,219 to 57,000, with deposits and advances taking a huge jump by 11,000 per cent and 9,000 per cent to Rs 5,035.96 billion and Rs 2,765.3 billion respectively. [24] 

It is argued that even today the nation is reaping the benefits of nationalization. For instance the national banks are still serving over 90% of the country’s population availing banking services and thus driving the force of the Indian economy. Moreover, recently, P Chidambaram, the finance minister stated that nationalized banks were the reason that India recovered from the 2007 financial crisis faster than other economies of the world . [25] 

However, there have been negative impacts as well. Some economists argue that the benefits of the nationalization haven’t still been fully realized. Government has failed to implement most of the recommendations of the committees and study teams charged with reforming the banking sector. For instance, the Narsimhan Committee in its report in 1991 stated that “Management weaknesses and trade union pressures have seriously undermined the efficiency of banks and financial institutions”. It referred to the “lack of sufficient delegation of authority, inadequate internal control in respect of balancing of books and reconciliation of inter-branch and inter-bank entries.” [26] The committee also suggested that for the banking sector to flourish it is imperative that the banks becomes competitive and innovative.. New sets of skills need to be developed and new areas of expertise need to be identified. [27] 

Values have been sacrificed for expediency and as a result the banks suffered huge losses which can be only attributed to the poor management of these banks

However, even though one may say that there have been negative impacts on the economy by reason of nationalization one can safely say that the positive contribution overshadows this negative impact and nationalization brought about a complete reform of the banking sector at at time when it was needed the most.