HISTORICAL EVOLUTION OF BANKING IN INDIA

Najmi Shabbir*

ABSTRACT

This paper mainly analyses the early phase of Banking in India upto 1947. The phase

leading up to independence laid the foundation of the Indian banking system. The

initial phase (up to 1947) was a difficult period for the banking sector. In Pre-

independence period most banks were small and had private shareholding, they were

largely localised and many of them failed. They came under the purview of the

Reserve Bank that was established as a central bank for the country in 1935. In this

phase, many banks failed which was marked by the two World Wars and the Great

Depression. By the end of this phase, the country’s financial requirements were still

catered to, in a large measure, by the unorganised sector. The focus of the banking

sector was on urban areas and the requirements of agriculture and the rural sector

were neglected. Although the co-operative credit movement had a very encouraging

beginning, it did not spread as expected despite Government patronage.

Key Words: Unorganised Sector, World Wars, Government Patronage, Reserve

Bank, Great Depression.

*Lecturer, Shia P.G. College, Lucknow

Introduction

The financial Sector of a country is very critical for the development of the economy,
and Banks are the most important institutions of the financial sector. Banks act as
intermediaries between savers and investors. On the one hand, they collect funds from
those who have surplus money and on the other they provide these funds to the
investors that are the entrepreneur, firms and the companies.

A developed banking sector discharges this function efficiently and effectively. It can
be seen in the modern world that only those countries have developed fast that had an
efficient financial sector in general and banking Sector in particular. This is true not
only of today but in the past also. The development of the economy and its various
sectors depends primarily upon the flow of credit from the Banks. It has been
experienced that those Sectors which have an easy access to the bank credit, develop
faster as compared to those which do not have such an access. Since Banks are
commercial ventures they have a natural tendency to make their credit available to
those parties which are financially viable. In the process it often happens that many of
the important sectors are left out which are important from a social and economic
point, but might not be financially so rewarding. To address this issue the government
either directly or through the central Bank of the country directs the banking sector to
make their credit available to particular Sectors of the economy. Such sectors may be
called the Priority Sectors. The focus of the present study is on analysing the Priority
sector lending by the Banks in India. However, before coming to this specific issue,
an introduction to the evolution of banking in India and its present status is necessary
which is being done in the following paragraphs.

Although Banks had existed in ancient period also, their evolution can be traced back
to the development of different economies and the modern pattern of banking can be
traced to the fifteenth century, in Banca Monte dei Paschi di Siena in Italy (1472),
Riks bank in Sweden (1668) and the Bank of England (1694). Thereafter the
development of banks spread across the entire Europe, the U.S. and other colonies of
the European countries.
In India, although the moneylenders etc. had existed in an ancient period also but the
development of modern form of Banks is attributed to the establishment of British
rule. From these early days of banking in India to the present times, Indian banking
system has reached International standard with different types of Banks. There are
approximately 18,000 Bank branches in the country having all modern means of bank
management. For analysing the changing banking scenario historically, the time
period has been divided in four phases.

I. The Early Phase of Banking in India- up to 1947

II. Banking in the Early years of Independent India- 1947 to 1967
III. After Nationalisation - 1969 to 1991
IV. Post Reforms – 1991 onwards.

1. The Early Phase of Banking In India –up to 1947

The foundations of the Indian banking system were laid down during this period. The

western variety of joint stock banking was brought to India by the English Agency

houses of Calcutta and Bombay (now Kolkata and Mumbai). Bank of Bombay was

the first bank of a joint stock variety which was established in 1720 in Bombay1. This

was followed by Bank of Hindustan in Calcutta, which was established in 1770 by an

agency house2. This agency house, and hence the bank was closed down in 1832. The

General Bank of Bengal and Bihar, which came into existence in 1773, after a

proposal by Governor (later Governor General) Warren Hastings, proved to be a short

lived experiment3. The first ‘Presidency bank’ was the Bank of Bengal established in

Calcutta on June 2, 1806 with a capital of Rs.50 lakh. The Government subscribed to

20 per cent of its share capital and shared the privilege of appointing directors with

voting rights. The bank had the task of discounting the Treasury Bills to provide

accommodation to the Government. The bank was given powers to issue notes in
1823. The Bank of Bombay was the second Presidency bank set up in 1840 with a

capital of Rs.52 lakh, and the Bank of Madras the third Presidency bank established in

July 1843 with a capital of Rs.30 lakh. These banks were known as Presidency banks

as they were set up in the three Presidencies that were the units of administrative

jurisdiction in the country for the East India Company. The Presidency banks were

governed by Royal Charters. The Presidency banks issued currency notes until the

enactment of the Paper Currency Act, 1861, when this right to issue currency notes by

the Presidency banks was abolished and that function was entrusted to the

Government. The first formal regulation for banks was perhaps the enactment of the

Companies Act in 1850. This Act is based on a similar Act of 1844 in Great Britain.

With the collapse of the Bank of Bombay, the New Bank of Bombay was established

in January 1868. The three Presidency banks came under the Presidency Bank Act,

(1876) and it imposed some restrictions on their business. It prohibited them from

dealing with risky business of foreign bills and borrowing from abroad. In terms of

Act XI of 1876, the Government of India decided for the periodic inspection of the

books of these banks. Until the enactment of the Paper Currency Act, 1861, the

Presidency banks had the right to issue currency notes. The right to issue currency

notes by presidency banks was abolished and that function was entrusted to the

Government.

The first Indian owned bank was the Allahabad Bank which was set up in Allahabad

in 1865, followed by Punjab National Bank in 1895 in Lahore, and Bank of India in

1906 in Mumbai. All these banks were established under private ownership. The

Swadeshi Movement of 1906 gave a great impetus to joint stock banks of Indian

ownership and many Indian commercial banks such as Central Bank of India, Bank of
Baroda, Canara Bank, Indian Bank, and Bank of Mysore were established between

1906 and 1913. By the end of December 1913, the total number of reporting

commercial banks in the country reached 56 comprising 3 Presidency banks, 18 Class

‘A’ banks (with capital of greater than Rs.5 lakh), 23 Class ‘B’ banks (with capital

between Rs.1 lakh to 5 lakh) and 12 exchange banks. Exchange banks were foreign

owned banks that engaged mainly in foreign exchange business in terms of foreign

bills of exchange and foreign remittances for travel and trade. Class A and B were

joint stock banks. The banking sector during this period, however, was dominated by

the Presidency banks. Three presidency banks were amalgamated into a single bank

i.e. Imperial Bank of India in 1921 (table 1)

1.1 Setting up of the Reserve Bank and its Role

On account of Bank failures the setting up of a central bank of the country was

recommended by various committees. To take care of bank failures many central

banks were established all over the World4.The US Federal Reserve was established

in 1913 due to recurrent banking crises. The Reserve Bank of India Act 1934 was

enacted for the setting up of the Reserve Bank of India. The reason of bank failures

and the need for catering to the requirements of agriculture were the two prime

reasons for the establishment of the Reserve Bank. The banking sector came under the

purview of the Reserve Bank in 1935. At the time of setting up of the Reserve Bank,

the joint stock banks constituted the largest share of the deposits held by the banking

sector, followed by the Imperial Bank of India and exchange bank

 Table 1 : Number of Banks, Capital and Deposits (Amount in Rs Lakhs)

No of Reporting Commercial Banks Paid up Capital and Reserves Deposits

Exchange Bank
Imperial Bank

Imperial Bank

Imperial Bank
Presidency

Presidency

Presidency

Class B’’
Class A’

Exchange
Class B’’

Class B’’
End Dec

Class A’

Class A’

Bank
Total

Total

Total
1870 3 2 3 - 8 362 12 _ 374 1197 14 52 1263
1880 3 3 4 - 10 405 21 _ 426 1140 63 340 1543
1890 3 5 5 - 13 448 51 _ 499 1836 271 754 2861
1900 3 9 8 - 20 560 128 _ 688 1569 808 1050 3427
1910 3 16 11 - 30 691 376 _ 1067 3654 2566 2479 8699
1913 3 18 12 23 56 748 364 # 1112 4236 2259 3104 151 9750
1920 3 25 15 33 76 753 1093 81 1927 8629 7115 7481 233 23458
1930 1 31 18 57 107 1,115 1190 141 2,446 8397 6326 6811 439 21973
1934 1 36 17 69 123 1,128 1267 149 2,544 8100 7677 7140 511 23428
Note:
‘: Banks with capital and reserves of Rs 5 lakh and over
“: Banks with capital and reserves over Rs 1 lakh and up to Rs 5 lakh
#: Negligible.
Source: Statistical Tables Relating to Banks in India, Various Issues
 Table 2: Number of Commercial Banks in India and their Deposits

Imperial Bank Exchange Joint Stock Total

December

of India Banks Banks All Banks

End

Number Deposits Number Deposits Number Deposits Number Deposits

(Rs crore) (Rs crore) (Rs crore) (Rs crore)
1 2 3 4 5 6 7 8 9
1926 1 80 18 72 76 63 95 215
(37.4) (33.3) (29.4) (100)
1929 1 79 18 67 79 66 98 212
(37.3) (31.4) (31.2) (100)
1932 1 75 18 73 87 76 106 225
(33.6) (32.5) (33.9) (100)
1935 1 79 17 76 106 90 124 245
(32.3) (31.1) (36.7) (100)
Note: Figures in brackets are percentage share in total
Source: Statistical Abstract Relating to Banks in India, 1935
 The Reserve Bank of India Act, 1934 gave various powers to the Reserve Bank,
which include the power to issue the currency notes, the custody of the commercial banks’
cash reserves and the discretion of granting them accommodation. To secure monetary
stability in India and generally to operate the currency and credit system of the country to its
advantage, it keeps the Reserves of the Banks. The main functions of the Reserve Bank could
be classified into the following broad categories (a) to act as a banker to the Government; (b)
to issue notes; (c) to act as a banker to other banks; and (d) to maintain the exchange rate. In
1935, banks were required to maintain cash reserves of 5 per cent of their demand liabilities
and 2 per cent of their time liabilities on a daily basis. The task of managing the currency that
was assigned to the Controller of Currency came to the Reserve Bank in March 1935 under
Section 3 of the RBI Act, 1934. The provisions of the RBI Act also required the Reserve
Bank to act as a banker’s bank. In accordance with the general central banking practice, the
operations of the Reserve Bank with the money market were to be largely conducted through
the medium of member banks, viz., the ‘scheduled’ banks and the provincial co-operative
banks. The ‘scheduled’ banks were banks which were included in the Second Schedule to the
RBI Act and those banks in British India that subsequently became eligible for inclusion in
this Schedule by virtue of their paid-up capital and reserves being more than Rs.5 lakh in the
aggregate. The power to include or exclude banks in or from the Schedule was vested with
the Governor General in Council. Agricultural credit was a special responsibility of the
Reserve Bank in terms of the RBI Act. The Reserve Bank had commenced two studies in
1936 and 1937 in this area. Almost the entire finance required by agriculture at that time was
supplied by moneylenders; cooperatives and other agencies played a negligible part. During
the period from 1935 to 1950, the Reserve Bank continued to focus on agricultural credit by
fostering the co-operative credit movement through the provision of financial accommodation
to co-operatives. A well-differentiated structure of credit institutions for providing credit to
agriculture and allied activities was emerged, due to concerted efforts and policies of the
Reserve Bank. Within the short-term structure, primary agricultural credit societies at the
village level formed the base level, while district central co-operative banks were placed at
the intermediate level, and the State co-operative banks at the apex level. The long-term
structure of rural co-operatives comprised State co-operative agriculture and rural
development banks at the State level, and primary co-operative agriculture and rural
development banks at the decentralised district or block level. These institutions focused on
providing typically medium to long-term loans for making investments in agriculture and
rural industries.

The central bank, if it is a supervisory authority must have sufficient powers to carry
out its functions, such as audit and inspection and restrain unsound practices and suggest
corrective measures like revoking or denying licenses. However, the Reserve Bank in the
earlier years did not have adequate powers of control or regulation. Commercial banks were
governed by the Company Law applicable to ordinary non-banking companies, and the
permission of the Reserve Bank was not required even for setting up of a new bank. The
period after setting up of the Reserve Bank saw increase in the number of reporting banks.
The classification of banks was expanded to include the banks with smaller capital and
reserve base. Class ‘A’ banks were divided into A1 and A2. Further, two new categories of
banks, viz,. ‘C’ and ‘D’ were added to include the smaller banks. Banks with capital and
reserves of greater than Rs.5 lakh and included in the second schedule to the RBI Act 1934
were classified as Class A1, while the remaining non-scheduled banks with capital and
reserves of greater than Rs.5 lakh were classified as Class A2. The rest of the non-scheduled
banks were classified according to their size; those with capital and reserves of greater than
Rs.1 lakh and lower than Rs.5 lakh were classified as Class B; banks with capital and
reserves of greater than Rs.50, 000 and up to Rs.1 lakh were classified as Class C; and those
With capital and reserves of less than Rs.50, 000 were classified as Class D. In 1940, the
number of Reporting banks was 654.

1.2 The World War II and its Impact on Indian Banking

The effects of the Second World War (1939 to 1944) on Indian banking were far-
reaching. As India increasingly became a supply base for the Allied armies in the Middle East
and South-East Asia, Government expenditure on defence and supplies to the Allies led to a
rapid expansion of currency. As a result, the total money income of some sections of the
community rose. This combined with a diversity of causes such as the difficulty in obtaining
imports, the diversion of internal supplies to war needs, the control of the channels of
investment and the distortion in the pattern of income distribution, among others, led to a
rapid increase in the ‘unspent margin’ in the higher income groups, which, in turn, brought
about a large pool of bank deposits. Such a situation encouraged the development of banking
enterprises, apart from exchange banks, whose performance was driven mainly by external
factors. The number of branches increased sharply between 1940 and 1945 and most of this
branch expansion was accounted for by scheduled commercial banks (other than Imperial
Bank of India and exchange banks) and non-scheduled banks. ( table 3)

Table 3: Number of Bank Branches: 1940-45

End Imperial Exchange other Total Non All

Dec. Bank of Banks Scheduled Scheduled Scheduled Banks
India Banks Banks Banks
1 2 3 4 5 6 7
1940 383 87 844 1314 650 1964
1941 393 84 937 1414 882 2296
1942 392 84 971 1447 1132 2579
1943 399 84 1395 1878 1396 3274
1945 428 77 2451 2956 2245 5201
Source: GOI, Reserve Bank (History) volume I

Several of the banks that expanded had very low capital. For instance, one bank with
a capital of less than Rs.2 lakh opened more than 75 branches.

Conclusion

The phase leading up to independence laid the foundation of the Indian banking system. The
initial phase (up to 1947) was a difficult period for the banking sector. In Pre- independence
period most banks were small and had private shareholding, they were largely localised and
many of them failed. They came under the purview of the Reserve Bank that was established
as a central bank for the country in 1935. The Swadeshi Movement during this phase saw the
establishment of many Indian banks, most of which continue to operate even now. In this
phase, which was marked by the two World Wars and the Great Depression, many banks
failed. Most of the small banks were local in character and had low capital base. As a result,
they were not resilient enough. Apart from the global factors, one of the major reasons for
failures of small banks was fraudulent manipulation by directors and managers and inter-
connected lending. Also, several banks that failed had combined trading functions with
banking functions. Partly, in order to address the problem of bank failure, the Reserve Bank
was set up in 1935. In fact, central banks in several other countries, including the US, were
also set up to address the problem of bank failure. However, the Reserve Bank had a limited
control over banks and lack of an appropriate regulatory framework posed a problem of
effective regulation of small banks. By the end of this phase, the country’s financial
requirements were still catered to, in a large measure, by the unorganised sector. The focus of
the banking sector was on urban areas and the requirements of agriculture and the rural sector
were neglected. Although the co-operative credit movement had a very encouraging
beginning, it did not spread as expected despite Government patronage.

Notes and References

1. Reserve Bank of India (2006)

2. Indian Central Banking Enquiry Committee (1931)
3. Reserve Bank of India (History), Volume 1, page 6
4. op.cit.(1931)