ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Narrow Banking Theory, Evidence and Prospects in India

Prospects in India Saibal Ghosh Mridul Saggar The narrow banking proposal defining a class of safe and liquid assets (generally sovereign government securities) for investments by weak banks, backed fully by demand liabilities (generally non-interest bearing deposits) has been considered as a means of deposit protection and a possible solution to the banking problems. We seek to explain the theoretical implications of the proposal and examine its implications for the Indian public sector banks facing large non-performing loans. The evidence presented in this paper, based on published and audited annual accounts, shows that even without a directive, narrow banking on the asset side is already being practised as part of the asset-liability management by these banks. However, given the structure of deposit ownership, narrow banking in its strict sense does not afford a solution to reforming weak banks. Strictly practised narrow banking can neither guarantee deposit protection nor turn around the weak banks. On the contrary, it can expose weak banks to immense market and interest rate risks which can make the banking system vulnerable to idiosyncratic and systemic risks arising from macro-economic shocks. Considering the fact that the problem of non-performing loans is not as alarming in India as in some other emerging markets, this paper suggests a cautious Approach to strengthening the banking structure. Pitching excessively restrictive speed limits in this scenario might turn out to be counter-productive. The paper, however, recognises that some contraction in the scale of Operations of the weak banks seems to be an unavoidable by-product of measures which may be necessary to strengthen weak banks.

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