EARLY EVOLUTION OF CENTRAL BANKING IN INDIA: The impact of the Great War

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Date:
29 Mar 2016

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The Great War had a phenomenal impact on banking business globally, bringing financial stress throughout the world including India, Britain’s most important colony. Research by Tehreem Husain and Nadeem Aftab, to be presented at the Economic History Society’s 2016 annual conference in Cambridge, shows that the Great War brought macroeconomic and financial stress, leading to the collapse of 83 banks during the war. This crisis went on unabated due to lack of a formal regulatory structure to lend support to troubled institutions.

The researchers hypothesise that the lack of a financial regulatory institution in the presence of macroeconomic stress led to a contagion-like crisis, erasing 16.7% of paid up capital of Indian commercial banks during the war period (1914-18). They argue that the onset of banking crisis gave currency to the idea that a central banking institution for India should be in place. This realisation led to creation of a quasi-central banking institution, the Imperial Bank of India in 1921, which later provided foundation for the establishment of Reserve Bank of India in 1935.

The idea of a ‘great banking establishment’ for India (read central bank) dates back to 1836 but the structure of the Indian financial system excluded the need for one. There were three ‘quasi-government’ Presidency banks that dealt with the local financial market and European exchange banks that dealt with foreign exchange, thus excluding the need for a central bank. This arrangement was similar to Canadian banks, which kept their reserves on ‘call’ at the New York money market and excluded the need for a central banking institution.

But with the onset of the Great War, the weaknesses in the system became prominent. The need for war financing led to stressed macroeconomic and financial conditions.

To analyse the macro-financial environment of India at the time of the Great War, this study divides the economy into four major sectors; fiscal, external, real and monetary. Data on the Indian economy and financial system have been extracted from the Banking and Monetary Statistics in India, an important document published by the Reserve Bank of India and Statistical Abstract Relating to British India digitally archived by the University of Chicago.

Trends of some crucial explanatory variables in each of these four sectors as well as in the Indian financial industry are analysed. In addition, some select variables have been used to create a financial pressure index that tracks the stressed macro-financial environment of those years.

It is seen that during the war, all sectors exhibited stress conditions including the financial pressure index. To finance the war effort, huge amount of external debt, worth £173 million pounds, in 1918 was contracted. Domestic debt also registered accelerated growth. Ordinary unproductive debt rose from 4.6% of total debt in 1914 to a significant 24% in 1918. This was primarily long-term in nature having a long-term maturity of three, five, seven and ten years. On the other hand, deposits were raised which had a maturity of six months to one year. This created a maturity mismatch that was one of the pivotal reasons behind the crisis.

Furthermore, deposits were raised at a high percentage without an adequate increase in the capital or reserves base. Banks’ cash balances fell during the war years and money market rates exhibited volatility. Macro-financial pressures resulted in a spate of bank failures across India during the war years.

This lends credence to the argument that the financial crisis was brought on by an effort to finance the Great War. More importantly, the crisis gave impetus to the creation of a central banking institution in India.

Even though this crisis is a century old, it is still of interest to academics and policy-makers alike. Similar to the global financial crisis of 2007, where regulatory institutions were either restructured or new regulatory standards were innovated, this crisis, among others, set the foundation for a regulatory institution for India.

The historical evolution of banking regulation in India has been given little attention and this study aims to fill that gap. The importance of this work can be judged by the fact that the creation of the Imperial Bank of India in 1921 and subsequent creation of the Reserve Bank of India in 1935 marked the evolution of a formal regulatory structure in the region that is now home to three nations on the world map today.

ENDS

Evolution of Central Banking in India: What role did the Great War play?

Dr Nadeem Aftab

Lecturer Banking and Finance

University of Northampton

nadeem.aftab@northampton.ac.uk

 

Tehreem Husain

Regular Columnist (Business page)

The Express Tribune

tehreemh@gmail.com

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