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Page 1: Banking developments&perspectives (2)

Banking Developments and Perspectives

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Chapter I

Banking Developments and Perspectives

One of the major areas of the macro-economythat has been the subject of focused attentionin recent years is the financial sector soundnessand efficiency. Within the broad ambit of thefinancial sector, a well-functioning bankingsector is regarded as the bedrock of a stablefinancial system. The renewed focus on thebanking sector has been driven by two majorconsiderations. First, the growinguniversalisation and internationalisation ofbanking operations, driven by a combinationof factors, such as, the continuing deregulation,heightened competition and technologicaladvancements, have altered the face of banksfrom one of mere intermediator to one ofprovider of quick, efficient and consumer-centric services. In the process, the potentialfor risks has also increased. Secondly, thewidespread banking problems that haveplagued large areas of the globe have raiseda gamut of questions relating to the linkagesbetween banking reforms and reforms of othersegments of the financial sector, the extentof exposures to sectors which arecharacterised by asymmetric informationproblems, and the ‘contagion’ effect. It has,therefore, become necessary to promote robustfinancial practices and policies, especially inrespect of banks, in order to sustain financialstabili ty. This is all the more true indeveloping economies where assets of thebanking system constitute a substantialproportion of financial sector assets. In thiscontext, a number of policy measures havebeen taken in recent years to improve thehealth and efficiency of Indian commercialbanks. This chapter provides an overall viewof the policy initiatives undertaken since1999-2000, the financial performance ofscheduled commercial banks during

1999-2000 and a perspective towardsdeveloping a more stable, efficient, resilientand vibrant banking system.

1. Policy Environment

Monetary and Credit Policies

1.2 The annual Monetary and Credit PolicyStatements as well as Mid-term Reviews have,in recent years, elaborated on a number ofmedium to long-term structural reform measuresfor providing stability to the financial system,besides undertaking short-term monetary policyinitiatives, when felt necessary, to stimulate theeconomy. The major short-term monetary andcredit policy measures announced during1999-2000 and 2000-01 (up to October) aregiven in Appendix Table I.1. The table showsthat interest rates generally softened in 1999-2000 as cash reserve requirements werereduced and access to liquidity supportmechanisms was eased. In 2000-2001 (up toOctober), after a brief continuation of thetrends noticed in the previous year, the interestrates and cash reserve requirements weremoved up, and liquidity support was modulatedto suit the market conditions. The mainobjectives of structural measures have beenfive-fold, viz., (a) to increase operationaleffectiveness of monetary policy by broadeningand deepening various segments of the market;(b) to redefine the regulatory role of theReserve Bank in order to make it moreefficient and purposive; (c) to strengthen theprudential and supervisory norms; (d) toimprove the credit delivery system; and (e) todevelop the technological and institutionalinfrastructure of the financial sector.

1.3 The important pol icy measures

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pertaining to various segments of the moneymarket during 1999-2000 and 2000-01 (upto October 2000) are given in AppendixTable I.2. The table shows that liberalisationof money market has been given a major

thrust essentially to improve the functioningof the market. The major monetary and creditPolicy measures announced in the Mid-termReview of October 10, 2000 are indicatedin Box I.1.

(i) In the context of improving the efficacy of theLiquidity Adjustment Facility (LAF) and tomake the money market more efficient and toenable the development of a short-term rupeeyield curve, as recommended by theNarasimham Committee II, it is necessary tomove towards the objective of pure inter-bankcall money market. However, considering thefact that the repo market is yet to be broad-based in terms of instruments and participantsand yet to acquire enough depth, it was decidedto extend the permission granted to selectcorporates, which have been given specificpermission to route call money transactionsthrough Primary Dealers (PDs) which isavailable up to December 2000, for a furtherperiod of six months, i.e., up to June 2001. Inaddition to select corporates which have beenpermitted to route call money transactionsthrough PDs, there are several non-bankinstitutions such as Financial Institutions andMutual Funds which are currently permitted tolend directly in the call/notice money market.In order to make necessary transitionalprovisions in respect of these institutions also,before the call money market is confined onlyto banks and PDs, it was decided to constitutea Group to suggest a smooth phasing out by aplanned reduction in their access to call/noticemoney market. The Group would also includerepresentatives of non-bank institutions.

(ii) The guidelines for issue of Commercial Paper(CP) were finalised, after taking into accountthe views from the market participants on thedraft guidelines and the Report of an InternalGroup circulated in July 2000. The newguidelines are expected to provide considerableflexibility to participants and add depth andvibrancy to the CP market while at the sametime ensuring prudential safeguards andtransparency.

(iii) In order to provide flexibility and depth to the

Box I.1: Major Policy Measures Announced in the Mid-termReview of Monetary and Credit Policy for the year 2000-2001

secondary market, the restriction ontransferability period for CDs issued by bothbanks and financial institutions, which wasearlier fixed at 15/30 days from the date ofissue, is withdrawn.

(iv) In order to improve the functional efficiency ofthe market, the rating for the term depositsaccepted by select all-India financial institutions,which are governed by the Reserve Bankguidelines, has been made mandatory, witheffect from November 1, 2000.

(v) As a part of tightening the prudential norms,banks were advised in October 1998 to make ageneral provision on standard assets of aminimum of 25 basis points from the year endedMarch 31, 2000. The guidelines were partiallymodified on April 24, 2000 stipulating that theprovision should be made on a global portfoliobasis and not on domestic advances. The generalprovision on standard assets woud be includedin Tier II Capital, in line with international bestpractices followed in this regard.

(vi) The Reserve Bank issued final guidelines oncategorisation and valuation of banks’investment portfolio. As per the new guidelines,banks are required to classify the entireinvestment portfolio (including SLR securitiesand non-SLR securities) under three categories,viz., ‘Held to Maturity’, ‘Available for Sale’ and‘Held for Trading’. Out of these, the investmentportfolio ‘Held to Maturity’ will not exceed 25per cent of the total investments, subject tocertain criteria.

(vii) In order to bring more transparency to thebalance sheets of public sector banks and as afurther step towards consolidated supervisionand to provide additional disclosures, it has beendecided that public sector banks should alsoannex the balance sheets of their subsidiaries to

(Contd....)

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Liquidity Adjustment Facility

1.4 In line with the recommendations of theCommittee on Banking Sector Reforms(Chairman: Shri M. Narasimham), popularlyknown as the Narasimham Committee II, theReserve Bank decided to introduce a LiquidityAdjustment Facility (LAF) to set a corridorfor money market interest rates. LAF hasreplaced the Interim Liquidity AdjustmentFacility (ILAF) which was introduced in April1999, pending upgradation in technology andlegal/procedural changes to facil i tateelectronic transfer and settlement. The ILAFoperated through a combination of repo,export credit refinance, collateralised lendingfacilities and open market operations (OMO)and provided a mechanism for injection aswell as absorption of liquidity to/from banksand primary dealers (PDs) in order toovercome the liquidity mismatches in supplyand demand.

1.5 In the light of the experience gainedduring 1999-2000, the introduction of LAF bythe Reserve Bank in June 2000 represented thefirst stage of transition to a full-fledged LAF.In this stage, the additional collateralisedlending facility (ACLF) for banks and level IIliquidity support to PDs were replaced byreverse repo auctions, while the fixed rate repowas replaced by variable rate repos, effective

June 5, 2000. In the next stage, collateralisedlending facility (CLF) for banks and level Iliquidity support to PDs would also be replacedby variable rate repo/reverse repo auctions.Some minimum liquidity support to PDs wouldbe continued but at an interest rate that wouldbe linked to a variable rate in the daily repoauctions as obtained from time to time. Withfull computerisation of Public Debt Office(PDO) and introduction of real time grosssettlement (RTGS) system expected to be inplace by the end of 2000-01, in the subsequentstage, repo operations through electronictransfers would be introduced. In the finalstage, it would be possible to operate LAF atdifferent timings of the same day. The quantumof adjustment as also the rates would beflexible, responding immediately to the needsof the system. The funds would meet primarilythe day-to-day liquidity mismatches in thesystem and not the normal financingrequirements of eligible institutions. Both thetime-table and the scope of proposed changeswould, however, be subject to review in thelight of actual experience.

1.6 Effective June 5, 2000, the first stage ofLAF was operationalised. Initially, repos/reverse repo auctions, conducted on a dailybasis (Monday through Friday) and with oneday maturity (except on Fridays/days preceding

their balance sheet beginning from the yearending March 31, 2001.

(viii) Owing to factors such as the improvements inthe payment and settlement systems, recoveryclimate, and upgradation of technology in thebanking sector, the concept of “past due” (graceperiod of 30 days) would be dispensed with,effective March 31, 2001.

(ix) In order to facilitate quick export-relatedpayments and to reduce transaction costs, itwas decided to res tore fu l ly the ear l ie rentitlements in respect of Exchange Earners

Foreign Currency (EEFC) accounts of Exportoriented units, units in Export ProcessingZone, Sof tware Technology Park orElectronic Hardware technology Park, asprevalent prior to August 14, 2000, i.e., 70per cent ( f rom 35 per cent ) . S imi lar ly ,entitlement regarding inward remittances inrespect of others was restored to 50 per cent(from 25 per cent). It was also decided thatEEFC accounts (including existing accounts)would henceforth be held in the form ofchequeable, current deposit accounts and nocredit facility would be provided by banksagainst EEFC balances.

(....Concld.)

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holidays) were introduced. Subsequently, inAugust 2000, multiple repo/reverse repoauctions with 3-7 day maturity periods wereintroduced. Interest rates in respect of bothrepos and reverse repos are the cut-off yieldsemerging from auctions conducted on auniform price basis.

Special Fund Facility for Security Settlement

1.7 Pursuant to the announcement in theMonetary and Credit Policy for 2000-01, theReserve Bank introduced a special fundfacility, effective October 3, 2000, forsettlement of transactions in Central/StateGovernments dated securities as well asTreasury Bills. The scheme would providecollateralised intra-day (not overnight) fundsto banks and PDs to facilitate settlement ofsecurities transactions in case of gridlock.Gridlock occurs in the delivery versus paymentsystem on account of shortage of funds on agross basis in the current account of SGLaccount holder(s). Banks and PDs who areeligible for CLF and Liquidity Support Facility(LSF), respectively, from the Reserve Bank,are entitled to this facility. Credit would beavailable at the Bank Rate on a collateralisedbasis and would be extended against undrawnCLF/LSF. In addition, a flat fee of Rs.25 pertransaction would be charged from each of thebeneficiary participants. All transferableCentral Government dated securities andTreasury Bills (except 14-day Treasury Bills)would be eligible collateral for this facility.The drawal would be restricted to 95 per centof the face value of outstanding securities inreverse repo constituent SGL account of aparticipant after providing for successful bidsin reverse repo auctions.

Government Securities Market

1.8 The Reserve Bank continued with theprocess of further deepening and widening ofthe Government securities market. The

number of PDs increased to 15 as at end-March 2000 from 13 as at end-March 1999.The system of underwriting by PDs in respectof Treasury Bill auctions was changedeffective April 20, 1999. Presently, each PDis required to bid up to a fixed percentage ofthe notified amount and all PDs together haveto bid for more than 100 per cent of the issue.Consequently, PDs are not required to takedevolvement and the commission payment toPDs for participation in the Treasury Billauctions was withdrawn, effective June 5,2000. As regards dated securities, it wasdecided to accept underwriting from PDs, upto 100 per cent of the auction issue (as against50 per cent earlier), effective April 27, 2000.PDs were earlier permitted in 1999-2000 tounderwrite auction issues of State Governmentsecurities. The liquidity support to PDs wasbased on their bidding commitments andsecondary market operations during 1999-2000. From the year 2000-01, biddingcommitments and primary and secondarymarket performance are taken into account forfixing liquidity support under Level I whichis subject to a cap of three times their netowned funds. PDs were advised to evolvereasonable leverage ratios with the consent oftheir boards of directors. Detailed guidelineson internal control systems relating tosecurit ies transactions were issued onDecember 31, 1999 on a uniform basis. Freshguidelines for capital adequacy standards forPDs are being evolved to address marketrisks.

1.9 The Reserve Bank has been announcingan advance release calendar on issue ofTreasury Bills on a half-yearly basis sinceApril 1999 to remove market uncertainties.Further, 182-day Treasury Bills werereintroduced on fortnightly basis, effectiveMay 26, 1999 providing market players withan additional instrument. The Reserve Bankalso initiated the process of consolidation of

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outstanding loans since May 1999 to ensuresufficient volumes and liquidity in anyparticular issue which would also facilitate theemergence of benchmarks and development ofSeparate Trading of Registered Interest andPrincipal Securities (STRIPS). Further, asannounced in the Monetary and Credit Policyfor 2000-01, entities allotted securities inprimary auctions have been allowed to sellthem on the date of allotment itself, thetransfer and settlement being effected in thenext working day. Technological upgradationof Government securities market by setting upan Electronic Screen-based Negotiated DealingSystem and computerisation of the Public DebtOffice will facilitate electronic bidding inauctions and dealing in Government securitiesand money market instruments including theirderivatives. This would also facilitate smoothsettlement through connectivity.

1.10 The amendment to Securities Contracts(Regulation) Act, 1956, effective March 1,2000, has vested the Reserve Bank withregulatory powers to regulate dealings ingovernment securities, money market securities,gold related securities as well as securitiesderived from these securities and ready forwardcontracts in bonds, debentures, debenture stock,securitised and other debt securities. TheReserve Bank permitted all entities having SGLand current account with Mumbai office, toenter into repos in Treasury Bills and Centraland State Government dated securities. So far,64 non-bank entities are eligible.

Commercial Banking System

1.11 In the wake of the recent financialcrises, there has been a renewed focus worldwide on containing risks. In this context, therehave been proposals for introduction of newcapital adequacy norms and development ofinternational standards and codes with theobjective of achieving/maintaining stability. InIndia too, efforts have been made to move

towards international best practices in bankingsupervision. The policy measures during 1999-2000 and 2000-01 (up to October) concerningbanking activities focus on various issues suchas regulation and supervision, enhancedcompetition, prudential norms, etc (AppendixTable I.3).

Strengthening the Banking System

Capital Adequacy

1.12 As a part of the follow-up of therecommendations of the Narasimham CommitteeII, it was decided in October 1998 to raise thestipulated minimum capital to risk-weightedassets ratio (CRAR) of scheduled commercialbanks by one percentage point to 9 per centfrom the year ended March 2000. Banks wereadvised in October 1999 to assign a risk-weightof 2.5 per cent to cover market risk in respectof investments in securities outside the SLR bythe year ending March 31, 2001 (over andabove the existing 100 per cent credit risk-weight). A market risk-weight of 2.5 per centhad been prescribed for Government and otherapproved securities from March 31, 2000.Further, banks were advised in April 2000 toassign a risk-weight of 100 per cent only onthose State Government guaranteed securitiesissued by defaulting entities and not on all thesecurities issued or guaranteed by the concernedState Government. With regard to provisioningfor standard assets, it was clarified that thegeneral provision of 0.25 per cent on standardassets should be made on global portfolio basisand not on domestic advances alone. It wasannounced in October 2000 that the generalprovision on standard assets would be includedin Tier II capital, together with other 'generalprovisions/loss reserves', up to a maximum of1.25 per cent of the total risk weighted assets.

Public Issue of Shares

1.13 During 1999-2000, six old private sectorbanks – Ganesh Bank of Kurundwad Ltd.

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(Rs.0.54 crore), Ratnakar Bank Ltd. (Rs.5.89crore), Nainital Bank Ltd. (Rs.2.50 crore),Bharat Overseas Bank Ltd. (Rs.10.50 crore),Bank of Rajasthan Ltd. (Rs.67.24 crore) andSangli Bank Ltd. (Rs.15.77 crore) were grantedpermission to issue shares on rights basis foraugmenting their capital. While five bankshave collected the full amounts of the issue,Sangli Bank Ltd. has collected Rs.3.15 crore.

Ownership Pattern of Nationalised Banks

1.14 Recognising that the nationalised banksneed to augment their capital base to copeup with the changing operat ionalenvironment, the Government has permittedbanks to access capital market, both at homeand abroad. However, as the amount ofcapi tal which can be raised by thenationalised banks from the capital markethas been constrained by the minimumshareholding of 51 per cent by the CentralGovernment, the Union Budget for 2000-2001 has envisaged a reduction in theminimum Government shareholding innationalised banks to 33 per cent. It was alsostated in the Budget that in the process ofreduction of Government shareholding limit,the public sector character of these bankswould remain unchanged and that the freshissue of shares would need to be widely heldby the public. The Government also proposedto bring about necessary changes in thelegislative provisions to accord flexibilityand autonomy to the Boards of the banks.

Recapitalisation and Write-offs of Lossesagainst Capital of Nationalised Banks

1.15 The Government had contributed anaggregate amount of Rs.20,446.12 croretowards recapitalisation of nationalised banksby end-March 1999. The Government did notprovide any amount on this account in 1999-

2000. During 1999-2000, the Governmentprovided a sum of Rs.297.07 crore towardswriting down of the investments (capital base)of Vijaya Bank for adjustment of its losses.With this, the losses of nationalised bankswritten off against capital amounted toRs.6,334.44 crore.

Recovery Management

1.16 The relatively high level of non-performing assets (NPAs) of public sectorbanks (PSBs) has been a matter of concern.Its reduction is closely linked to recoveries.However, the recovery management has beenimpeded by the fact that laws have not beenrobust enough to provide comfort to banks’efforts in reducing the level of NPAs. Variousmeasures have been taken recently to addressthis issue which include: announcement in theUnion Budget 2000-01 for setting up of sevenmore debt recovery tribunals (DRTs),strengthening the infrastructure of DRTs andamendment to the Recovery of Debts Due toBanks and Financial Institutions Act. The Act,inter alia, has sought to empower the DRT tostraightaway issue certificate for recovery onthe basis of decree or order of Civil courts.

1.17 The Reserve Bank had issued guidelinesto PSBs for the constitution of SettlementAdvisory Committees (SACs) for compromisesettlement of chronic NPAs of small scalesector in May 1999. A review of theperformance of SACs revealed that progressof recovery of NPAs through this mechanismwas not satisfactory. Consequently, the ReserveBank issued revised guidelines in July 2000covering all sectors, including the small scalesector, to provide a simplified, non-discretionary and non-discriminatorymechanism for recovery of NPAs withoutstanding balance of up to Rs.5 crore as at

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end-March 1997. The scheme would beoperative up to end-March 2001.

Restructuring of Weak Public Sector Banks

1.18 The Working Group on RestructuringWeak PSBs (Chairman: Shri M.S. Verma), hadconcluded that a comprehensive restructuringstrategy dealing with operational,organisational, financial and systemic aspects,would be the most appropriate for the threeidentified weak banks. Subsequently, the UnionBudget for 2000-2001 announced that weakbank-specific Financial Restructuring Authority(FRA) would be constituted, not an authorityto deal with all weak banks put together asrecommended by the Working Group. Underthe proposed framework, the statutes governingPSBs would be amended to provide forsupersession of the Board of Directors on thebasis of recommendations of the Reserve Bankand constitution of a FRA for such a bank,comprising experts and professionals. Theamendments would also enable the FRA toexercise special powers, including all powersof the Board of the bank. The Governmentwould consider recapitalisation of the weakbanks to achieve the prescribed capitaladequacy norms, provided a viablerestructuring programme acceptable to theGovernment as the owner and the ReserveBank as a regulator is made available by theconcerned banks. The restructuring planssubmitted by the three identified weak banksare being finalised by the Government/ReserveBank.

Asset-Liability Management

1.19 Given the increasing internationalisationof banking operations, commercial bankingoperations are subject to significant mismatchbetween assets and liabilities with implicationsfor several types of risks, such as, the interestrate risk, liquidity risk and foreign exchangerisk which are likely to arise and need to be

addressed. It may be recalled that draftguidelines on asset-liability management(ALM) were issued in September 1998 and onthe basis of the feedback received from bankson the draft guidelines, the final guidelineswere issued in February 1999 forimplementation by banks from April 1, 1999.

1.20 Asset-Liability Management Committees(ALCOs) have been set up in all banks and areheaded by Chairman and Managing Director/Executive Director to manage various risks fromrisk-return perspective. Besides, ManagementCommittee or a specific Committee of the Boardhas been formed in each bank to overseeimplementation of the ALM system and reviewits functions periodically.

1.21 The guidelines introduced two returns,viz., Statement of Structural Liquidity andStatement of Interest Rate Sensitivity coveringliquidity risk management and interest rate riskmanagement in respect of banks’ dealings inrupee. As regards foreign currency risk, bankswere advised to follow the instructions issuedby the Exchange Control Department inDecember 1997 that introduced two returns,viz., Statement of Maturity and Position (MAP)and Statement of Interest Rate Sensitivity(SIR).

1.22 In July 1999, the Reserve Bank advisedbanks to submit four returns with effect fromthe quarter ended June 1999. The two returnson foreign currencies, viz., MAP and SIR havebeen aligned in periodicity and time–bucketswith the Rupee statements on StructuralLiquidity and Interest Rate Sensitivity for thepurpose of supervisory returns. Banks havebeen provided with structured formats forcompiling these returns. Banks have startedsubmitting the returns since the quarter endedJune 1999.

1.23 Keeping in view the prevailing

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Management Information System (MIS) inbanks and in the absence of high level ofcomputerisation, banks were advised to ensurecoverage of at least 60 per cent of their assetsand liabilities from April 1, 1999 and 100 percent by April 1, 2000. In view of genuinedifficulties expressed by a few banks, it wasdecided to grant extension to some of thebanks, subject to their covering at least 80 percent of business by April 1, 2000 and 100 percent by April 1, 2001.

1.24 The Reserve Bank embarked on aproject to upgrade the off-site data basesupervisory statistics with enhancedcapabilities of processing of reports on riskexposures based on submission of returns onALM, introduced for banks and all-India termlending and refinancing institutions.

1.25 Considering the existing MIS andtechnical expertise, banks have been advisedto adopt the Traditional Gap analysis as asuitable method for measuring interest raterisk. It is, however, the intention of theReserve Bank to move over to the moderntechniques like Duration Gap analysis,Simulation and Value at Risk over time whenbanks acquire sufficient expertise andimprovement in acquiring and handling ofMIS. Banks are, therefore, required tostipulate a time frame for switching over tothe new techniques. The switchover is forprescribing explicit capital charge for interestrate risk in the trading book.

Risk Management

1.26 The increased complexity in bankingoperations, and the need to prevent financialcrises of the type witnessed in East Asia, havenecessitated continuous efforts towardsstrengthening the soundness of financialentities, and in particular, upgradation of riskmanagement practices and procedures. As part

of this, guidelines on Risk ManagementSystems were issued in October 1999,providing essential details to enable the banksto put in place a comprehensive riskmanagement system to take care of credit risk,market risk and operational risk. Theguidelines show that risk management is anecessary condition for maintaining, preservingand enhancing financial stability in the contextof the financial and structural reforms that arebeing undertaken. An important means forpositioning appropriate risk managementtechniques is the MIS. Development andstrengthening of MIS would require in the firstplace a strong data base, and other informationsets, and secondly, application of data miningtechniques and behavioural and technicalrelationships among different variables.

Exposure Norms

1.27 Effective April 1, 2000, the exposureceiling in respect of an individual borrowerwas reduced from 25 per cent to 20 per centof the bank’s capital funds. Where the existinglevel of exposure as on October 31, 1999, wasmore than 20 per cent, banks were expectedto reduce the exposure to 20 per cent of capitalfunds over a two-year period (i.e., by end-October 2001). The Rupee sub-ordinated debtraised by banks as Tier-II capital would notbe included in the capital funds for the purposeof determining the exposure ceiling toindividual group borrowers.

1.28 A review of current practices regardingcredit exposure limits vis-à-vis internationalbest practices shows that there are certainissues which require further consideration. Thefirst relates to the concept of ‘capital funds’;second relates to the scope of the measurementof credit exposure, in particular, the coverageof non-fund and other off-balance sheetexposures; and the third relates to the level ofexposure limit itself. Taking into account the

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complexities involved, it has been decided toprepare a detailed Discussion Paper on thesubject which would inter alia address issuesrelating to current practices in India vis-à-visinternational best practices and the possiblealternative approaches with pros and cons andother relevant aspects. The Discussion Paperwhich is expected to be finalised by December2000, would be circulated among banks. Basedon the comments and suggestions on the issues,and followed by an interaction with banks, theReserve Bank would take a final view on theapproach that should be adopted with a viewto making it effective from end-March 2002.

Consolidated Supervision of Banks and theirSubsidiaries

1.29 The Reserve Bank initiated steps tomove towards consolidated supervisionwhereby banks would voluntarily build in therisk-weighted components of their subsidiariesinto their own balance sheet on notional basisby applying risk-weights to subsidiaries’ assetsidentical to those applied to banks’ own assets.Banks would also be required to earmarkadditional capital in their books in a phasedmanner beginning from the year ending March2001 to obviate the possible impairment totheir net worth during the period of switchingover to a unified balance sheet for the groupas a whole. The principal bank in the groupwould be responsible for monitoring the groupoperations from prudential perspective andprovide data/information to the Reserve Bankincluding filing of returns regardingsubsidiaries. The returns in respect of each ofthe subsidiaries would cover capital adequacy,large credit exposures, asset quality, ownershipand control, profitability and contingentliabilities and credit exposure to each of thesubsidiaries. Further, PSBs would also berequired to annex the balance sheets of theirsubsidiaries to their balance sheet beginningfrom the year ending March 2001, to bringmore transparency to the balance sheets of

PSBs and as a further step towardsconsolidated supervision and to provideadditional disclosures.

Supervisory Initiatives relating to ForeignBranches of Indian Banks

1.30 A Working Group was set up in theReserve Bank to go into the entire gamut ofthe management of overseas operations ofIndian banks. Officials from major bankshaving overseas operations, apart from officialsfrom the Reserve Bank were represented in theWorking Group. Some of the importantrecommendations of the Group are:

• Introduction of a new supervisoryreporting system called the DSB-O returnsto replace the existing RALOO (Returnson Assets and Liabilities of OverseasOffices) statements. The existing systemis to be rationalised with focus on marketrisks which were not adequately capturedin the present set up.

• Introduction of comprehensive policies inrespect of credit and investmentmanagement at the overseas branchestaking into account the host countryregulation/legislation. The objective is toimprove the asset quality by takingadvantage of the emerging opportunities inthe overseas markets.

• Formulation of appropriate riskmanagement policies taking into accountthe scale and complexity of operations,risk philosophy and risk taking capacityof banks. Such policies should aim atidentification of risks, their quantification,monitoring and control.

• Banks to put in place strong managementinformation system which would providecomprehensive/valuable feed back to thetop management on a timely basis to

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enable the top management to initiateappropriate action.

• Periodicity of inspection of foreignbranches to be decided by banks takinginto account the instructions of the hostcountry regulator in this regard, if any, andstatus of the branch. In addition, banks tointroduce a system of quick assessment/review of the larger foreign branches atmore frequent intervals.

• As regards supervision by the ReserveBank, apart from the DSB-O returns, thequarterly DO letters from the HeadOffices, copies of the head officeinspection reports of the foreign branchesand inspection reports of the host countryregulator to be used as supplementary off-site tools. The Reserve Bank is requiredto undertake on-site supervision offoreign branches, the frequency of whichdepends on its perception of supervisoryconcerns.

• Banks to initiate action on reviewing theirpersonnel policies consisting of placementpolicy, succession policy, and retentionpolicy for smooth functioning of overseasbranches.

1.31 In view of these recommendations, theReserve Bank set up a new cell named‘Foreign Branches Cell’ in the Department ofBanking Supervision to oversee theimplementation of these recommendations andalso to provide sharper focus on thesupervision of overseas operations. TheReserve Bank has introduced DSB-Oquarterly reporting system consisting of sevenreturns in place of RALOO statements fromthe quarter ended June 2000. Further, thebanks were advised to review their policiesrelating to credit , investment, r iskmanagement, etc. in the light of the Group’s

recommendations and furnish to the ReserveBank the progress reports in this regard on aquarterly basis, which are being monitored inthe Cell.

1.32 The Cell has started analysing theportfolio appraisal reports of the overseasoperations. The supervisory action beingundertaken includes discussion with the topmanagement on the identified supervisoryconcerns and follow-up action on theassurances given by the bank. Other activitiesof the Cell include analysis of returns fromoverseas offices and undertaking countryanalysis on a periodical basis.

1.33 The most recent initiative undertaken bythe Cell is the preparation of marketintelligence reports on overseas markets. Suchreports are being prepared and circulated in thedepartment on a fortnightly basis. Thesereports are expected to act as an importantinput for initiating supervisory action.

Technological Developments

Information Technology

1.34 During 1999-2000, the Reserve Bankfocussed on two major areas in the field ofcomputers and information technology (IT).One of the issues of concern related to smoothyear 2000 transition which entailed a thoroughexamination of the hardware, software,operating system and networking systems invogue in the entire financial sector and inparticular, in the banking sector so as to ensurethat there would be business continuity. Theefforts made by the Reserve Bank to encourageand to foster implementation of necessary actionin this regard by commercial banks helped tofurther improve IT infrastructure with latestequipments and solutions and integratednetworks. The second area of focus was onoverall technological upgradation in banks,essentially to facilitate smooth and efficient

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payment and settlement, improved customerservice and the resultant increase in profitability.

1.35 It was in this direction that theCommittee on Technology Upgradation in theBanking Sector set up by the Reserve Bankmade wide-ranging recommendations based onwhich the Reserve Bank drew up an ActionPlan for implementation of therecommendations. Besides, three sub-groupshave also been constituted to (i) reviewperiodically security policies, message formats,software, etc.; (ii) examine legal issues ofelectronic banking; and (iii) monitor progressof computerisation of branches of bankshandling Government transactions.

1.36 Furthermore, an institutional mechanismin the form of National Payments Council hasbeen constituted in May 1999, with DeputyGovernor Shri S.P. Talwar as the Chairman,to focus and recommend broad policyparameters that provide basis for designing and

developing an integrated payment andsettlement system. The council has a broadrepresentation from commercial banks andother financial sectors (Box I.2).

1.37 The ultimate goal is to design anddevelop a settlement system which will bebased on multiplicity of deferred/discrete netsettlement systems and RTGS, and facilitateefficient funds management, house-keeping andcustomer service. Both domestic and cross-border payment transactions as well as equityand other securities settlements would be partof such a system. The infrastructure that willhelp to make it a reality will be large, andwill include networking of computerised bankbranches, with their controlling offices, centraltreasury cells and head offices with the provisofor introducing standardisation of operatingsystems and networking platforms within thebank and a bank-level standardised gateway toIndian Financial Network (INFINET). Aconsultant has been appointed to assist the

The National Payments Council was constituted inMay 1999 with the objective of providing perspectivesand recommendations on broad policy issues to helpdesign, develop and maintain an integrated, robustpayment and settlement system for the country.Several important policy decisions were taken by theNational Payments Council in its meetings heldbetween July 1999 and June 2000. These are detailedas under:

(i) Introduction of Real Time Gross Settlement(RTGS) System.

(ii) Adoption of the ‘Y’ topology for the RTGSinvolving a service provider between theoriginator and beneficiary of the transaction andits settlement in the books of the Reserve Bank(Chart I.1).

(iii) Constitution of five permanent Task Forces ona) Monetary Policy and related issues, b)Payment and Settlement Systems Oversight, c)Legal Issues, d) Technology Related Issues, and

Box I.2: National Payments Council - Policy Decisions

e) Systems and Procedures - related issues.

(iv) Provision of Collateralised credit and/or Repobased intra-day liquidity by the Reserve Bankwith terms and conditions providing duerecognition to risk management.

(v) Recommendation of standards for smart cards forfinancial transactions and thereafteroperationalisation of these standards in thecontext of the guidelines given for theintroduction of debit/smart cards.

(vi) Adoption of Generic Architecture Model forpayment systems which provides for a ‘tree’structure (for older banks) and a ‘star’ topology(for newer banks) for inter branch networkingof individual banks with the proviso for a bank-level standardised gateway to the IndianFinancial Network (INFINET).

(vii) Strategies for computerisation and networking ofbank branches, to ensure that most of the majorcentres are covered by the INFINET.

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Rationalisation of Procedures

Regulations Review Authority

1.39 The Reserve Bank had set up aRegulations Review Authority (RRA) (withDeputy Governor Dr. Y.V. Reddy as RRA) onApril 1, 1999 for one year for reviewing theReserve Bank’s rules, regulations, reportingsystems, etc., in the light of suggestions receivedfrom general public, market participants and usersof services of the Reserve Bank. However, asthe scope of the work for RRA has been foundto be large, the term of RRA has been extendedby one more year from April 1, 2000. During1999-2000 and the first half of 2000-01, theAuthority received 235 applications, whichcontained more than 400 suggestions, pertainingto various functional areas of the Reserve Bank.Implementation of the accepted suggestions haspaved way for streamlining several existingprocedures in the Reserve Bank, particularly inits departments which deal with the public. Thesuggestions also compelled a review of theReserve Bank’s reporting systems and contributedto rationalisation of a number of statistical returnsand reports. The RRA initiated the work relatingto compilation of subject-wise master circularsby merging circulars issued over the years onselect subjects. One circular on Exposure Normshas already been issued and others are at variousstages of finalisation. Further, it is proposed toissue an updated Master Circular on selectsubjects at the beginning of each year.

1.40 With a view to having a consistent policywith regard to investor protection, MMMFswere brought under the regulatory purview ofSecurities and Exchange Board of India (SEBI)which regulate mutual funds in general. MutualFunds have been permitted to issue units toforeign institutional investors (FIIs).

implementation of the RTGS.

Smart Card based Payment System

1.38 Progress is being made towardsdeveloping standards for newer paymentsinstruments such as SMART cards. A pilotproject on SMART Card technology in Indiatitled ‘SMART Rupees System (SMARS)’ wasundertaken by the Indian Institute ofTechnology, Mumbai to examine the viabilityand use of SMART cards as retail paymentinstruments within the country. It came outwith a set of recommendations on SMARTcards standards. With a view to examiningthese recommendations and for determining thestandards for the Indian banking industry, theReserve Bank set up a ‘Working Group tostudy the recommendations for SMART cardbased Payment System Standards’ inSeptember 1999. The Working Groupsubmitted its Report to the Reserve Bank inJanuary 2000 and the recommendations wereaccepted by the Reserve Bank. These havebeen forwarded to the Bureau of IndianStandards for adoption as National Standards.

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1.41 The Reserve Bank has permitted banksto fix service charges which would generallybe based on the cost of providing services.Banks have also been urged to pay interest atthe rate applicable for appropriate tenor offixed deposit for the period of delay beyond10/14 days in collection of outstationinstruments and pay penal interest at the rateof 2 per cent above the fixed deposit rateapplicable for any abnormal delay that mightbe caused by bank branches in collection ofoutstation instruments.

1.42 The Reserve Bank also did away withsample test checking of newly printed MICRinstruments at MICR cheque processing centresbefore putting them into use and withdrew therequirement of obtaining succession certificatefrom the legal heirs, irrespective of the amountinvolved in the account of a deceasedcustomer.

1.43 A few important developments duringthe first half of the current year (April-September, 2000) as a result of implementationof the suggestions were : (a) putting in placein the Reserve Bank, a comprehensiveinformation transmittal system in electronicform for the benefit of seekers of informationfrom the Bank, (b) revision in the Bank’sinstructions relating to nomination facility forthe benefit of investors in Relief Bonds, (c)increase in the limit of same day credit oflocal/outstation instruments sent for collectionby banks from Rs.5,000 to Rs.7,500 perinstrument, (d) streamlining the procedure forprompt payment of interest to scheduledcommercial banks on the eligible CRRbalances, and (e) relaxation in the prescribedeligibility criteria for opening and maintainingNon-Resident External Rupee Accounts by thecentral co-operative banks.

Transparency and Disclosure

1.44 In February 1999, the Reserve Bankissued guidelines for improving transparencyin the financial statements of banks.Accordingly, banks were required to disclosethe following information as ‘Notes onAccounts’ to their balance sheets from the yearended March 31, 2000: (i) maturity pattern ofloans and advances, investments in securities,deposits and borrowings, (ii) foreign currencyassets and liabilities, (iii) movements in NPAs,and (iv) lending to sensitive sectors as definedby the Reserve Bank from time to time. It wasdecided that the sensitive sectors in respect ofwhich information was to be disclosed for theyear 1999-2000 would include (i) capitalmarket, (ii) real estate and (iii) commodities.Considering, however, the difficultiesexpressed by certain banks in disclosing thematurity pattern of Indian Rupee assets andliabilities, in the ‘Notes on Accounts’ as theyhave not covered 100 per cent of their businessunder ALM system, banks were allowed todisclose, if need be, this information in theDirector’s Report. Banks were, however,advised in May 2000 to disclose the aboveinformation in the ‘Notes on Accounts’ to theirbalance sheets from the year ending March 31,2001. Such disclosures and transparencypractices would help improve the process ofexpectation formation by market players andeventually lead to effective decision-making bybanks.

Institutional Reforms for Capacity Building

Credit Information Bureau

1.45 There has been a widely felt need toestablish a Credit Information Bureau (CIB)designed to obtain and share data on borrowersin a systematic manner for sound creditdecisions, thereby helping to facilitate

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avoidance of adverse selection. This wouldalso facilitate reduction in NPAs. In June 1999,a Working Group was constituted to explorethe possibilities of setting up a CIB in India.The Group, in its Report submitted to theReserve Bank, recommended the setting up ofa CIB in India (Box I.3).

1.46 Based on the recommendations of theWorking Group and realising the importanceof developing better institutional mechanismsfor sharing of credit-related information, theUnion Budget 2000-01 announced theestabl ishment of a Credi t InformationBureau. Subsequently, in the Monetary andCredit Policy of April 2000, the ReserveBank advised banks and financial institutionsto make the necessary in-house arrangementfor transmittal of the appropriate informationto the Bureau. The State Bank of India (SBI)has entered into a Memorandum ofUnderstanding (MOU) with the HousingDevelopment Finance Corporation (HDFC),with Dun and Bradstreet InformationServices Ltd. and Trans Union International

Inc. as foreign partners, to set up a CIBwithin the confines of the exist inglegislation. The work of preparing a masterlegislation to establish a full-fledged Bureauis underway.

Deposit Insurance Reform

1.47 Reforming the deposit insurance systemis a crucial component of the present phase offinancial sector reforms in India. Accordingly,a Working Group was constituted by theReserve Bank on Reforms in Deposit Insurancein India (Chairman: Shri Jagdish Capoor). TheGroup submitted its Report in October 1999.The major recommendations of the Groupinclude: (i) fixing the capital of DepositInsurance and Credit Guarantee Corporation(DICGC) at Rs.500 crore, to be contributedfully by the Reserve Bank; (ii) withdrawingthe function of credit guarantee on loans fromDICGC; and (iii) risk-based pricing of thedeposit-insurance premium in lieu of thepresent flat rate system. The task of preparationof the new draft law has been taken up insupersession of the existing law.

The Working Group constituted by the Reserve Bankto explore the possibilities of setting up a CreditInformation Bureau in India submitted its Report inNovember 1999. The major recommendations of theWorking Group are indicated below.

The existing legal framework does not permitdisclosure of information except in cases where thereis explicit consent of the constituent or where suitshave been filed. Amendments to existing Acts relatingto banking sector or enactment of a master legislationwould be necessary to form a full-fledged CreditInformation Bureau.

Pending legislative changes, to begin with, a CreditInformation Bureau can be set up to pool the limitedinformation as is possible under the existing legal

Box I.3: Working Group to Explore the Possibilities of Setting up a CreditInformation Bureau in India – Major Recommendations

framework and share such information among itsmembers.

The proposed Credit Information Bureau could beset up as a separate company jointly owned bybanks and FIs under the regulatory purview of theReserve Bank. Co-option of a foreign technologypartner/col laborator would also provide thenecessary expertise.

The Bureau should inherit the best internationalpractices with regard to collection of information,processing of data and sharing of information and itshould build up effective systems to ensure thesecurity of data maintained by it and restrict accessto its data base to institutions accredited by it andevolve an appropriate code of access.

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Diversification in Banking Operations

Insurance

1.48 The Insurance Regulatory andDevelopment Authority (IRDA) Act, 1999 waspassed by the Parliament. The Act is a majormilestone in liberalisation as it opens the wayfor private sector entry into the insurancebusiness. It also provides statutory backing tothe IRDA. Under this Act, foreign equity willbe restricted to 26 per cent of the total paid-up capital.

1.49 With a view to assessing the scope,desirability and eligibility of institutions totake up insurance business, draft guidelineswere initially framed for banks entering intoinsurance business with risk participation asalso for permitting banks to undertake fee-based business as insurance agents. On thebasis of feedback received from banks andfinancial insitutions (FIs), the Reserve Bankissued final guidelines for banks’ entry intoinsurance business along with theannouncements in the Monetary and CreditPolicy for the year 2000-2001. The guidelinesare as under:

1. Any scheduled commercial bank wouldbe permitted to undertake insurancebusiness as an agent of insurancecompanies on fee basis, without anyrisk participation. The subsidiaries ofbanks would also be allowed toundertake distribution of insuranceproduct on agency basis.

2. Banks which satisfy the eligibilitycriteria would be permitted to set up ajoint venture company for undertakinginsurance business with riskparticipation, subject to safeguards. Themaximum equity contribution such abank can hold in the joint venture

company will normally be 50 per centof the paid-up capital of the insurancecompany. On a selective basis, theReserve Bank may permit a higherequity contribution by a promoter bankinitially, pending divestment of equitywithin the prescribed period. Theeligibility criteria for joint ventureparticipant as on March 31, 2000 willbe as under: (i) the net worth of thebank should not be less than Rs.500crore; (ii) the CRAR of the bank shouldnot be less than 10 per cent; (iii) thelevel of NPAs should be reasonable;(iv) the bank should have net profit forthe last three continuous years; and (v)the track record of the performance ofthe subsidiaries, if any, of theconcerned bank should be satisfactory.

3. In cases where a foreign partnercontributes 26 per cent of the equitywith the approval of IRDA/ForeignInvestment Promotion Board, more thanone public sector bank or private sectorbank may be allowed to participate inthe equity of the insurance jointventure.

4. A subsidiary of a bank or of anotherbank will not normally be allowed tojoin the insurance company on riskparticipation basis. Subsidiaries wouldinclude bank subsidiaries undertakingmerchant banking, securitiestransactions, mutual fund, leasingfinance, housing finance, etc.

5. Banks which are not eligible as jointventure participant, as above, can makeinvestments up to 10 per cent of thenet worth of the bank or Rs.50 crore,whichever is lower, in the insurancecompany for providing infrastructure

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and services support. Such participationshall be treated as an investment andshould be without any contingentliability for the bank.

1.50 Prior approval of the Reserve Bank isrequired for banks to enter into insurancebusiness. The Reserve Bank would givepermission to banks on a case-by-case basis,keeping in view all relevant factors includingthe position in regard to the level of NPAs ofthe applicant bank so as to ensure that NPAsdo not pose any future threat to the bank inits present or in the proposed line of activity,viz., insurance business. With a view toensuring insulation of banking business fromany risks which may arise from insurancebusiness, there should be ‘arms length’relationship between the bank and theinsurance outfit. With the issuance ofNotification by the Government, specifying“Insurance” as a permissible form of businessthat could be undertaken by banks underSection 6(1)(o) of the Banking RegulationAct, 1949, applications were invited frombanks with supporting documents for theirentry into insurance business. While 12 bankshad expressed their intention to enter intoinsurance business either by way of jointventure, strategic investments or agencyarrangements, applications to enter intoinsurance business on risk participation basis,supported by required documents have beenreceived from three banks. Of these, “inprinciple” approval has been given to twobanks, viz., SBI and Vysya Bank Ltd.

Subsidiary for Assaying and Hallmarking ofGold

1.51 The Reserve Bank granted ‘in principle’approval to the SBI for setting up thesubsidiary SBI Gold and Precious MetalsPrivate Ltd. (SBIGPMPL) with an authorisedand paid up capital of Rs.15 crore forundertaking assaying and hall marking of gold.

The SBI’s share in equity would be 51 percent in the joint venture. The other equityparticipants in the venture are Allahabad Bank(8.5 per cent), Corporation Bank (8.5 per cent)and Canara Bank (6 per cent). Credit SuisseFinancial Products, London (as the foreignpartner) would be holding 26 per cent equityin the joint venture.

Banks’ Investments

Investment in Shares and Debentures

1.52 Effective April 24, 1999, the overallceiling of investment by banks in ordinaryshares, convertible debentures of corporatesand units of mutual funds (other than debtfunds), which was at 5 per cent of theirincremental deposits of the previous year, wasenhanced to the extent of banks’ investmentsin venture capital. Such investments in venturecapital were also included under the purviewof priority sector lending.

Valuation of Banks’ Investments

1.53 The Reserve Bank had advised the banksin April 1992 to bifurcate their investments inapproved securities into ‘permanent’ and‘current’ categories, and to keep not less than30 per cent of their investments in the currentcategory from the accounting year 1992-93.The ratio of current investments was graduallyincreased to a minimum of 70 per cent of theapproved securities for 1998-99 and further toa minimum of 75 per cent for 1999-2000.

1.54 Under the Mid-term Review of Monetaryand Credit Policy of October 10, 2000, theReserve Bank finalised the guidelines oncategorisation and valuation of banks’investment portfolio. The guidelines would beeffective from the half-year ended September2000. First, the banks are required to classifythe entire investment portfolio (including SLRsecurities and non-SLR securities) under threecategories, viz., ‘Held to Maturity’, ‘Available

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for Sale’ and ‘Held for Trading’. Theinvestments in the ‘Held to Maturity’ categoryshould not exceed 25 per cent of the totalinvestments. The banks have been given thefreedom to decide on the extent of holdingsunder ‘Available for Sale’ and ‘Held forTrading’ categories. Secondly, investmentsclassified under ‘Held to Maturity’ categoryneed not be ‘marked to market’ and will becarried at acquisition cost, unless it is morethan the face value, in which case the premiumshould be amortised over the period ofremaining maturity. The individual scrips in the‘Available for Sale’ category will be markedto market at the year-end or at more frequentintervals. The individual scrips in the ‘Heldfor Trading’ category will be marked to marketat monthly or at more frequent intervals.Thirdly, the Reserve Bank will not announcethe Yield to Maturity (YTM) rates forunquoted Government securities, as hitherto,for the purpose of valuation of investments bybanks. The banks are required to value theunquoted SLR securities on the basis of theYTM rates to be put out by the PrimaryDealers Association of India (PDAI) jointlywith the Fixed Income Money Market andDerivatives Association (FIMMDA) atperiodical intervals. The valuation of the otherunquoted non-SLR securities, wherever linkedto the YTM rates, will be with reference tothe YTM rates as put out by the PDAI/FIMMDA.

Banks’ Investments in Capital Market

1.55 In pursuance of the Monetary and CreditPolicy for 2000-01, a Standing TechnicalCommittee of the Reserve Bank and SEBI onBank Financing of Equities was constituted todevelop operative guidelines for a transparentand stable system of banks’ financing ofequities and investments in shares. TheCommittee submitted its report to the ReserveBank on August 30, 2000. The guidelinesreflected the Committee’s approach to optimise

the capital market returns without exposingthem to undue risks arising from marketvolatility. The Reserve Bank circulated thedraft guidelines in September 2000. The finalguidelines were announced in October 2000,after taking into account the views expressedby the banks and other market participants.As per the final guidelines, the terms andconditions for financing of initial publicofferings (IPOs) should be the same as thoseapplicable to advances against shares toindividuals. As recommended by theCommittee, within the overall exposure tosensitive sectors, the bank’s total exposure tothe capital market by way of investments inordinary shares, convertible debentures andunits of mutual funds (other than debt funds)should not exceed ‘5 per cent of totaloutstanding advances as on March 31 of theprevious year’ as against the earlier ceilingof ‘5 per cent of incremental deposits of theprevious year’. The Board of Directors ofbanks shall formulate their policy on totalexposure to capital market, keeping in viewits overall risk profile. In respect of thosebanks where the present outstandinginvestments in equities are relatively smalland well below the 5 per cent overall ceiling,as a prudential measure, the Board should alsolay down an annual ceiling for freshinvestments in equities so that any increasein fresh investments in equities takes placein a phased, gradual and cautious manner,within the absolute ceiling fixed by the Boardfor each year. The RBI-SEBI TechnicalCommittee will review the actual working ofthe new guidelines in consultation with selectbanks.

Rural Credit, Housing Finance and Creditto Small Scale Industries

Rural Credit

1.56 In order to strengthen the capital baseof the rural institutions, a sum of

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Rs.152.65 crore was expended by the CentralGovernment during 1998-99 to strengthen thecapital base of Regional Rural Banks (RRBs).Besides, a budgeted sum of Rs.168 crore wasreleased for restructuring the capital base ofselect RRBs during 1999-2000. The ReserveBank has been providing to National Bank forAgriculture and Rural Development(NABARD), a General Line of Credit (GLC)to enable it to meet the short-term creditrequirements of co-operative banks and RRBs.For the year 1999-2000 (July–June), the ReserveBank renewed a credit limit of Rs.5,700 crore,sanctioned in the previous year, to NABARDconsisting of Rs.4,850 crore under GLC I (forseasonal agricultural operations) and Rs.850crore under GLC II (for various other approvedshort-term purposes). In view of the increasein sanction of credit limit by NABARD to co-operatives and RRBs in general, and for meetingthe additional requirements of funds on accountof cyclone /floods in Orissa in particular, anadditional limit of Rs.400 crore under GLC Iwas sanctioned in December 1999, on requestby NABARD.

1.57 Provision of micro-credit by banks hasemerged as an important instrument foralleviating poverty, particularly in rural areas,as this raises the productive capacity of thebeneficiaries. Banks were accordingly advisedin February 2000 to make micro-credit anintegral part of their corporate credit plan.Micro-credit is reckoned as part of banks’priority sector lending since February 2000.Further, with a view to providing an additionalavenue for bank’s lending to agriculture andincreasing the outreach of banks in rural areas,lending by banks to non-banking financialcompanies (NBFCs) for on-lending toagriculture is reckoned for the purpose ofpriority sector lending as indirect finance toagriculture since April 2000. In a significantmove, micro-credit/ rural credit has beenincluded in the list of eligible NBFC activity

for being considered for FDI/OCB/NRIinvestment. This would cover extension ofcredit facilities at the micro level to smallproducers and small enterprises in the rural andurban areas.

1.58 The total ground level credit foragriculture and allied activities disbursed byco-operative banks and commercial banks(including RRBs) increased by 13.2 per centto Rs.41,764 crore during 1999-2000 fromRs.36,897 crore during 1998-99. TheNABARD has been playing a significant rolein providing and facilitating adequate creditsupport to agriculture and other rural activities.The amount of funds sanctioned and disbursedby NABARD under Rural InfrastructureDevelopment Fund (RIDF) amounted toRs.14,923 crore and Rs.6,680 crore,respectively, as at end-August 2000. KisanCredit Cards (KCC) numbering 57.41 lakhwere issued by PSBs, RRBs and co-operativebanks; the amount sanctioned under thisscheme amounted to Rs.9,632 crore as at end-March 2000. All PSBs have been advised toset monthly targets within the yearly targetfixed for the bank and draw action plan forachieving the overall target. The role playedby NABARD and co-operative banks inaugmenting the flow of credit to the ruralsector is detailed in Chapter III, while that ofcommercial banks (including RRBs) is detailedin Chapter II of this Report.

Housing Finance

1.59 Commercial banks were advised tocompute their minimum share of housingfinance allocation for 1999-2000 and 2000-01at 3 per cent of their incremental deposits ofthe previous year or the amount of housingfinance allocation fixed for the previous year,whichever was higher. Prior to October 1999,indirect housing loans sanctioned by banks tointermediary housing agencies against thedirect loan sanctioned/proposed to be

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sanctioned by the latter were reckoned as partof their housing finance allocation, provided theloan per borrower by such intermediaryagencies did not exceed Rs.5 lakh and Rs.10lakh in rural/semi-urban and urban/metropolitan areas, respectively. In order toenhance the flow of credit to housing sector,effective October 29, 1999, banks were advisedthat housing finance sanctioned by them tohousing finance intermediary agencies wouldhenceforth be reckoned for the purpose ofachievement of their housing financeallocations, irrespective of the per borrowersize of the loans extended by these agencies.

Credit to Small Scale Industries

1.60 Total credit provided by PSBs to small-scale industries (SSIs) as at end-March 2000constituted 15.6 percent of net bank credit and35.8 per cent of total priority sector advancesof these banks. Out of the advances to SSIsector, the advances to tiny sector (i.e. to unitswhere investment in plant and machinery doesnot exceed Rs.25 lakh) constituted 54.0 percent of advances to SSI sector. Those bankswhich have not achieved the priority sector-lending target of 40 per cent even aftereffecting their contribution to the RIDF, have,however, been included in the consortium forproviding finance to the Khadi and VillageIndustries Commission (KVIC). Such credit isreckoned as their indirect lending to SSIs underthe priority sector. These loans are providedat 1.5 percentage points below the averageprime lending rates (PLRs) of five major banksin the consortium. As at the end of June 2000,an amount of Rs.518.18 crore was outstandingout of an amount of Rs.704.00 crore disbursedby the consortium under the scheme.

1.61 Banks were advised in January 1998 toensure that their corporate borrowers financedat least 25 per cent of their credit purchases

by accepting bills drawn on corporates by theirsuppliers, particularly those belonging to theSSI sector. This was aimed at development ofa bills culture. Effective October 29, 1999,banks were given freedom to charge interestrates on discounting of bills without referenceto PLR, thereby enabling banks to offercompetitive rates of interest. This measurewould motivate corporates to make use of thebill route for receiving/paying their creditsales/credit purchases. In view of the aboveand considering the operational problems facedby banks in implementing the bills discipline,the mandatory minimum 25 per cent foracceptance of bills was withdrawn, effectiveNovember 2, 1999.

1.62 As a part of follow up of the UnionBudget 2000-01 proposals, the Reserve Bankincreased the limit for collateral requirementon loans from Rs.1 lakh to Rs.5 lakh in respectof the tiny sector. To promote credit flow tosmall borrowers, the composite loan limit (forproviding working capital and term loansthrough a single window) was increased fromRs.5 lakh to Rs.10 lakh. PSBs were requestedto accelerate their programme of SSI branchesto ensure that every district and SSI clusterswithin districts are well served by at least onespecialised SSI bank branch. The Governmentdecided that SSI branches would need to obtainISO certification to improve the quality of theirbanking services. A new central creditguarantee scheme for SSI is proposed to beimplemented through Small IndustriesDevelopment Bank of India (SIDBI), whichwould cover loans up to Rs.10 lakh for thebanking sector. The guaranteed loans would besecuritised and tradable in the secondary debtmarket. Further, PSBs have been advised tocomplete the process of opening/operationalising SSI branches by December2000.

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2. Financial Performance ofScheduled Commercial Banksduring 1999-2000

1.63 This Section presents highlights of thefinancial performance of scheduled commercialbanks during the year 1999-2000 on the basisof the balance sheets of these banks. Theanalysis is in terms of both the aggregate andgroup-wise position of scheduled commercialbanks.

Profitability

1.64 The operating profits of scheduledcommercial banks increased by Rs.4,613 crorein 1999-2000 (33.4 per cent) to Rs.18,423crore as against a decline of Rs.830 crore (5.7per cent) in 1998-99. Net profits increased byRs.2,816 crore (62.7 per cent) to Rs.7,306crore during 1999-2000 as against a declineof Rs.2,012 crore (30.9 per cent) during 1998-99. As a share of total assets, operating andnet profits increased by 21 and 19 basis pointsto 1.66 per cent and 0.66 per cent, respectively,during 1999-2000 as against a decline of 39and 35 basis points, respectively, during1998-99. The improvement in financialperformance reflected (i) higher rate of growthin interest income than interest expenditureduring 1999-2000, ii) a lower rate of growthin operating expenses during 1999-2000 ascompared with that in the preceding year, andiii) a higher rate of growth in other incomethan that in 1998-99.

1.65 Operating and net profits across allbank groups exhibited a substantial increaseduring 1999-2000 as against a decline acrossall bank groups (barring nationalised banksin operating profits) during 1998-99. Inparticular, new and old private sector banksregistered operating profit growth of 81.8 and80.4 per cent respectively, during 1999-2000,as against a decline of 7.5 and 26.8 per cent,respectively, in the preceding year. The rise

in operating profits of foreign banks tooturned out to be high at around 51.5 per centas against a decline of 30.3 per cent during1998-99.

1.66 PSBs exhibited an operating profitgrowth of 23.7 per cent during 1999-2000 ascompared with a marginal increase of 2.8 percent during 1998-99. Even more spectacularwas the increase in net profits (57.2 per cent)as against a decline of 35.3 per cent in 1998-99. The improved financial performance ofPSBs, despite a sharper increase in interestexpenditure (15.8 per cent) than that in interestincome (14.5 per cent), was attributable to thespurt in other income and deceleration inoperating expenses. Booking of capital gainsby PSBs in their treasury operations in thecontext of the downward movement of interestrates, inter alia, boosted their other income.

1.67 As a proportion of total assets,provisions and contingencies of scheduledcommercial banks increased by 2 basis pointsto 1.00 per cent during 1999-2000. Theaggregate figure, however, hides the vastdifferences in bank-group-wise position inrespect of provisions. On the one hand,provisions by both foreign and new privatesector banks increased sharply by 44 basispoints and 40 basis points, respectively, to 2.07per cent and 1.15 per cent, respectively, during1999-2000 while provision of old privatesector banks increased by 27 basis points to1.00 per cent. On the other hand, provisionsby PSBs declined by 6 basis points to 0.89per cent, mainly due to the sharp decline inthe provisions of 17 basis points by the SBIGroup. Provisions by nationalised banksincreased marginally by one basis point.

Spread

1.68 The movements in the interest incomeand interest expenditure were influenced byliquidity conditions and the varying response

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of major bank groups to the monetary policysignals of the Reserve Bank. The spread ofPSBs declined by 10 basis points to 2.70 percent during 1999-2000, due to a 9 basis pointsfall in interest income. The spread of SBI andnationalised banks group declined by 9 and 10basis points, respectively. The spread offoreign banks improved sharply by 38 basispoints owing to a sharper fall in interestexpenditure compared with that of interestincome. While the spread of old private sectorbanks improved by 18 basis points, that of newprivate banks declined by 11 basis points. Theinterest rate spread varied markedly acrossmajor bank groups – from 1.87 per cent fornew private sector banks to 3.85 per cent forforeign banks. For the SCBs, the spreadcontinued to exhibit a declining trend and wasat 2.72 per cent during 1999-2000 as against2.78 per cent during 1998-99.

Intermediation Cost

1.69 An indicator of competitiveness inbanking is the intermediation cost (i.e.operating expenses as a proportion of totalassets). There was a sizeable decline in theintermediation cost of SCBs to 2.49 per centduring 1999-2000 from 2.67 per cent in 1998-99, with wage bill declining from 1.75 per centto 1.66 per cent. Among the bank groups, thehighest order of decline in intermediation costduring 1999-2000 was recorded by the foreignbanks (38 basis points). New private sectorbanks recorded the lowest intermediation cost(1.42 per cent). PSBs recorded a decline of 14basis points in intermediation cost to 2.52 percent during 1999-2000.

Size of Balance Sheet

1.70 The share of capital in total liabilitiesdeclined to 1.66 per cent as at end-March 2000from 1.92 per cent as at end-March 1999. Withregard to assets, scheduled commercial bankswere able to increase their total assets by 16.8

per cent. The share of loans and advancesand investments in the total assets increasedto 39.9 per cent and 37.3 per cent,respectively, as at end-March 2000.

Off-Balance Sheet Activities

1.71 Reflecting the growing importance ofnon-fund based activities of the banking sector,the off-balance sheet exposures (contingentliabilities) of all SCBs recorded an increaseof 27.6 per cent to Rs. 5,84,441 crore in 1999-2000, led by a sharp increase of 31.4 per centin forward exchange contracts. The off-balancesheet exposures as a proportion to the totalliabilities of all SCBs increased by 4.4percentage points from 48.2 per cent in 1998-99 to 52.6 per cent in 1999-2000.

Non-Performing Assets

1.72 During 1999-2000, there was a markedimprovement in the proportion of net NPAs tonet advances with the number of PSBs withnet NPAs up to 10 per cent increasing from18 to 22. Similarly, the number of old privatesector banks and foreign banks with net NPAsof less than 10 per cent went up from 17 to18 and from 27 to 31, respectively. Newprivate banks continued to have net NPAsbelow 10 per cent during 1999-2000.

Capital to Risk-Weighted Assets Ratio

1.73 As against the stipulated minimumCRAR of 9 per cent of scheduled commercialbanks, all but one PSB attained the normduring 1999-2000. This achievement needs tobe viewed against the fact that no public sectorbank was recapitalised during 1999-2000. Ofthe 24 old private sector banks, 21 banks metthe 9 per cent norm. All the 8 new privatesector banks and 42 foreign banks had CRARin excess of 9 per cent. It may be recalled thatthe Narasimham Committee II had emphasisedthe raising of CRAR to 10 per cent by end-March 2002. 22 PSBs, 19 old private sector

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banks, 7 new private sector banks and 37foreign banks had CRAR in excess of 10 percent as at end-March 2000.

3. Perspectives

1.74 As the present phase of reformsgathers momentum and competitive pressuresbecome strong, more focussed attention wouldneed to be paid to inter-related sets of issuesregarding (a) strengthening the foundation ofthe banking system; (b) streamlining bankingprocedures including upgrading oftechnologies and networking; and (c) effectingstructural changes in the system.

1.75 It needs to be recognised that given thesize of the financial system, broadly defined,the question of banking soundness cannot beanalysed in isolation from the broader system.This is because financial disturbances, whereverthey originate, can have serious consequencesfor the rest of the economy. In view of theuniversalisation of banking operations, the wallsbetween banks and non-bank entities are gettinggradually blurred. However, banks in theirpresent structural form continue to havestrategic importance, notwithstanding theimportance of other major entities of thefinancial system, viz., development financialinstitutions (DFIs) and NBFCs.

Strengthening the Commercial BankingSystem

Capital Adequacy Measures

1.76 Capital constitutes the basic cushion asa rescue for contingencies. The BasleCommittee on Banking Supervision (BCBS)had released a Consultative Paper on NewCapital Adequacy Framework in June 1999to further strengthen the soundness of thefinancial system and better align regulatorycapital with the underlying risks faced bybanks. Recognising the implications of the

new framework on emerging market economieslike India, the Reserve Bank constituted aninternal Working Group to examine the impact,applicability, scope, problems and the time spanof its implementation in India. The ReserveBank has finalised its views on the basis ofthe recommendations of the Group, andsubsequently forwarded its comments to theBasle Committee. The main thrust of thecomments is to ensure sufficient flexibility inthe framework to fully reflect the macro-economic environment, structural rigidities andconcerns of emerging markets. The ReserveBank felt that where banks are of simplestructure and have subsidiaries, the frameworkcould be adopted on stand-alone basis with thefull deduction of equity contribution made tosubsidiaries from the total capital. Besides,national supervisors should have discretion toprescribe a material limit up to which cross-holdings could be permitted. Moreover, theReserve Bank felt that assigning greater roleto external rating agencies in regulatoryprocess would not be desirable. Instead,domestic credit rating agencies, which aremore adequately informed, would be moreeffective, subject to adequate safeguards.Further, the Reserve Bank viewed that riskweights of banks ought to be de-linked fromthat of the sovereign. Instead, preferential riskweights in the range of 20-50 per cent, on agraded scale may have to be assigned on thebasis of risk assessments by domestic ratingagencies. Furthermore, the proposal forassigning favourable risk weight to short-termclaims would jeopardise the stability of theinternational financial architecture. Again, theproposal to link the banking supervisorimplementing/endorsing the Core Principlesfor Effective Banking Supervision was notconsidered desirable. Finally, while theCommittee’s views on increased disclosuresand enhanced transparency are reasonable,national supervisors should consider the ability

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of the market to logically interpret theinformation.

1.77 The new capital adequacy normsproposed by the BCBS in June 1999, ifimplemented, are likely to be stricter thanthose prevailing at present. The new norms

with its explicit emphasis on ratings, internaland external, are likely to have implicationsfor the required levels of capital (Box I.4).These issues gain in importance in view ofGovernment ownership of banks and theability of the PSBs to raise capital either

The Basle Committee on Banking Supervision (BCBS)has proposed a revised Capital Adequacy Frameworkin 1999, which uses a three-pillar approach consistingof (a) a minimum capital requirements pillar, (b) asupervisory review pillar to ensure that the bank’scapital is aligned to its actual risk profile, and (c) amarket discipline pillar to enhance the role of theother market participants in ensuring that appropriatecapital is held by prescribing greater disclosure. Therevised framework is presently being discussed bysupervisory authorities all over the world.

The revised framework places an explicit emphasison ratings. Risk differentiation between counterparties,be they sovereign governments, banks, corporates,public sector enterprises or securities firms is soughtto be done either on the basis of external or internalratings. In broad summary, the weights based onexternal risk assessment proposed for claims onsovereign governments, banks and corporates arepresented in Table 1.

Box I.4: Ratings of Banks

The Reserve Bank, however, favoured greaterreliance on internal ratings-based approach for banks,which could be structured under an acceptableframework so that a standardised approach to internalrating could be adopted. The internal ratings-basedapproach could incorporate supplementary customerinformation, which is typically not available to creditassessment institutions. It could also extend to agreater number of counter-parties, such as, unratedborrowers in the small/retail sector. This wouldencourage banks to refine their risk assessment andmonitoring process, which would facilitate bettermanagement of their loan books. The regulatorsshould, however, evolve suitable process and criteriafor approving the rating framework so as to ensurethe integrity of different banks’ systems and that theparameters are consistent across various institutions.While encouraging banks to use their own internalrating systems for distinguishing better the creditquality, the issues that need to be addressed relateto: (i) mapping of bank grades into a series of

Table 1: Proposed Risk Weights based on External Risk Assessment

Assessment Claim on

Sovereign Banks CorporatesGovernments Option 1 Option 2

1 2 3 4 5

AAA to AA- 0 20 20 20

A+ to A- 20 50 50 * 100

BBB+ to BBB- 50 100 50 * 100

BB+ to B- 100 100 100 * 100

Below B- 150 150 150 150

Unrated 100 100 50 * 100

* Claims on banks of short-term maturity, e.g., less than 6 months would receive a weighting that is one categorymore favourable than the usual risk weight on the bank’s claim.

Option 1 : Based on risk weight of sovereign where bank is incorporated.Option 2 : Based on assessment of the individual bank. (Contd....)

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internally or from the market. It appears thateven after allowing for additional infusion ofcapital through internal generation and access tosubordinated debt, the gap between the additionalcapital requirement and the leeway available toraise capital from the market is likely to remainquite sizeable. In this situation, an issue that wouldrequire critical attention and would need to beresolved is whether this gap should be filled

by contribution from the owners/shareholdersor whether legislative ceiling for capital tobe subscribed by the public should be raised.Provision of banks’ capital by the ReserveBank would tantamount to monetisation withinflationary implications, while contributionto additional capital by the Government willadversely impact the fiscal situation.Therefore, there seems on balance, to be a

(...Concld.)

regulatory risk-weight baskets; (ii) development ofcapital charge on the basis of rating grades; (iii)ensuring consistency between the standardisedapproach and an internal ratings-based approach; and(iv) minimum standards and sound practicalguidelines for key elements of rating process andsupervisory process. Besides, a common standardsreview mechanism would need to be put in place.

Secondly, with regard to the new framework, theReserve Bank has preferred that assessments be madeby the domestic rating agencies for assigningpreferential risk weights for banking book assets(excluding claims on sovereign), subject to adequatesafeguards. In its view, domestic rating agencies thathave up-to-date and ongoing access to information ondomestic macro-economic conditions, legal andregulatory framework, etc. would be better placed torate domestic entities vis-à-vis external ratingagencies. This would also facilitate the nationalsupervisory authorities to have greater access to thequality of assessment sources and methodologies usedby various rating agencies and also facilitate evolvingcountry-specific parameters for rating of variouscounter-parties. In general, the skepticism about therole of external rating agencies arises because differentexternal rating agencies resort to different parametersfor risk evaluation, which are often not transparent.Apart from the lack of uniformity in selection ofparameters, the mix and weightage of objective andsubjective factors also vary across agencies, which,in the Reserve Bank’s view, may lead to incorrectassessments. Due to enormous subjective elementinvolved in the rating process and the lack oftransparency in risk assessment, and other reasons,the role proposed to be assigned to the external ratingagencies is a matter of supervisory concern. This isparticularly so in emerging market economies whichare assigned sovereign credit ratings which put an

upper limit on corporate credit ratings, irrespectiveof their individual creditworthiness and past debtservice record.

Yet another type of rating that can be expected toplay a significant role is supervisory rating. Thesecond pillar of the new framework expectssupervisors to specify bank-specific capital add-onsbased on the risk profile of individual banks, therebyeffectively raising the Basle minima for riskier banks.Although supervisors would use different methods todiagnose the risk profile of their banks, it can beexpected that some would use the component orcomposite ratings of supervisory rating models (suchas CAMELS) which can provide useful indicators ofrisk profile. Whatever be the manner of determiningrisk profile, what is evident is that several banks inthe Indian context could be expected to have higherthan system capital charge required of them, whichwould eventually raise the capital requirements forthe system as a whole.

References

Karacadag, C. and M.W.Taylor (2000), ‘The NewCapital Adequacy Framework: InstitutionalConstraints and Incentive Structures’ , IMFWorking Paper No. 93, IMF: Washington.

Monfort, B. and C.Mulder (2000), ‘Using CreditRatings for Capital Requirements on Lending toEmerging Market Economies: Possible Impact ofa New Basle Accord’, IMF Working Paper No.69, IMF: Washington.

Reserve Bank of India (2000), ‘Comments of theReserve Bank of India on A New CapitalAdequacy Framework’, Reserve Bank of India:Mumbai.

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strong case for raising the legislative ceilingfor market participation in equity capital ofPSBs. In this context, the pronouncement inthe Union Budget 2000-01 that theGovernment would reduce its holdings inPSBs to 33 per cent while ensuring thatbanks retain their public sector character,assumes importance.

Asset-Liability Management

1.78 The increasing internationalisation ofbanking operations engenders the possibility ofa significant mismatch between assets andliabilities, which have adverse implications forliquidity and solvency of the banking sector.In this context, pro-active ALM assumesimportance. Broadly, the objectives of ALMare to contain the volatility of net interestincome and net economic value of a bank. Thesupplementary objectives would be to reducevariability in all target accounts includingcontrol of liquidity risk, and to ensure balancebetween profitability and asset growth. Torealise these objectives, asset-liability managersmust be guided by policies that specificallyaddress the bank’s overall ALM goals and risklimits, and also by information that relatesdirectly to its asset-liability positions. Such riskmanagement strategies would help to reducethe adverse effects of macro-economic shockson the soundness of the financial system.

Risk Management

1.79 Given the diversity and varying size ofbalance sheet items among banks as well asacross the bank-groups, the design of riskmanagement framework would need to begeared to meet bank-specific requirements,covering the size and complexity of theirbusiness, risk philosophy, market perceptionand the existing level of their capital. In otherwords, banks would need to evolve their ownsystems compatible with the type and size ofoperations as well as risk perception. While

doing so, banks would need to criticallyevaluate their risk management systems in thelight of the guidelines issued by the ReserveBank and evolve an appropriate system toovercome the existing deficiencies and institutethe requisite improvements.

1.80 The need for putting in place ALM andrisk management systems in banks hasunderscored the imperative of building internalcapacities to make appropriate analysis of theevolving domestic and international businessand economic circumstances. These includeboth market conditions and the issues arisingout of financial market integration. In thiscontext, the role of bank economists assumescrucial importance. Bank managements willhave to reorient and restructure their statisticaland economics wings in a way that economistsin Indian banks have an important role to playas much as in most international banks.

Risk Based Supervision

1.81 Considering the complexities of bankingbusiness and emerging product innovationswith complex risk profiles, there is a growingacceptance that a Risk Based Supervision(RBS) approach would be more efficient thanthe traditional transaction based approach.RBS entails monitoring of banks by allocatingsupervisory resources and focusingsupervisory attention according to the riskprofile of each institution. The instruments ofRBS are off-site monitoring and on-siteinspection supplemented by marketintelligence mechanism. However, off-sitesurveillance has gained primacyinternationally in recent times, given the easeand promptness of monitoring (Box I.5).Therefore, the Reserve Bank has decided togradually move towards a risk based approachto inspection. Apart from strengthening therisk modelling capabilities based on off-sitedata and associated research for ‘predictive

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The growing complexity of financial institutionscoupled with the need for frequent and continuousmonitoring has made off-site monitoring an importantinstrument of supervision. Countries all over the worldhave embraced off-site surveillance mechanisms invarying degrees. The Monetary and Credit Policy ofApril 2000 has observed that the Reserve Bank woulddraw on other countries’ experiences in movingtowards RBS and it would be instructive, in thiscontext, to examine the off-site monitoring proceduresadopted in different countries.

United Kingdom: In the UK, integrated supervisionover the financial system is carried out by theFinancial Services Authority (FSA). The FSA systemof bank supervision is predominantly off-site withmost of the on-site work being done by accountancyfirms called ‘reporting accountants’ specialising inbank audit. The off-site database of FSA includesstatistical returns submitted by banks to the Bank ofEngland and information available within FSA filesabout the banks. Banks are required to submit returnscovering aspects of capital adequacy, balance sheet,profit and loss account, liquidity and large exposures,large deposits, foreign exchange exposures andcountry exposures. Risk assessment of banks is carriedout on the basis of CAMELB factors (capital, assets,market risk, earnings, liabilities and business) coveringbusiness risk and COM factors (internal controls,organisation and management). The supervisoryprocess is divided into three phases, viz ., riskassessment phase, tools of supervision and riskevaluation phase. The concerns identified by off-siteanalysis are supplemented by one or all of the toolsof supervision, i.e., accountants reports, traded marketsteam visit, risk review team visit, liaison with overseasregulators, prudential and ad-hoc meetings with thebanks. The risk-based supervisory process is dynamic,in that the analyst receives new informationthroughout the process. This may cause the analystto adapt or revise supervisory actions and initiativesthroughout the supervisory period.

France: Supervision over the banking system iscarried out by the French Banking Commission knownas Commission Bancaire. The off-site monitoringsystem involves prudential regulation of banks on fiveparameters, viz., minimum capital and reserves,liquidity, large exposures ratio, solvency ratio andcapital adequacy ratio. Quarterly monitoring of bank’scompliance with the prescribed guidelines is done andany violations are taken up with the bank. The returns

Box I.5: Off-site Monitoring and Surveillance Systems in Select Countriesreceived from banks include prudential ratios, balancesheet and off-balance sheet exposures, and profit andloss accounts. While prudential ratios and balancesheet are received on quarterly basis (some of theinstitutions submit them on monthly basis), profit andloss account and prudential ratios like capitaladequacy and solvency ratios are required to besubmitted on half-yearly basis. In addition to theabove off-site returns received from the supervisedinstitutions, the Commission also receives two reportsrelating to internal controls containing details ofinternal control policies every year. The off-siteinformation is supplemented by on-site inspectionreports. Actions under off-site surveillance arepreventive measures like advising bank management,resorting to on-site inspection and other measures anddisciplinary sanctions.

Singapore: Bank supervision in Singapore is theresponsibility of the Monetary Authority of Singapore(MAS). The authority’s off-site monitoring systemcomplements and provides the basis for continuoussupervision of banks. Under the off-site system, theMAS has prescribed a set of returns of varyingperiodicity (monthly, quarterly and annual). Thereturns cover the capital adequacy, asset quality,statutory liquidity, connected lendings, call moneyborrowings, negotiable certificates of deposit, balancesheet, large borrowers, profit and loss account, foreignexchange business transacted and loan syndication.The returns are analysed by a team of off-site analysts,each analyst being responsible for a portfolio of banks.The results of the off-site analysis are conveyed tothe on-site examination division. Specific concernsarising out of the off-site analysis are also investigatedthrough targeted appraisals carried out by on-siteexamination teams.

Hong Kong: The Hong Kong Monetary Authority(HKMA) is entrusted with the responsibility ofpromoting general stability and effective working ofthe banking system under the Banking Ordinance. Amember of off-site team is assigned to supervise aportfolio of banks as a Case Officer and to do allrelated off-site supervisory work. The HKMA’sapproach is that of continuous supervision through acombination of on-site inspection, off-site reviews andprudential meetings. HKMA collects monthly/quarterlyprudential off-site returns covering assets andliabilities, profit and loss, capital adequacy, liquidity,large exposures, loan classification, maturity profile

(Contd....)

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supervision’, the overall compliance burdenunder the RBS framework is likely to belargely rationalised.

1.82 To develop an overall plan for movingtowards RBS, international consultants wereappointed. They completed Phase 1 of theproject by conducting a review and evaluationof the current supervisory and regulatoryframework, policies, guidelines, instructions,

tools, techniques, systems, available ITinfrastructure and various internal and externallinkages. The thrust of the Phase 1recommendations is on enhancements to theregulation and supervision framework leadingto increased effectiveness of overallsupervision through greater focus on risk aswell as a realignment of the inspection processto fall in line with a more risk-based approach.Their recommendations cover vital areas, such

(...Concld.)

of assets and liabilities, foreign exchange position,interest rate risk, country risk, market risks and acertificate of compliance with various requirementsunder the law. These returns are called either on anindividual basis, or combined or in the case of capitaladequacy, liquidity and large exposures, on aconsolidated basis. The accuracy of submitted returnsand the quality of systems are regularly scrutinisedby external auditors, besides by the HKMA’s on-sitesupervisors. There is a CAMEL rating system in placeto trigger discriminatory supervision. Off-siteexaminers use the data to make regular (at leastannual) off-site reviews, which result in a CAMELtype rating and they also set the triggers for each bankor bank group. Where there are causes for concern,the reviews are more frequent. The off-site examinersalso run regular reports mirroring bank performanceon the bank data.

United States: In the US, the Board of Governors ofFederal Reserve (FED) is responsible for supervisingnational banks. The Federal Deposit InsuranceCorporation (FDIC) and the Office of the Comptrollerof Currency (OCC) are responsible for supervision ofother types of banks. The supervision is basicallyconducted by a very strong on-site examination. Thisis supplemented by the off-site surveillance processcalled the Financial Institutions Monitoring Systems(FIMS), which is used to track the financial conditionof individual banks and banking organizations betweenon-site examinations. Based on the call reports, whichcover the entire gamut of banking operations includingCapital Adequacy, Asset Quality, Earnings and Largeexposures, received from the bank, the FED preparesa Uniform Bank Performance Report (UBPR) bank-wise or bank-holding company (BHC)-wise. UBPRcovers five quarter’ data. This report is generated atquarterly intervals and forwarded to banks/ BHCs. The

report covers all the important supervisory indicators.Comparisons with the peer group are also provided.Peer group is arrived at on the basis of asset size ofthe existing banks and newly established banks aregrouped separately.

India: In India, as part of the new supervisory strategypiloted by the Board for Financial Supervision (BFS),the Reserve Bank set up an Off-Site Monitoring andSurveillance system (OSMOS) in 1995 in order tosupplement the existing system of on-site inspectionsand to provide a means of closer and continuousmonitoring of bank performance. Under OSMOS,banks are required to submit quarterly and half-yearlyreturns on several aspects of financial performance,including asset quality, capital adequacy, largeexposures, connected lending, ownership patterns, etc.As a move towards further strengthening the off-sitemonitoring process, a second tranche of four returnscovering liquidity and interest rate risk in local andforeign currencies has recently been introduced. Areturn covering critical information about theoperations of Indian subsidiaries of banks has beenintroduced, effective quarter ended September 2000as a move towards consolidated supervision of bankinggroups. Standard reports and detailed individual andsystemic analyses are carried out and shared with theBank Monitoring Divisions of respective banks toinitiate timely supervisory intervention.

Off-site surveillance in different economies hasevolved over a period of time, depending on thecountry’s financial system and their level ofdevelopment. As the supervisory framework acquiresgreater sophistication, it is expected that the off-sitesurveillance will acquire greater prominence fordeveloping policy positions that are both relevant andbeneficial.

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as, data management, supervisory process,inspections, feedback to banks, external audit,etc. During Phase 2 of the project, theConsultants are expected to work out thepractical and operational aspects of the aboverecommendations and suggest a new RBSframework including the sequencing ofdifferent stages and a time frame forimplementation.

International Financial Standards and Codes

1.83 Against the background of financial andcurrency crises in some parts of South-EastAsia, Mexico, Brazil and Russia, the systemicstability issues have come under a sharp focus.Best market practices, transparency and datadissemination have been increasingly viewed asimportant areas where standards, codes, andcore principles need to be evolved andinternationally accepted for adoption. India hasrecognized that fostering the implementation ofstandards is a means through which financialstability could be secured and maintained. Inthe context of the ongoing financial reforms andin the light of the country’s economiccircumstances and institutional and legalinfrastructure, a Standing Committee onInternational Financial Standards and Codes(Chairman: Dr.Y.V.Reddy) was set up inDecember 1999 with the objective of layingdown a road-map for aligning India’s standardsand practices with international best practices.The Standing Committee identified ten coreareas and set up Advisory Groups for each ofthe areas, viz., international accounting andauditing, monetary and financial policies,banking supervision, fiscal transparency,securities regulation, insurance regulation, datadissemination, payment and settlement system,corporate governance and bankruptcy laws. TheGroups are undertaking a review of standards,with reference to the Indian circumstances andthe feasibility of implementation of internationalstandards within a time frame, given the legaland institutional practices in India. The

Advisory Group on Transparency in Monetaryand Financial Policies (Chairman: ShriM.Narasimham) has submitted its report to theChairman of Standing Committee on September13, 2000. The Group has examined in detailissues related to the clarity of roles andresponsibilities including transparency inmonetary policy formulation andimplementation. Further, the Advisory Groupson Banking Supervision (Chairman: ShriM.S.Verma), Insurance Regulation (Chairman:Shri R.Ramakrishnan) and Payment andSettlement System (Chairman: Shri M.G.Bhide)submitted the first part of their Reports inSeptember 2000. The Report on “BankingSupervision” has taken an exhaustive accountand given recommendations pertaining to fourmajor areas in banking regulation, viz., corporategovernance in banks, transparency practices inIndian banking, supervision of cross-borderbanking and internal rating practices adopted bybanks. The Report on “Insurance Regulation”mainly deals with the various provisions relatingto licensing of insurance companies in the lightof standards set by the International Associationof Insurance Supervisors (IAIS) and the TwentyInsurance Guidelines issued by OECD. TheReport on “Payment and Settlement System”has dealt with issues pertaining to the inter-bankpayment and settlement system covering CorePrinciple and Central Bank responsibilities. Thereports have been placed on the Bank’s web-site for wider public information and debate.

Prompt Corrective Action

1.84 Worldwide, there is an increasingmovement towards building a safe and soundbanking system, backed by a strongsupervisory regime. This is in accordance withone of the Core Principles for EffectiveBanking Supervision, which mandates thatbanking supervisors must have at their disposaladequate supervisory measures, backed bylegal provisions, to bring about timelycorrective action. Such a phenomenon has

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prompted the supervisory authorities toconsider the possibility of introducing a systemof Prompt Corrective Action (PCA) in India.The response has been dictated by two majorconsiderations. The first is the responsibilityof bank supervisors to identify problem banksat an early stage. The other is to monitor thebehaviour of troubled banks in an attempt toprevent failure or to limit losses or contagion.

1.85 In view of the above considerations, asystem of PCA with various trigger points andmandatory and discretionary responses by thesupervisors is envisaged for the banking systemin India. In addition to CRAR, two additionalindicators, viz., ‘Net NPA’ and ‘Return onAssets’, reflecting asset quality andprofitability, respectively, have been includedunder the broader PCA regime. Trigger pointshave been proposed under each of the threeparameters, taking into account the practicalityof implementation of certain measures in theIndian context. For CRAR, three trigger pointshave been proposed - CRAR of greater thanor equal to 6 per cent, but less than 9 per cent;greater than or equal to 3 per cent but lessthan 6 per cent; and less than 3 per cent. ForNet NPAs, two trigger points have beenproposed - greater than 10 per cent but lessthan 15 per cent; and 15 per cent and above.For ROA, the trigger point has been set at lessthan 0.25 per cent. A discussion paper on PCAhas been put on the Reserve Bank's web-sitefor wider circulation, inviting suggestions andcomments from banks and others.

Non-Performing Assets

1.86 The level of NPAs of the banking systemin India has shown an improvement in recentyears, but it still remains high. A significantpart of the problem arises on account of thecarry-over of old NPAs in certain sun setindustries. The problem is often complicatedby the fact that there are a few banks whichare fundamentally weak and where the

potential for return to profitability, withoutsubstantial restructuring, is doubtful. Theresolution of the NPA problem requires greateraccountability on the part of corporates,greater disclosures in the case of defaults, andan efficient credit information system. Actionhas been initiated in all these areas, and it isexpected that, with the help of stricteraccounting and prudential standards andappropriate legal support, NPAs will beeffectively contained.

1.87 The problem of NPAs is closely tied tothe issue of legal reforms. Recognizing thatthe legal framework pertaining to the bankingsystem might act as an impediment to itsefficient functioning, initiatives have beentaken to align the legal setup with therequirements of the banking system. The legalframework is a key ingredient for limitingmoral hazard. Given the high transactionscosts of finality of settlement, including legalcosts, there is an urgent need for developingworkable laws on contract, collateral andbankruptcy proceedings and to implement andstreamline court procedures for seekingeffective and rapid remedies under these laws.The issue would assume greater importance aseconomic liberalization gathers momentum.Otherwise, the continual state of innovationand evolution of new financial products in theliberalization process would outpace theexisting legislation and raise the need forimplementing fine and sharper points of law.It is, therefore, essential that the requisite legalframework is quickly put in place.

1.88 In India, the issues pertaining to legalframework have been examined by the ExpertGroup under the Chairmanship of ShriT.R.Andhyarujina, former Solicitor General ofIndia. The Group, in its Report submitted inFebruary 2000 to the Governmentrecommended, among other things, the creationof a new law granting statutory power of

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possession and sale of security directly tobanks and FIs and adoption of the draftSecuritisation Bill. It has also suggested theprovision of additional avenues of recovery ofdues to banks and FIs by empowering them totake possession of securities and sell them forrecovery of loans. The Report is underconsideration of the Government.

Corporate Governance

1.89 Experience of various countries withregard to bank failures has clearly identifiedinadequate/inefficient management as one ofthe principal factors. Banking supervisorstherefore seek, as one of their key tasks, toenhance the quality of corporate governancein bank management. The corporategovernance structure of the bank needs to betransparent and consistent, striking a balancebetween promoting safe and sound banking, onthe one hand, and the flexibility required foreffective competition, on the other. The BasleCommittee has also mentioned in one of itsCore Principles that supervisors shouldencourage and pursue market discipline byencouraging good corporate governance(through an appropriate structure and set ofresponsibilities for a bank’s Board of Directorsand senior management), and enhancing markettransparency and surveillance.

1.90 The Advisory Group on BankingSupervision (Chairman: Shri M.S.Verma)observed that while ownership of banks is notan important issue in establishing corporategovernance practices, the extent of complianceof the standards of corporate governance variesfrom bank to bank. The salientrecommendations of the Group are given below.

(i) All banks should attain an acceptableminimum level of corporategovernance. Subsequently, banks maymake a sustained progress towards

achieving the best internationalstandards within a reasonabletimeframe.

(ii) The unions and the managementshould achieve a consensus onconverting the present performance-unrelated uniform remunerationstructure fixed for all PSBs and at alllevels of management intoperformance-related remunerationstructure.

(iii) A comprehensive risk managementsystem should be put in place in allbanks within two to three years. Sincebanks are in different stages ofimplementation of risk managementsystems, small banks, in particular,would require encouragement andtechnical support to undertake riskmanagement practices.

(iv) The statutory provision (Section 20of the B.R. Act, 1949) prohibitingconnected lending to directors andtheir connected parties needs to beextended to include largeshareholders.

(v) Banks need to develop mechanismsfor ensuring percolation of corporatestrategic objectives and set valuesthroughout the organisation.

(vi) Since Boards of very few banks areknown to enforce clear lines ofresponsibility and accountability forthemselves, there is an urgent need tofollow the best practices in the banksin respect of constitution andfunctioning of the Boards. Whilenominating individuals on banks’Boards, the practice of pre-induction

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briefing or post-induction orientationcan be put in place forthwith todevelop a proper appreciation of theirrole in the banks’ corporategovernance. A ceiling needs to beimposed on the number of Boards andthe number of Committees a Directorcan work at a time, since members ofBoard of Directors are required to givetheir valuable time to the governanceof banks.

(vii) With a view to conducting corporategovernance in a transparent manner,public disclosure in respect of detailsof qualifications of the Directors needsto be revealed in the balance sheet.Banks also need to be encouraged todisclose the senior managementstructure, basic organisational structure,information about incentive structure,and nature and extent of transactionswith affiliated and related parties.

(viii) The legal processes also need to bestrengthened to facilitate correctiveaction like removal of the incompetentmanagement.

1.91 The Group, however, noted that theguidelines and norms for good corporategovernance in banks and overall responsiblecorporate governance are still in formativestages and healthy conventions do not exist.Laws which can be seen as supporting orfacilitating corporate governance are also yetto be framed. It will, therefore, take time toenact tenets of good governance in a piece oflegislation.

1.92 Compliance with regulatoryprescriptions is a minimal requirement ofgood corporate governance and what isrequired are internal pressures, peer pressuresand market pressures to reach standards farhigher than those prescribed by regulatoryagencies (Box I.6).

Under corporate governance, banks articulate corporatevalues, codes of conduct and standards of appropriatebehaviour etc, and have systems and controls to ensurecompliance with them. The Board sets the strategicobjectives and corporate values of banks and specifytransparent lines of responsibility and accountability,which are communicated throughout the organisation.The Board and the top management meet at specifiedintervals for timely exchange of information on thebank’s financial condition and management practices.

It is, therefore, possible to identify different sets ofplayers in the corporate governance system. There isa dynamic balance among them that determines theprevailing corporate governance system depending onthe stage of institutional development and thehistorical development. Two aspects of financialsystems in other countries emerge as particularlyimportant in determining the operation of corporategovernance, viz., ownership of the corporate sectorand the structure of corporate Boards. In UK, morethan 60 per cent of issued equity is held by financialand non-financial corporations. In US, on the other

Box I.6: Corporate Governance in the Banking Sector

hand, shareholdings have until recently been heldmainly by individuals. In Japan, the groupings canbe classified into former zaibatsus, new bank-centredgroups and manufacture-centred groups. In Germany,most groupings are industry-based but there are alsobank and insurance-based groupings. In Sweden,groupings are predominantly family-controlled. Withregard to structure of corporate Boards, several authorshave observed that carefully designed Board structuresprevent hostile takeovers from taking place.

Since banks are important players in financial systemin India, special focus on the corporate governancein the banking sector becomes critical. Secondly, theReserve Bank, as regulator, has responsibility on thenature of corporate governance in the banking sector.Thirdly, to the extent that banks have systemicimplications, corporate governance in the banks is ofcritical importance. Fourth, given the dominance ofpublic ownership in the banking system in India,corporate practices in the banking sector would alsoset the standards for corporate governance in private

(Contd....)

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Streamlining the Banking Procedures

Importance of Audit Procedures

1.93 The system of audit plays an importantrole in ensuring a proper functioning of thebanking system. The need for external auditin maintaining the soundness of the bankingsystem is being increasingly felt, particularlyafter the recent experience of many East Asiancountries. In India, auditors nominated by theReserve Bank have been playing a crucial rolein ensuring the overall soundness of thebanking system. However, the system of auditneeds to be made more extensive, accountableand brought in line with the internationallyaccepted standards.

Transparency and Disclosure

1.94 One of the characteristic features of aperfectly competitive market model is the freeflow of information or the transparency ofbusiness operations. Transparency not onlyhelps the creditors to make optimal decisionsregarding their investment portfolio, but alsoimposes market discipline on banks toperform well in a competitive manner(Box I.7).

Internal Controls

1.95 Cumbersome loan and documentationprocedures in banks impinge on the efficientfunctioning of the banking sector. It is,

(...Concld.)

sector. Finally, with a view to reducing the possiblefiscal burden of recapitalising the PSBs, attentiontowards corporate governance in the banking sectorassumes added importance since PSBs must be in aposition to assure the market that their system ofcorporate governance is such that they can be trustedwith shareholders’ money.

It is important in this context to examine theregulatory issues under Government ownership thatinteract with the corporate governance practices inIndia. The first issue is that of enhancing corporategovernance in banks. However, the usefulness of thecommon supervisory mechanism would requirestrengthening internal controls and facilitatemonitoring by focusing on a few identifiableparameters.

Secondly, the approach of the Reserve Bank toregulation has some features that would enhance theneed for and usefulness of good corporate governancein the banking sector. The transparency aspect hasbeen emphasised by expanding the coverage ofinformation, timeliness of such information and theanalytical content in various publications. Further,interaction with market participants has beenintensified both at informal level and formal fora, like

advisory committees.

Thirdly, there is an issue of institutional structure forregulation. The basis of the institutional approach isto cover institutions, irrespective of business, whichis convenient from the prudential angle. This contrastswith the functional approach to regulation which seeksto control business activity, irrespective of institutions.In reality, there is an overlap and over time, suchoverlap between institutions and business are boundto become increasingly complex. In view of the above,it is deemed essential to review and identify a modelthat is suitable in the Indian conditions and isconsistent with future needs.

References

Bank for International Settlements (1999), ‘EnhancingCorporate Governance in Banking Organisations’,Basle, Switzerland.

Jenkinson, T and C.Mayer (1992), ‘The Assessment:Corporate Governance and Corporate Control’,Oxford Review of Economic Policy, 8, pp.1-10.

Reddy, Y.V. (1999), ‘Corporate Governance inFinancial Sector’, RBI Bulletin, August, pp.993-1004.

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Transparency of banking operations plays an importantrole in ensuring effective market discipline, apotentially crucial mechanism for keeping banksprudent. This particularly helps investors anddepositors to ascertain the true health of financialentities and assist policy makers to initiate timely andadequate remedial action when required. Transparency,in the context of the banking operations, may bedefined as public disclosure of reliable and timelyinformation that enables the users of that informationto make an accurate assessment of a bank’s financialcondition and performance, business activities, riskprofile and risk management practices.

In a liberalised economic framework, market disciplineconstitutes a critical pillar of supervision ofcommercial banks, together with minimum capitalrequirements and supervisory review of capitaladequacy. Under certain circumstances, marketmechanisms complement supervisory efforts byrewarding banks that adopt prudent business strategiesand penalising those that do not. Public disclosureencourages safe and sound banking practices and actsas a deterrent to imprudent risk taking while providingincentive for effective risk management. Marketdiscipline, however, can be effective only if marketparticipants have access to timely and reliableinformation which enables them to assess correctly abank’s activities and the risks inherent in thoseactivities.

Systematic transparency in the working of the bankingsector enhances the stability of a financial system. Aregular flow of information keeps market agents awareof the situation and prevents sudden unpredictablereactions. Public disclosure also helps limit thecontagion of a run on a bank by allowing the marketto distinguish between banks that are genuinelyvulnerable from those that are not. If disclosure normsare universally implemented, whereby banks providecomprehensive, accurate, and timely information ontheir financial conditions, performance, risk exposure,etc., a sound and well managed bank stands to benefit,e.g. in accessing the capital market and in developing

Box I.7: Transparency Practices in Commercial Banks

immunity to contagion. However, while piecemealimplementation does not ward off the threat of the‘contagion effect’, systemic stability would beimpaired if adverse information about weak banksbecomes public knowledge all of a sudden. Hence,complete transparency would need to be gradually putin place. Further, operational risks associated withcertain activities cannot be unambiguously quantified,so that disclosures in this respect may not always givea clear picture to the market. Riskiness of a bank’sportfolio must also be viewed in the context of itsrisk appetite and its risk management skills. Theseagain tend to be somewhat subjective in nature sothat an exact quantification is not possible. In suchcases disclosure alone would not lead to transparency.

The Transparency Sub-group of the Basle Committeeon Banking Supervision (BCBS) identified sixqualitative characteristics of the information disclosedby banks that are critical for ensuring that suchdisclosure leads to transparency regarding theoperation of banks. These characteristics includecomprehensiveness, relevance, timeliness, reliability,comparability and materiality. Comprehensiveness ofinformation relates to the scope or span of activitiescovered by such information. The supervisor shouldseek information about the different activitiesundertaken by banks by themselves or throughsubsidiaries and the risks associated with theseactivities. Relevance is the characteristic thatdistinguishes facts, qualitative or quantitative, frominformation and in order to be relevant, informationmust be timely. Reliability of information dependson its factual accuracy and freedom from bias inpresentation. As regards comparability, informationdisclosed must be comparable on two fronts. First, itmust be comparable for the reporting entities, toenable the market mechanism to distinguish between‘good’ and ‘bad’ banks. Second, it must becomparable across time for the supervisor to be ableto gauge the trends in the performance of banks. Theonus for ensuring comparability, therefore, rests to alarge extent with the supervisor. Finally, information

(Contd....)

therefore, vital that internal controls, whichconsist of a wide spectrum of internalinspection and audit, observance of manualsand procedures, submission of control returnsby branches/controlling offices to higher

level offices, visits by controlling officials tothe field level offices, simplification ofdocumentation procedures and efficient inter-off ice communication channels , aresubstantially strengthened. The Reserve Bank

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issued guidelines in June 1999 to banks tostrengthen the internal control system bysetting up Electronic Data Processing auditcel l in computerised branches/off ices .Besides, banks have been advised toconstitute Audit Committees of the Boardsto enable focussed attention by the Boardson internal control systems. It is now timethat such a control system is implemented,even though they necessitate revisions in the‘Operational Manuals’, audit procedures andbetter evaluation of clients. A few banksseem to have already initiated steps in thisdirect ion but these efforts need to beenhanced throughout the banking system.

Information Technology

1.96 Information technology (IT) has wideramifications for an entire gamut of issuesconcerning the banking sector. The growinginternationalisation of banking operationsnecessitates flexibility in financial policies toraise and sustain economic growth. In thiscontext, the switchover from manual operationsto reliable and time-saving operations has tobe rendered possible through appropriateapplication of IT. Secondly, seamlessintegration of applications and systems iscrucial to ensure smooth passage of inter-related transactions over the electronic medium

(...Concld.)

is material if its omission or misstatement couldchange the assessment or decision of a user relyingon that information.

The goal of achieving transparency has become morechallenging in recent years as banks’ activities havecome to include many new areas of financialoperations and become more complex and dynamic.The Narasimham Committee II, recognising theimportance of adequate disclosure norms for theIndian banking sector, noted that there is a need fordisclosure, in a phased manner, of the maturity patternof assets and liabilities, foreign currency assets andliabilities, movements in provision account and NPAs.The Reserve Bank accordingly, instructed banks toprovide information regarding these items, exceptmovements in provisions, in their ‘Notes on Accounts’to their balance sheets with effect from March 31,2000. The Committee also suggested that fulldisclosure would also be required of connectedlending, lending to sensitive sectors and loans givento related companies in the banks’ balance sheets.Banks would be required to publish half-yearlydisclosure statements. There should be a generaldisclosure, providing a summary of performance overa period of time, say 3 years, including the overallperformance, capital adequacy, information on thebank’s risk management systems, the credit rating andany action by the regulator/supervisor. The disclosurestatement should be subject to full external audit and

any falsification should invite criminal procedures.The Reserve Bank agreed with these recommendationsin principle and referred them to the Audit Committeeof the Board of Financial Supervision. With a viewto discouraging false/inaccurate disclosures by banks,the Reserve Bank can impose a penalty, asrecommended by the Committee. The banks hadearlier been advised to disclose CRAR, the level ofnet NPAs, the ratio of net NPAs to net advances,break-up of the provisions made towards NPAs anddepreciation on investments.

Consequent to the implementation of therecommendations of the Narasimham Committee II,the standards of disclosure of Indian commercial bankshave moved closer to the international best practicesincluding the standards set by the BCBS. The processof expansion of the ambit of statutory disclosurecontinues.

References

Bank for International Settlements (1999), ‘Report ofthe Transparency Sub-group of the BasleCommittee on Banking Supervision’, Basle,Switzerland.

Government of India (1998), ‘Report of the Committeeon Banking Sector Reforms’, (Chairman: Shri. M.Narasimham), New Delhi.

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for facilitating greater integration of variousmarkets. Thirdly, developments in IT havecontributed to devising complex financialproducts, such as, derivatives which in turn,has expanded the options for both savers andinvestors, in terms of asset preferences and riskprofiles. Coupled with improvements incommunications infrastructure, this is expectedto give rise to efficiency advantage over aperiod of time and to act as a driving forcefor gradually reducing the digital dividebetween the rural and urban segments of thesociety.

1.97 However, several areas would need to beaddressed before IT can act as a catalyst forenhancing financial development. In the highlyindustrialised countries, access to financialentities is increasingly on an on-line basis withvirtual banking gaining in prominence. InIndia, while the pace of technologicalupgradation would need to be accelerated toattain international standards, large investmentrequirements of the IT sector, particularly inbanking, often acts as an impediment towardsundertaking full-fledged computerisation ofbranches. It would be useful if banks devise aroadmap for networking ‘critical offices’,defined in terms of their volume, diversity andscope of work, so as to ensure coverage of acertain minimum quantum of business, withcustomer service as the main focus in themedium-term. Secondly, under the paymentsystem, claims to various parties are interlinkedwhich create potential risk problems, especiallyif the systems are too ‘open’. As a result,smooth functioning of the payments systemrequires the integration of work processes,communication linkages and integrateddelivery systems with focus on stability,efficiency and security. While adopting therelevant security standards for India, thespecific requirements of the Indian bankingsystem would need to be kept in view. Finally,to enhance further appreciation of IT

applications, banks would need to proactivelyaddress issues that help set up an efficient MISthrough adoption of modern IT methods. Toensure sustained use of IT, institution ofappropriate systems and procedures incommercial banks, and effecting requisite shiftsfrom the written manuals to manuals inelectronic form would be imperative.

Entry of Banks into Insurance Business

1.98 The IRDA Act, 1999, has been enactedagainst the background of the widelyrecognised need for opening up of theinsurance sector. Banks, with their wide branchnetwork, particularly in the rural areas, andwith available manpower, would like to utilizethis opportunity in mobilising sizeable fundsof long-term nature, which could financeinfrastructure projects having long gestationperiods. However, international experienceclearly reveals that insurance business may notbreak-even during the initial years ofoperations. It would, therefore, be necessaryfor banks to have adequate financial strengthto commence this activity. Insurance businessalso requires product designing skills andactuarial expertise, and banks may be requiredto enter into joint ventures with foreigninsurance partners. The entry of banks intoinsurance would, however, raise a number ofother issues of overlap between banking andinsurance business which have been recognizedin India as very critical. These would need tobe addressed as experience is gathered and assituations develop in this overlapping businessactivity (Box I.8).

Financial Innovations

1.99 The financial services industry in Indiahas witnessed a phenomenal growth,diversification, transformation andspecialisation since the initiation of financialsector reforms. The industry has gained indepth and sophistication following the entry

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Insurance may be defined as a ‘social device whereby

a large group of individuals, through a system of

contributions, may reduce or eliminate certain

measurable risks of economic loss common to all

members of the group’. Insurance involves the transfer

of potential losses to an insurance pool. The pool

combines all the potential losses and then transfers

the cost of the predicted losses back to the exposures.

Thus, insurance involves the transfer of loss exposures

of several entities into a common pool, and the

redistribution of the cost of actual losses among the

members of the pool. The intermediary in the process,

which collects premia (payment for the purchase of

insurance) from individual entities with risk exposures

and pays compensation to the ones that actually suffer

the loss insured against, is the insurer. The insurer

is a risk taker who accepts the risks of others and

earns a profit given by the difference between the total

premium collected from the buyers of insurance and

the total payment made on account of compensation

for losses.

Whenever the contract period of an insurance contract

covers a long time, as is the case with life insurance,

premium payments have two components. The first is

the payment for risk coverage and the second goes

towards savings. The saving component of life

insurance results in enhanced competition between the

insurer and other financial intermediaries like banks

offering different savings instruments. It may be noted

here that the combination of risk coverage and savings

is peculiar to life insurance, especially in developing

countries.

The progressive expansion of the insurance sector in

India has certain implications for the banking industry.

The overlaps between banking and insurance business

implies that, on the one hand, the two can be

competitors and hence substitutes of each other, and

on the other hand, they can complement each other

as well.

Box I.8: Insurance and Banking – Issues of Overlap

Banks are the chief purveyors of financial services to

a very large number of individuals and small

borrowers. On account of their geographical reach and

access to customers, banks could be used as channels

for the distribution of insurance products. Since

banking services, insurance selling and fund

management are all interrelated activities and have

inherent synergies, selling of insurance by banks

would be mutually beneficial for banks and insurance

companies. In Europe this synergy between banking

and insurance has given rise to a novel concept called

‘bankassurance’. Also known as ‘Alfinanz’,

bankassurance can be defined as a package of

financial services that can fulfil both banking and

insurance needs at the same time. For instance,

financial services companies offer a whole gamut of

financial products that include banking services, motor

insurance, home finance, life insurance and pensions.

Many European markets have put bankassurance into

practice. In France more than 50 per cent of life

insurance is sold through banks. In the United

Kingdom a large number of banks deal with insurers

as providers of products. In the USA, banks lease

space to insurers and retail products of multiple

insurers. In India too, banks have been offering

personal accident and baggage insurance directly to

their credit card holders as value addition to their

products.

In developed economies, the collaboration between

banking and insurance is brought about by several

means. Banks like the Deutsche Bank and the Credit

Agricole have entered the insurance market by starting

their own insurance companies. Others like SE Banken

(Sweden) and Lloyds Bank have chosen to buy stakes

in already existing insurance companies. A third group

of banks have chosen to swap shares with insurance

companies, while some banks have resorted to mergers

as means of making inroads into the insurance sector.(Contd....)

of new products, including, among others, take-out finance and securitisation.

Take out Finance

1.100. In order to meet long term financing

requirements of infrastructure projects, FIs/banks have been taking recourse to newproducts and in this context, take-out financeis one of the emerging products . TheReserve Bank has issued guidelines to banks

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(...Concld.)

Initiatives in this direction have not been one sided

either. Insurance companies have also sought to

acquire stakes in some banks.

In India the concept of bankassurance has been

recognised with its inclusion in the broader ambit of

universal banking. The Discussion Paper (RBI, 1999)

states that in a very broad sense, ‘Universal Banking’

refers to the combination of commercial banking and

investment banking. In other words, universal banks

refer to those banks that offer a wide range of

financial services, beyond commercial banking and

investment banking, such as insurance.

The guidelines issued by the Reserve Bank in April

2000 permitting banks to enter the insurance market

emphasise the symbiotic aspect in the relationship

between commercial banks and insurance companies.

As per the guidelines, commercial banks, depending

on their satisfying specified eligibility criteria, can

take any of the three routes: i) undertake distribution

of insurance product as an agent of insurance

companies on fee basis, ii) make investments in an

insurance company for providing infrastructure and

services support, or iii) set up a joint venture company

for undertaking insurance business with risk

participation. The Advisory Group on Insurance

Regulation (Chairman: Shri R.Ramakrishnan), in its

Report submitted to the Chairman of the Standing

Committee on International Financial Standards and

Codes in September 2000, noted the possible future

role of co-operative credit institutions in spreading

insurance business in rural areas. Similarly, the

distribution of insurance products was one of the areas

that co-operative banks could undertake to diversify

their portfolios as per the recommendations of the

Task Force to Study the Co-operative Credit System

and Suggest Measures for its Strengthening

(Chairman: Shri J.Capoor).

As per the Reserve Bank guidelines, banks are not

allowed to conduct insurance business departmentally.

Nor can they set up a separately capitalised subsidiary.

There has to be an ‘arms length’ relationship between

the bank and the insurance entity, so that risks inherent

in insurance business do not contaminate the bank’s

balance sheet. Second, the guidelines have made a

distinction between the banks which, by setting up

joint venture companies, can ‘underwrite’ or perform

the principal function and those banks which could

only distribute insurance products, i.e., the agency

function. Third, insurance companies will benefit from

the wide net work of rural branches of commercial

banks in India through the agency route while enabling

banks to earn fee income.

The issue of regulatory overlap also comes to the fore

when banks enter insurance business through setting

up of joint venture companies. The guidelines,

however, seek to eliminate any concern on this

account. Whereas the holding of equity by a promoter

bank in an insurance company or participation in any

form in the insurance business is subject to

compliance with the Government/IRDA regulations,

the authority to grant case-by-case permission to banks

to enter insurance business is vested with the Reserve

Bank.

References

Canals, Jordi (1997), ‘Universal Banking,

International Comparisons and Theoretical

Perspectives’, Oxford University Press, New

York.

Dorfman, Mark S. (1994), ‘Risk Management and

Insurance’, Prentice Hall, New Jersey.

Ranade A. and R. Ahuja (1999), 'Insurance' in India

Development Report: 1999-2000, Indira Gandhi

Institute of Development Research, Mumbai.

Reddy, Y.V. (1999), ‘Universal Banking and Beyond’,

in Monetary and Financial Sector Reforms in

India: A Central Banker’s Perspective, UBSPD,

New Delhi.

Reserve Bank of India (2000), ‘Monetary and Credit

Policy for the Year 2000-2001’, Reserve Bank of

India, Mumbai.

Reserve Bank of India (1999), ‘Harmonising the Role

and Operations of Development Financial

Institutions and Banks’, A Discussion Paper,Reserve Bank of India, Mumbai.

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and FIs on take-out finance. The FI/bankthat finances infrastructure projects couldhave an arrangement with any FI fortransferring to the latter the outstandings inrespect of such financing in their books ona pre-determined basis. Take-out financewould be of help to banks in ALM, sincethe financing of infrastructure is long-termin nature against their predominantly short-term resource base. Take-out finance couldbe either unconditional of conditional. Thetake-out-finance products involve threeparties viz., the project company, taking overinstitution and the lending banks/FIs. Banks,however, would have to assign the riskweights for calculat ion of CRAR andapplication of other prudential norms, asadvised by the Reserve Bank.

Securitisation

1.101. A prominent development ininternational finance in recent years has beenthe growing importance of securitisation.Securitisation can be best described asstructured financing in which assets, having astable and predictable stream of cash payments,can be monetised through a public offering orprivate placement of securities in the capitalmarkets and which are secured by, anddependent in part upon, the assets securitised

and their related cash flows. In effect,securitisation is a combination of traditionalsecured financing and securities offering,involving the issuance of asset-backedsecurities. Virtually every asset that has apredictable stream of cash payments could besecuritised (Box I.9).

1.102 The Reserve Bank, considering theevolving situation in this area and the needfor reducing risks for the banks, appointed anin-house Working Group on AssetSecuritisation (Chairman: Shri V.S.N. Murty)in June 1999 to examine the applicability ofsecuritisation to the Indian financial system.The Group, in its Report submitted inDecember 1999, categorised therecommendations into short-term, medium-termand long-term, with a definite time frame forimplementation in each category. It suggestedthat securitisation should be appropriatelydefined to lend uniformity of approach andrestrict the benefits provided by law/regulationfor genuine securitisation transactions. Therecommendations also include rationalisation/reduction of stamp duties, inclusion ofsecuritised instruments in Securities Contracts(Regulation) Act, 1956, removal of prohibitionon investment in mortgage-backed securities bymutual fund schemes, tax neutrality of SPV,etc. As medium-term measures, the Working

Securitisation involves the process of pooling and re-packaging of homogeneous illiquid loans intomarketable securities and distributing to a broad rangeof investors through capital markets. In the process,the lending institution’s assets are removed from itsbalance sheet and are instead funded by investorsthrough a negotiable financial instrument. Increasedpressure on operating efficiency, market niches,competitive advantages and capital strength provideimpetus for change. Securitisation has emerged as oneof the solutions to these challenges.

Although relatively new in European and other

Box I.9: Securitisation

countries, asset securitisation as a structured financingtechnique had its genesis in the US in the late’seventies. Securitisation evolved rapidly throughoutthe ’eighties and ’nineties to become one of thedominant means of capital formation. As of 1995,securitisation accounted for more than US $ 450billion of financing per year and more than US $ 2trillion in financing outstandings in the US.

The core concept of securitisation pertains to thesegregation of the assets to be securitised from thecredit risk of entities involved in financing, except,

(Contd....)

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(...Concld.)

in some instances, for FIs, which provide creditenhancement for the securitised assets. Assets to besecuritised are transferred by the asset owner (theoriginator or transferor) to a special purpose vehicle(SPV) as the asset purchaser. The SPV may be acorporation, trust or other independent legal entity.The SPV issues securities to public or privateinvestors in the capital markets, which are backed (i.e.secured) by the cash payment streams generated bythe assets securitised and by the assets themselves.The net proceeds received from the issuance of thesecurities are used to pay the transferor for the assetsacquired by the SPV.

The principal advantage of securitisation is theseparation of the transferor’s credit risk from that ofthe SPV. By segregating its credit risk insecuritisation, a transferor can access the capitalmarket at a lower cost of financing because (a)significant differential exists between the stream ofcash payments that can be generated by the assetssegregated and the cost of securitisation, and (b) thecredit of securitisation is based primarily on the creditof the source of the cash payment streams generatedby the assets segregated and on credit enhancement,if any. In securitisation, investors focus mainly on thecredit and liquidity of the assets securitised and onthe structure of the financing - not on the transferor’scredit risk.

Assets that have been securitised in structuredfinancings in the US include, among others,mortgages, automobiles, aircraft, equipment andmunicipal leases, credit card receivables, hospital,retail and trade receivables, real estate, purchasecontract for natural resource assets such as oil, gasand timber, student and home equity loans.

The principal disadvantage of securitisation is itscomplexity. Securitisation, typically being‘transaction-specific’, is more costly to structure andimplement than other more traditional forms ofsecured financing. Therefore, securitisation is anappropriate alternative to traditional secured financingsonly if the securitisation costs are lower than the costof funds accessed in the public or private capitalmarkets or if other material benefits are realised fromthe securitisation deal.

Most securitisation deals in India have been related totransport sector financing, while there have been some

towards housing receivables. In India, securitisationdates back to 1991 when Citibank securitised auto loansand placed a paper with GIC Mutual Fund. Since then,a variety of deals have been undertaken. According tosome estimates, 35 per cent of all securitisation dealsbetween 1992 and 1998 were related to hire purchasereceivables of trucks and the rest towards other auto/transport segment receivables. These apart, SBI Capsstructured an innovative deal in 1994-95, where a poolof future cash flows of high value customers ofRajasthan State Industrial and Development Corporationwas securitised. The recent securitisation deal of Larsenand Toubro has opened a new vista for financing powerprojects. National Housing Bank (NHB) has also beenmaking efforts to structure the pilot issue of mortgagebacked securities (MBS) within the existing legal, fiscaland regulatory framework.

In October 1999, the Parliament was presented withamendment to the Securities Contracts (Regulation)Act that seeks to redefine ‘securities’. The amendeddefinition is broad and covers securitisationinstruments also. The results of the amendment, whenfinally adopted, is expected to bring securitisationpublic offers under the regulation of the securitiesregulatory body.

In future, financial entities will be judged more bythe informal strength and capital base rather than bythe external support from the central bank or thegovernment. Market penetration of financialinstitutions in the area of loan origination in futurewill be determined more by the volume of loansoriginated during a period than by the amount of loansowned at a particular point of time. As the structureof the financial system evolves over time, it isexpected that securitisation will play a much moreimportant role in the future.

References

Glennie. D.G., E.C.de Bouter and R.D.Luke (1998),‘Securitisation’, Kluwer Law International,London.

Kothari, V. (1999), ‘Securitisation: The FinancialInstrument of the New Millennium’, Academy ofFinancial Services, Calcutta.

Reddy, Y.V. (1999), ‘Securitisation in India: NextSteps’, RBI Bulletin, pp.693-701.

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Group suggested the increased flow ofinformation through credit bureaus,standardisation of documents, improvement inthe quality of assets, upgradation of computerskills and exploring the possibilities ofsecuritising NPAs. As a long-term measure, theGroup underscored the need to developinsurance/guarantee institutions to give comfortto investors, especially in infrastructure/

mortgage sectors. Adequate disclosure normshave also been suggested to facilitate informeddecision-making by investors. The Report alsosuggested that the Government might considerbringing out an umbrella legislation coveringall aspects of securitisation. The Reserve Bankhas set up an Implementation Committee forsuggesting the framework for giving effect tothe above recommendations.